Maybe Reynolds American should have held out for more before agreeing to a merger with British American Tobacco (NYSE:BTI). The $50 billion deal, in which the U.K.-based tobacco company acquired the 58% of its U.S. counterpart that it didn't already own, has given British American a big tax break.
More specifically, it was the recently passed tax reform law that helped give the cigarette giant a big break. But when the two companies were negotiating the deal, the potential ramifications of the tax changes were seen as a major benefit of the merger -- so Reynolds shareholders arguably should have wrung more money out of BAT for their shares.
BAT's CEO Nicandro Durante said at the time that the tax proposals played no part in how the deal worked out: "This is the right deal at the right time for both sides of shareholders." Although you can't base negotiations on potential outcomes, now that tax reform has become law, the U.K. tobacco company is getting a big break -- raising the question of whether Reynolds shareholders should have gotten more money in exchange for their stock.
Taxing closer to home
Whereas U.S. law had corporations paying a 35% tax rate regardless of where their income was earned, now it will be based on the country in which it was earned. While they may still pay 35% in the U.S., companies earning income in Ireland, for example, will only pay the 12.5% rate imposed on corporations there, while those in Canada will pay that country's 15% rate.
The change is meant to encourage companies that have parked some $2.6 trillion in profits overseas to repatriate those profits. (Apple, which reportedly had the largest stash, recently announced it would pay $38 billion in one-time foreign taxes, but invest $350 billion in the U.S. over the next five years as a result of tax reform.)
In a statement following the new law's adoption, British American said it had originally expected its tax rate would be around 30%. But the new law would revalue its deferred tax balances related to its acquisition of Reynolds American, so its tax rate will fall to the high 20% range: "All other things being equal, this would result in a benefit of 6% to full year 2018 earnings per share, supporting our commitment to high single digit earnings growth and increased investment in the roll out of Next Generation Products."
Analysts at Jefferies estimate this will be a windfall of around $541 million for BAT, at least a portion of which could have gone to Reynolds shareholders had management negotiated harder. At least it may now serve to level the playing field with Philip Morris International (NYSE:PM).
Tackling the smoke-free future
British American Tobacco has been behind its global rival in the area of reduced-risk products. Philip Morris is seeing strong market penetration overseas with its iQOS heat-not-burn electronic cigarette, especially in Japan, where shipments of reduced-risk product units surpassed those of traditional cigarettes for the first time in the third quarter.
It's also ahead here in the U.S., where the Food and Drug Administration is considering Philip Morris' applications to market the iQOS device and to earn a reduced-risk label. FDA approval should give it a big competitive advantage. British American has said it plans to submit its own marketing application to the regulatory agency this year.
The tax benefit could help the U.K. tobacco company invest more, in the U.S. market and elsewhere, to make up for its lagging performance. Both companies have a big hurdle to get over: Competitor Juul Labs has won some 40% of the market with its JUUL device, an e-cig that uses a completely different type of technology than heat-not-burn.
British American has already invested $1 billion in a portfolio of reduced-risk products, from the competing heat-not-burn technology of its glo iFuse to various vapor products like Vuse, a leading (though fading) electronic cigarette.
Competition is fierce as the industry grapples with the changes occurring worldwide. BAT's acquisition of Reynolds created a truly global company with a broad spectrum of traditional and reduced-risk products. Benefits from U.S. tax reform should make the tobacco giant a more competitive player.