There Are Still Some Big Questions Regarding Reynolds American's Snuff Buyout

Reynolds American Inc.’s $3.5 billion acquisition of Conwood has put it at risk of someday having to adjust its earlier estimates of the deal’s value.

The North Carolina cigarette maker announced on May 31, 2006 that it had completed its acquisition of Conwood. Then-chairman and CEO Susan M. Ivey said in a statement at the time that the smokeless tobacco maker would enhance Reynold American’s ability to continue to provide results to its shareholders. Reynold American paid around $2.5 billion more for Conwood than the company’s actual value on its books, but six years later it is not clear whether that valuation was justified.

How many people started chewing that Conwood tobacco? American Snuff, Reynolds American’s smokeless tobacco segment, generated sales of $648 million in the year ended Dec. 31, or only around 18% of what the company had paid for Conwood. Meanwhile sales for the rest of Reynolds American’s businesses have been declining so that the total of $8.54 billion for 2011 was only slightly more than before the Conwood acquisition in 2006. The company’s overall sales amount to only 62% of its total assets, in contrast with the industry median ratio of 120%. The smokeless segment is clearly a lagger.

Reynolds American has downwardly revised its earlier estimates on some of its assets, but on some occasions only in small chunks. For example, it had reported a whopping $2.60 billion in intangible assets such as brands as of the year ended Dec. 31, 2011. Then the company said this February — in a press release filled with far more adjustments to earnings and unusual items than is  typical — that it had $43 million in damage to the value mainly of its Doral cigarette brand during the fourth quarter 2011. And in the quarter and year ended Dec. 2010, it had downwardly adjusted its estimation of overvalued acquisitions by $26 million.

While warning that it had to use “considerable” judgment and forecasting to do so, Reynolds American said on February 15 in its annual statement that it believes it has used “reasonable estimates and assumptions” in finding that the fair value of each of its reporting units was substantially in excess of its original cost.

“Certainly the future cash flows that the brands are generating support those valuations on the balance sheet,” said McDara P. Folan, corporate secretary and deputy general counsel at Reynolds American.

American Snuff’s operating income rose 3.4% to $331 million during the year ended Dec. 31 compared to 2010, suggesting that the company could earn back what it paid for Conwood after more than a decade.

Reynolds American has been trying to pump its sales in recent months. For example, the company announced last week that it added a new section to its site focusing on its “commercial integrity,” “tobacco harm reduction” and “youth tobacco prevention” efforts.  It says on the site that smokeless tobacco presents less risk of oral cancer than cigarettes, and therefore “may play a valuable role in reducing tobacco consumers’ risk.”

In the meantime the company’s stock price has gained to $40.96 per share early on Monday from $32.03 on August 15, 2006, when Reynolds American split its shares so that its investors would hold double the volume for half the price.

While investors have remained sanguine enough about the company’s statements for its stock price to hold up so far, GMI gives Reynolds American an F on its corporate governance overall. Due to red flags such as those mentioned above, Reynolds American’s financial statements reflect an AGR score of 14, indicating higher accounting and governance risk than 86% of comparable companies. In March 2011 Reynolds American’s AGR was a 4. The low AGR doesn’t necessarily mean that Reynolds American is doing anything wrong, but it suggests that investors should scrutinize the company’s statements with extra care when using them to calculate the company’s value.

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