British American Tobacco (BAT) completed its buyout of the 57.8% of Reynolds American Inc. (Reynolds) that it did not already own on July 25, 2017, for $49.4 billion in cash and stock for full control of the firm. Including assumed debt of $12.6 billion, the enterprise value of the deal totaled $62 billion. The deal took place at a time when both firms were struggling to gain market share and to find acceptable alternatives to cigarettes. BAT agreed to pay $29.44 in cash and 0.5260 BAT shares for each Reynolds share outstanding. The purchase price represented a 26% premium over Reynoldss share price on October 20, 2016, the day before BATs first offer was made public. Reynolds had rejected the initial offer made in November 2016, although the two parties continued to negotiate. The merger gives BAT products direct access to the US cigarette market. The deal values 100% eynolds at about $85.5 billion ($49.4 billion/0.578) and marks the return of BAT to the highly regulated US cigarette market after a 12-year hiatus. BAT exited the United States in 2004 when it merged its subsidiary Brown & Williamson with R.J. Reynolds to form Reynolds American. BATs share price dropped after the announcement of the Reynolds takeover. Investors fretted about the total purchase price, the debt required to finance the cash portion of the deal, and Reynolds debt assumed by BAT. BAT anticipates annual pretax cost savings of at least $400 million within 2 years after closing. Failure to realize these savings in a timely manner can significantly impact the PV of synergy. Also, it is unclear if the full cost of realizing these synergies has been deducted from the projected savings. The outlook for the industry remains problematic. The merger was completed one day after the World Health Organization released a report on tobacco companies efforts to weaken anti-smoking laws worldwide. The UK public health charity Action on Smoking and Health (ASH) worried publicly that the creation of an even bigger tobacco firm would feed a growing tobacco epidemic in poor countries.

TABLE 8.5

Reynolds American valuation data 12-month trailing P/E ratio 12-month forward P/E ratio Col. 1 Col. 2 Primary competitors Philip Morris International 24.27 22.83 Imperial Brands 20.23 19.40 Swedish Match AB 17.98 16.05 Altria Group 18.35 17.78 Scandinavian Tobacco Company 21.28 20.64 Reynolds American (Dollars Per Share) 4.26 4.64 P/E, Price-to-earnings

Today, tobacco companies remain profitable, having weathered the lawsuits and regulations of the 1990s and by expanding sales in emerging countries. They seem to presume that growth in these markets will continue for the foreseeable future and that the attrition among smokers in the United States will slow to a crawl.

One way of determining if BAT overpaid for Reynolds is to estimate Reynoldss standalone value plus the PV of anticipated synergy. This estimate represents the maximum amount BAT should pay for Reynolds and still be able to earn its cost of capital. Any payment in excess of the maximum purchase price means that BAT is destroying shareholder value by, in effect, transferring more value than would be created to the target firm shareholders.

Table 8.5 provides data enabling an analyst to value Reynolds on a standalone basis using the comparable company method. The choice of valuation multiples is subjective in that it is unclear which best mirrors the standalone value of Reynolds. Abnormally low interest rates at the time of the merger announcement could have resulted in artificially high valuation multiples. Also, the competitors selected vary in size, profitability, and growth rates.

Discussion questions

1. Based on the information provided in Table 8.5, what do you believe is a reasonable standalone value for Reynolds? (Hint: Use the comparable-company valuation method to derive a single point estimate of standalone value.) Show your work.

2. Does your answer to question 1 include a purchase price premium?

3. What are the key limitations of the comparable-companies valuation methodology?

4. In estimating the value of anticipated cost savings, should an analyst use Reynolds marginal tax rate of 40% or its effective tax rate of 22%? Explain your answer.

5. What is the 2018 after-tax present value of the $400 million pretax annual cost savings expected to start in 2019? Assume the appropriate cost of capital is 10% and that the savings will continue in perpetuity. Show your work.

6. What are the key assumptions underlying the valuation of Reynolds? Include both the valuation of Reynolds as a standalone business and synergy value.

7. What is the maximum amount BAT could have paid for Reynolds and still earned its cost of capital? Recall that BAT acquired the remaining 57.8% of Reynolds that it did not already own. Did BAT overpay for Reynolds, based on the information given in the case? Explain your answer. (Hint: Use your answers to questions 1 and 5.)