Should you buy British American Tobacco plc after its proposed merger with Reynolds?

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British American Tobacco cigarette making equipment

British American Tobacco(LSE: BATS) has announced a proposal to merge with Reynolds to become the largest tobacco company by net turnover in the world. British American Tobacco already owns 42.2% of Reynolds and the deal would see it acquire the remaining 57.8% for an amount equal to $56.50 per share. This values Reynolds at a 20% premium to yesterday's closing price.

The deal will be funded partly through cash of $24.13 per share and partly through equity of 0.5502 shares in British American Tobacco per share. As always, there's no certainty that the merger will proceed since it's in its very early stages. The board of Reynolds has only very recently been notified of the news, but British American Tobacco must go public due to US securities regulations.

As with the vast majority of mergers, the deal will create synergies and should allow the combined group to become more efficient, as well as having a size and scale advantage over its rivals. It will provide greater financial firepower through which to develop more innovative products such as e-cigarettes as tobacco users become increasingly health conscious. As such, it seems to be a sound long-term move that should be earnings accretive in the first full year.

And the other news?

The deal perhaps ... no, definitely... overshadows British American Tobacco's third quarter trading update that was also released today. But it shouldn't. The update shows that the company is making excellent progress. Unlike many of its sector peers, British American Tobacco has been able to grow tobacco volumes in the first nine months of the year by 2.2%. This shows that its pricing and growth strategy is working extremely well, which should provide a sound platform for future growth.

Furthermore, British American Tobacco grew revenue by 8.1% at constant exchange rates, with sales up 10.2% on a reported basis thanks to weaker sterling. The company should gain further benefits from that weaker sterling since the pound seems likely to endure a difficult medium-term outlook.

The tobacco giant is forecast to grow its bottom line by 17% in the current year and by a further 13% next year. This puts it on a price-to-earnings growth (PEG) ratio of just 1.3. For a major global tobacco company, this is excellent value for money since the stability and resilience of its earnings profile is high. British American Tobacco also offers a yield of 3.3%, which is covered a healthy 1.5 times by profit.

As such, British American Tobacco makes for a top notch investment whether or not the merger with Reynolds progresses to completion. It offers good value for money, relatively low risk and healthy income potential. It also has significant growth prospects within the e-cigarette space, which should deliver double-digit growth over the medium-to-long term.

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Peter Stephens owns shares of British American Tobacco. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.


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