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One big tobacco deal is enough

Market caution around the mooted US$200b Philip Morris-Altria tie-up suggests that copycat dealmaking is unlikely to follow

SOMETHING must be done. That's often the response to a big deal like the planned US$200 billion union between cigarette makers Philip Morris International Inc and Altria Group Inc. For the duo's competitors overseas, the temptation will be to indulge in some copycat dealmaking. In reality, bulking up would be a bad way to address their strategic challenges.

There is some commercial logic in the tie-up of the two US tobacco giants given their complementary businesses: each has sought to expand into alternative tobacco products in different ways. Altria took a minority stake in vaping group JUUL Labs Inc, while Philip Morris developed its IQOS system for heating rather than burning tobacco. Altria is focused solely on the US, Philip Morris on the rest of the world.

Cost savings may be limited, but integration should be simple. Together, the pair can cross-sell some of their products in each other's markets. By definition, there is no antitrust hurdle. It is harder to make comparable arguments for any combination involving British American Tobacco Plc, Japan Tobacco Inc and Imperial Brands Plc.

For BAT, which has a market value of £65 billion (S$110 billion), the appeal of a takeover of domestic rival Imperial, capitalised at £20 billion, would merely be opportunistic and financial. Imperial's shares have a dividend yield of more than 10 per cent, a sign investors expect the annual payout will decline. The company's net debt is forecast to fall to below three times Ebitda this year, whereas BAT's net borrowings are expected to touch 3.6 times the same measure of profit. An all-share deal would therefore slightly improve BAT's leverage and generate some cost savings from cutting duplicate functions.

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But such a transaction wouldn't transform BAT's position in tobacco alternatives. A slightly stronger financial position would be a modest benefit set beside the distraction of the integration and the likely need to make disposals to assuage antitrust concerns.

Japan Tobacco, worth US$42 billion, is substantially less geared, so an all-paper deal would achieve more in terms of reducing indebtedness. But it, too, could pre-sent antitrust issues for BAT. The presence of the Japanese government as lead shareholder would also be a complicating factor. It's true both Imperial and Japan Tobacco are developing less risky tobacco products. But so, too, is BAT.

One idea is that Japan Tobacco and BAT carve up Imperial's geographical empire between them. The main outcome would, however, be to expand in conventional cigarettes. The wildcard buyer is Beijing-based China National Tobacco Corp.

The only compelling M&A transaction would be one that enabled these companies to redeploy large parts of their manufacturing, marketing and distribution assets into products that weren't just less harmful, but actually harmless. No banker has come up with that yet.

The combination of Philip Morris and Altria may nudge others elsewhere towards M&A at some point. For now, the market's caution around the mooted US tie-up suggests the effect is going to be marginal. Don't hold your breath for more deals. BLOOMBERG