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Philip Morris International Faces a New Threat From British American

By Dan Caplinger – Oct 24, 2016 at 11:13AM

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Philip Morris will have to pay close attention to a proposed full takeover of Reynolds American from its global tobacco rival.

Tobacco giant Philip Morris International (PM 1.56%) has faced plenty of threats lately, including the strength of the U.S. dollar and increased regulation from governments across the globe. Yet late last week, Philip Morris rival British American Tobacco (BTI 2.00%) made an aggressive move that could have implications for the entire global industry, and investors in Philip Morris need to assess British American's bid to take full control of Reynolds American (RAI) to determine how a merger could affect its recent strength in international markets.

Reduced-risk products could be a major motivation for British American Tobacco's proposed merger. Image source: Philip Morris International.

What British American is offering

The deal that British American involves paying a combination of cash and stock to Reynolds American shareholders in order to take control of the 58% of Reynolds American shares that it doesn't already own. The bid as it's currently proposed would pay Reynolds American shareholders 0.5502 shares of British American for every Reynolds share they own, along with an additional $24.13 per share in cash. The total value of the bid is $56.50 per share, which represents about a 20% premium above where Reynolds stock closed last Thursday.

In British American's view, the combination would have substantial benefits for both companies. The merger would create the world's largest listed tobacco company by sales and operating profit, and it would also reunite key brands such as Newport under one corporate entity worldwide. Investors in the combined entity would get one-stop exposure both to the U.S. tobacco market as well as high-growth emerging markets across South America, Africa, the Middle East, and Asia. British American believes the move would add to its earnings within the first full year, would add to dividends per share paid, and would open up new opportunities for growth.

What's really at stake for British American

Yet even with those clear advantages, some investors who follow the tobacco industry believe that British American's true motivation lies outside of the realm of traditional tobacco products entirely. British American said in its offer that it believes that the two companies' combined next-generation products and research and development capabilities could help it "deliver a world-class pipeline of vapor and tobacco heating products across all the fastest growing [next-generation product} markets globally."

Indeed, Philip Morris International has already made it clear how serious it is about pursuing reduced-risk products as a potential avenue for growth. The company has rolled out its iQOS technology and the HeatSticks tobacco products that iQOS uses in several test markets and intends to boost that number to 20 markets by the end of the year. Early results have been extremely encouraging, with Philip Morris having reported in its third-quarter financials that iQOS market share in Japan rose to 3.5% during the third quarter. That might not seem like much, but given how recently Philip Morris started its iQOS rollout there and given some past constraints on production, the speed of the ramp-up is impressive.

Philip Morris has also identified how important it is to build up positive momentum with iQOS. In late September, the company opened a new facility in Italy dedicated toward the large-scale production of two of its reduced-risk products. By boosting supply for iQOS, Philip Morris will be better able to meet the strong demand for the products as they roll out across the globe. As CEO Andre Calantzopoulos noted, the goal is to "ensure that non-combustible products ultimately replace cigarettes to the benefit of adult smokers, society, our company, and our shareholders."

At first glance, Reynolds might not seem to be a major threat. In its most recent quarter, the U.S. tobacco company said that it was looking to keep building up its VUSE line of vapor products, but Reynolds doesn't separate out its VUSE sales, and the "all other" line on its income statement showed just $54 million in revenue, or less than 2% of Reynolds' total sales. Yet Reynolds CEO Susan Cameron has high hopes for the new VUSE VIBE high-volume cartridge product, which she said will "hit the sweet spot that adult vapers tell us they want."

Philip Morris investors need to watch British American Tobacco's strategic moves closely. Even as iQOS starts to take off, Philip Morris will want to make sure that it can match up well against its archrival, especially if the trend toward consolidation makes reuniting the American and global tobacco markets a more attractive option for the company.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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