Reynolds Buys Into Smokeless

Conwood purchase drives speculation on what's next for Philip Morris

WINSTON-SALEM, N.C. -- Reynolds American Inc. (RAI) bought its way into the position of the nation's second largest manufacturer of smokeless tobacco products with its purchase of Conwood, makers of the Kodiak and Grizzly brands of moist smokeless tobacco among other products, for $3.5 billion, as reported yesterday in a CSP Daily News Flash.

Conwood truly is an excellent acquisition, said Susan M. Ivey, chairman and CEO of RAI, during an investor conference call yesterday. This acquisition provides us with a significant platform that would have [image-nocss] taken years to build.

The announcement of the sale comes three weeks after tobacco stock analyst Bonnie Herzog of Citigroup speculated on a possible purchase in an industry note titled A Race to Acquire Conwood. In a followup note sent yesterday, Herzog noted that RAI was the winner.

RAI's acquisition price of $3.5 billion, which is 14 times Conwood's 2005 EBIT (earnings before interested and taxes) of $250 million may sound quite rich, Herzog said. However, we argue that this is a very strong acquisition for the company and will provide it with long-term revenue enhancements and synergies. Furthermore, it was a key strategic move for the company since it will give Reynolds more leverage at retail and will provide the company with a platform to leverage its very strong brands such as Camel and Kool in a tin.

While not entirely a surprise to industry-watchers, the Conwood purchase now turns analysts' attention to key competitors of the players: United States Smokeless Tobacco Co. (USSTC) and Philip Morris USA (PM USA).

RAI's intention to purchase Conwood can be spun a few ways, said tobacco analyst Nik Modi with UBS, New York. 1.) RAI's entry into smokeless tobacco increases competition for USSTC; 2.) RAI's purchase of Conwood for 14 times EBIT (eight times sales) sales could translate positively for UST's valuation; 3.) RAI and UST could co-exist in the moist smokeless tobacco market with both players benefiting from category growth.

Meanwhile, Herzog said Philip Morris, to keep its competitive edge, should consider purchasing USSTC, but not anytime soon. Reynolds will put pressure on [USSTC] in the medium to long term, and we think a smart Philip Morris won't buy USSTC now, she said. We believe Philip Morris is very close to entering the smokeless market organically given feedback from our wholesaler contacts, and when this happens, USSTC's stock will get hit; therefore, it will be a good sale after it trades up today. Down the road, Philip Morris should look at UST when the price is right.

Conwood, headquartered in Memphis, Tenn., had 2005 annual net sales of more than $450 million and operating income of nearly $250 million, which represents an operating margin of about 55%. Over the past five years, Conwood has delivered strong compound annual growth in net sales and operating income of approximately 8% and 10%, respectively.

"This transaction is expected to be accretive to earnings in both the short and long term, and enhances shareholder value," said Dianne M. Neal, RAI's executive vice president of finance and CFO. "Conwood's strong growth and high margins should make it an important driver of RAI's future profitability."

Conwood is the only company to compete in all five segments of the U.S. smokeless tobacco industry, manufacturing moist and dry snuff; and loose leaf, plug and twist chewing tobaccos. Conwood holds the No. 1 or No. 2 position in every segment of the smokeless tobacco market. Moist snuff accounts for more than 70% of Conwood's sales, led by both its premium-priced Kodiak brand and its rapidly growing value-priced Grizzly brand.

Conwood, which traces its roots back to the 1782 founding of the Garrett Snuff Co., operates seven facilities and employs about 900 people in Tennessee, Kentucky and North Carolina.

Reynolds American is also the parent company of R.J. Reynolds Tobacco Co.; Santa Fe Natural Tobacco Co. Inc.; R.J. Reynolds Global Products Inc.; and Lane Ltd. Conwood will operate as a subsidiary of Reynolds American. Bill Rosson, Conwood's CEO, will report to Jeffrey A. Eckmann, Reynolds American's executive vice president of strategy and business development.

"Conwood's management team has an excellent record of delivering growth and building strong brands," said Eckmann. "They have doubled their share of the moist snuff market over the last five years. Their commitment to product innovation and brand building is an excellent fit with the strategic direction of all of RAI's operating companies."

Reynolds American will combine its Lane subsidiary with Conwood to consolidate and drive the companies' portfolio of other tobacco products. Lane markets a wide range of specialty tobacco products, including cigars and little cigars; roll-your-own and pipe tobaccos; and Dunhill and other premium international cigarettes. The headquarters of the newly combined companies will be located in Memphis, and full integration is expected to be completed by the end of 2007.

Adding [Conwood's] No. 2 position in the growing moist snuff category to our portfolio gives us a strong presence in virtually every domestic tobacco category, said Ivey. In addition, the terms of this transaction will enhance Reynolds American's profits and cash flow.

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