Tobacco Deal: Smoke Signals Lead To Smog

On Monday, BAT Industries, the British tobacco and insurance group that commands 16.5 per cent of the US cigarette market, briefed analysts on the $368bn (223bn) US tobacco settlement announced last week.

Yesterday, shares in the company closed down 3 1 /2p at 564p - evidence that no-one knows quite how to value BAT in the wake of the deal.

For investors in BAT, three questions are key. What will be the impact on profits if the deal goes through?

Will it affect the prospects of BAT's tobacco businesses elsewhere, and what are the chances that the long-debated demerger of BAT's financial services businesses will at last be carried through? No final answers to these questions can be given unless the deal between the US industry and 40 states' attorneys-general is finally signed.

 

For that to happen, myriad pressure groups must be corralled, and the US Congress persuaded to pass an enabling bill. It will not be easy, particularly since critics will claim the deal lets the industry off too easily.

If it can be achieved, timing is important. Under the terms agreed, the industry will pay $10bn into a special fund to treat and compensate sick smokers on the day the deal is signed. The share of that total payable by Brown & Williamson, BAT's US subsidiary, would be $1.74bn. If Congress were to approve the deal before its year-end on December 31, BAT would presumably be obliged to take that charge against the profits of B&W for the current year. Given that BZW, the company's broker, is forecasting pre-tax profits for the group of 2.68bn this year, the impact would be substantial - although tax deductible.

Equally significant, payment of the industry's Year 1 installment of $8.5bn would fall due on December 31 1998. If completion of the deal were delayed into 1998, however, the Year 1 installment would not be payable until December 1999.

Payments under the installment arrangement will be made by cigarette makers according to market share. As the table shows, if B&W were to maintain its current 16.5 per cent share, its contributions would rise in steps to almost $2.5bn a year.

But that cash would not come from profits. Under the terms agreed, the industry will finance these payments entirely from an increase of 50 cents a packet in the price of cigarettes. In effect, the tobacco barons will become tax collectors for state authorities, who hope to escape the opprobrium resulting from the price rise.

Nothing cuts cigarette consumption like higher prices, but in the US, such a tax rise would be unprecedented. The negotiators estimated that demand would fall by about 11 per cent, but who can say? Tobacco taxes in the US range from 3 cents a pack in Kentucky - which has the highest smoking rate at some 27.8 per cent of adults - to 82.5 cents in Washington State - which ranks 45th, with a rate of 21.2 per cent.

Martin Hawkins, of Grieg Middleton, says any fall in numbers smoking is likely to be accompanied by a tendency to switch to cheaper brands and by price competition among premium products.

Even if a shift down-market gave B&W, owner of the Lucky Strike and State Express 555 brands, a larger share, profit margins are likely to be squeezed.

Any decline in demand would be exacerbated by other conditions designed to cut the number of young smokers, and by enlarged health warnings on the front of packs.

What does all that mean for the value of BAT? At yesterday's close, the group is capitalised at about 17.5bn.

Nyren Scott Malden, of BZW, says the main settlement elements would reduce BAT's value by 21p a share, with a further 16p reduction for a fall in B&W profits. Add a 15 per cent discount for lawsuits outside the US, including the UK, and the company should still be worth at least 640p a share, he says. Tony Silverman, of NatWest Securities, puts its value at just 609p a share. ''I don't believe there is break-up value there,'' he says. On that basis, the group is already valued close to the sum of its parts. One broker estimates BAT's financial services businesses, embracing Eagle Star, Allied Dunbar and Threadneedle, could be worth 10.6bn.

Associates would bolster that total by 2.2bn, leaving a valuation of 4.7bn for B&W and the UK-based, export-oriented tobacco operation serving the rest of the world. Some analysts argue that BAT needs a sizeable partner for its financial services business - both to achieve operational economies of scale and to make demerger worthwhile. Talks last year with Commercial Union came to nothing.

Valuations of financial services businesses have since risen sharply. Even if the cloud of tobacco litigation is lifted, BAT's best hope of kindling investor enthusiasm remains demerger - but the task may now be harder than it was.