Analyst speculates on Reynolds spin-off
WINSTON-SALEM, N.C. — Reynolds American Inc. has a lot of pivotal proposals on its plate if analyst and industry speculation is accurate, according to the Winston-Salem Journal.
Talk has swirled for months about a potential $18 billion to $29 billion purchase of rival Lorillard Inc. and/or Reynolds being taken over by its largest shareholder, British American Tobacco Ltd., potentially as soon as July 30.
Still, a leading analyst tossed out last week another potential move for Reynolds – selling its Santa Fe Natural Tobacco Co. subsidiary or spinning it out as a publicly traded company.
Santa Fe makes Natural American Spirit cigarettes, which are marketed as being additive-free. Although it is based in Santa Fe, N.M., the subsidiary has a large production operation in Oxford.
Wells Fargo Securities analyst Bonnie Herzog calls Santa Fe “an unappreciated asset” considering Natural American has become a Top10- U.S. brand with a 1.5 percent market share since Reynolds bought the company for $340 million in January 2002.
The last time Reynolds sold or spun out a subsidiary was in March 2011 when it sold Lane Ltd. to Scandinavian Tobacco Group A/S for $205 million. Lane specialized in roll-your-own tobacco and pipe tobacco.
Herzog is perhaps the loudest voice in projecting a Reynolds purchase of Lorillard, reiterating she believes there is a 90 percent chance it will happen.
Herzog said Santa Fe could be worth as much as $6 billion, or about 166 percent more than what Reynolds paid for it.
Herzog based her projection on “Natural American’s growing market share, superior volume growth, super premium pricing and above industry profitability (49 percent operating margin).”
She said Santa Fe could be worth $11 a share compared with a current industry evaluation of $7 a share as a Reynolds subsidiary.
“Given this potential opportunity for Reynolds to unlock value, which we believe is not being fully recognized by investors, we raise our valuation range by $4 to $65” – the midpoint of Herzog’s share price forecast range.
Reynolds spokesman David Howard said the company does not comment on rumors or speculation.
Herzog said Santa Fe has significant international distribution potential, such as in Germany, Japan and Switzerland, where there is preference for natural/organic tobacco products, along with eco-consciousness and sustainable manufacturing.
Herzog said Natural American also could carve out a niche in the electronic and vapor cigarette markets. R.J. Reynolds Tobacco Co. launches national distribution of its Vuse e-cig brand Monday. It is ramping up Vuse production at its Tobaccoville plant.
Natural American’s 1.5 percent market share is up from 1.3 percent a year ago. Reynolds said 800 million Natural American cigarette sticks were made during the quarter, up 10.7 percent year over year.
By comparison, Camel is the No. 3 U.S. brand at 10 percent, while Pall Mall is fourth at 9.5 percent. The remaining Reynolds cigarette brands have a combined 7.2 percent market share. Those brands include Kool, Winston, Salem, Doral, Misty and Capri.
Herzog said it makes sense to sell or spin off Santa Fe “whether or not Reynolds and Lorillard combine.”
She said the proceeds from such a sale or spinoff could be used to pay down potentially billions of dollars in debt that Reynolds could take on as part of buying Lorillard.
“Given Santa Fe is a wholly-owned subsidiary, with its own headquarters, manufacturing facility and separate sales force, we believe it would be easier to unlock value with a spin/sale,” Herzog said.
Santa Fe had annual sales of about $94 million and net income of $27 million when it was bought by Reynolds.
By comparison, its first-quarter sales for fiscal 2014 were $135 million, up 17.4 percent from a year ago, while its operating income was $65 million, up 20.4 percent year over year.
Santa Fe accomplished that growth spurt while walking a tightrope of expanding nationally while remaining marketed as a niche product option.
Stephen Pope, managing partner of Spotlight Ideas in London, said Reynolds’ interest in selling or spinning off Santa Fe is likely to be intertwined with the interest of BAT because of its current 42 percent ownership stake in Reynolds.
“One has to question how far-sighted or patient is the Reynolds board, or the shareholders that have a high level of influence, namely BAT,” Pope said.
“If Reynolds were to merge with Lorillard, it is suggested that BAT would have to seek borrowed funds if it were to at least re-establish a 40 percent shareholding in the new company.
“If it sees greater potential in such a deal, as against developing the unvalued potential in Santa Fe, it not reasonable to spin off the undervalued entity and seek the funding into an area where there are more globally lucrative gains to be enjoyed,” Pope said.
Pope said Reynolds’ board also could make the point that “a well-reasoned strategic plan could exploit the hidden potential in North American Spirit.”
“As such, I think BAT and Reynolds would best advised to hold onto the potential diamond in the rough that is Santa Fe and let BAT pump in the capital to consummate the deal with Lorillard.”