RAI Reynolds American (delisted)

By Ben Dummett 

LONDON--Britain's vote to exit from the European Union has been a key factor behind British American Tobacco's decision to initiate a $47 billion takeover bid of Reynolds American Inc., despite the general slowdown in U.K. deal-making.

A tie-up between the two tobacco giants has long been rumored because of BAT's existing 42% stake in its U.S. rival. But BAT's decision to approach Reynolds' board is in part a reaction to its rising stock price, the falling pound and cheap debt which has made it easier to finance the deal in the aftermath of the Brexit vote.

The move comes as the year-over-year value of U.K. outbound mergers and acquisitions activity fell 63% to $23.8 billion since the Brexit vote on June 23, according to Dealogic. U.K. multinationals are financially well positioned among British companies to grow through acquisitions amid an uncertain domestic economic environment created by the vote.

The British pound has sold off sharply against the euro, U.S. dollar and other currencies since the vote. That has hurt the profits of many small and midsize British-based companies that generate revenue in the domestic currency but rely on imports for supplies. The currency weakness, though, has had the opposite effect on BAT and other U.K. multinationals, which generate a big part of their income abroad in foreign currencies.

That trend is evident in BAT's stock price, which had gained more than 12% since Brexit and before it announced its offer Friday. Further, Reynolds' stock price had fallen about 7.5% over the same period of time, bringing the valuations of each more in line with historic norms, people familiar with BAT's thinking said.

Ahead of the offer announcement, BAT traded at about 19.5 times projected 2016 earnings, compared with just over 20 times for Reynolds.

Cheap debt financing is also a key driver behind BAT's move. BAT is offering cash and BAT stock worth $56.50 a share for the rest of the company, representing a roughly 20% premium to Reynolds's closing share price Thursday.

That will require BAT to pay about $20 billion in cash toward financing the transaction. Still, by striking now, BAT benefits from the availability of low interest-rate debt.

In a global economic environment where interest rates remain under pressure, BAT will be able to take advantage of relatively low bond yields still prevalent in the U.S. where it expects to raise most of the financing, according to a person familiar with the transaction.

"Debt is cheap so actually the cost of capital is very reasonable," said another person familiar with BAT's offer.

BAT's shares were trading up 2.6% in midafternoon trade in London, a sign that investors support the deal's strategic merits. Assuming a transaction proceeds, it would create the world's biggest publicly listed tobacco company measured by operating profits. The combined company's operations would stretch across the U.S., South America, Africa, the Middle East, and Asia where cigarette makers are betting population growth and rising disposable income in these regions will offset the health warnings and antismoking regulation in Europe and North America, to continue to boost cigarette sales overall.

BAT said it would drop its takeover pursuit of Reynolds if the U.S. company opposes a friendly transaction. But BAT signaled Friday that support from its own shareholders for the deal gives it an advantage in bringing Reynolds to the negotiating table because of the companies' shared investor base. Among the top five shareholders of BAT and Reynolds three are the same, including, BlackRock Investment Management, Vanguard Group and Capital Research & Management Co., according to FactSet

"There is substantial overlap in the shareholder registers of our two companies," BAT Chief Executive Nicandro Durante, noted in his letter to Reynolds' board of director outlining the deal merits.

Saabira Chaudhuri contributed to this article

Write to Ben Dummett at ben.dummett@wsj.com

(END) Dow Jones Newswires

October 21, 2016 09:58 ET (13:58 GMT)

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