How Would A Reynolds American-Lorillard Deal Affect British American Tobacco plc’s Profits?

British American Tobacco (LSE: BATS) (NYSE: BTI.US) shares put on a spurt last week, after reports emerged that Camel owner Reynolds American, in which BAT has a 42% stake, could be nearing a deal to acquire the pair’s smaller competitor, Lorillard.

british american tobacco / imperial tobaccoA deal of this nature could help strengthen BAT’s earnings from the mature North American market, by combining top US brands such as Newport, Camel, Pall Mall and Natural American Spirit under one roof — paving the way for further efficiency gains.

I’ve been taking a look at how this deal might affect BAT’s profits, if it goes ahead.

£250m boost?

In 2013, British American’s share of Reynolds’ post-tax profits was £441m — just over 10% of the firm’s total post-tax profits of £4,199m.

Lorillard is the third-largest cigarette manufacturer in the US, with a 14.9% market share, and last year reported post-tax income of $1,180m, or around £708m. Although reports suggest that Lorillard would be forced to divest some of its brands if it was acquired by Reynolds American, 85% of Lorillard’s sales come from just one brand, Newport, which would be a core part of any deal, protecting most of Lorillard’s earnings potential.

My rough calculations suggest that if Reynolds acquired Lorillard, BAT’s share of Reynolds’ earnings could rise by as much as £250m, which would be a material increase for BAT, and should help fund further dividend growth.

Electronic cigarette giant?

In 2012, Lorillard acquired the leading US electronic cigarette brands, blu eCIGs, which has a 47% market share in the US. blu sales rose from $61m in 2012 to $226m in 2013, and Lorillard has recently introduced blu to the UK, via leading UK brand SKYCIG, which it also owns.

In addition, Reynolds American owns the VUSE e-cigarette brand, and BAT launched the Vype brand in 2013: the market for e-cigarettes is growing fast, and by using their marketing muscle and taking advantage of the current lack of regulation for these products, I believe BAT and Reynolds could grow sales very fast in mature western markets, where tobacco sales are falling.

Is BAT a buy?

I wouldn’t buy BAT shares in expectation of this deal, but for existing British American shareholders, I think it’s good news. If a deal does go ahead, I would expect it to generate additional free cash flow for BAT over the medium term, which could be used to fund dividend growth and share buybacks.

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Roland does not own shares in any of the companies mentioned in this article.