Japan Tobacco to Buy Gallaher for 7.5 Billion Pounds

Dec. 15 (Bloomberg) -- Japan Tobacco Inc., the world's third-largest traded cigarette maker, agreed to buy Gallaher Group Plc for 7.5 billion pounds ($14.7 billion) in the biggest international takeover by a Japanese company.

Japan Tobacco will pay 1,140 pence a share for Gallaher, the Tokyo-based company said in a statement. That's 16 percent more than the closing price on Dec. 6, when the maker of Benson & Hedges cigarettes in Europe said it had been approached.

The acquisition would make Japan Tobacco the leader in the Russian cigarette market, Europe's biggest. Analysts said the takeover may spur a competing bid for the Weybridge, England- based company from buyout firms or Altria Group Inc., the world's largest cigarette maker.

``There is an increasing need to gain scale in global tobacco, and more specifically in Europe and Russia,'' said David Hayes, an analyst at Lehman Brothers in London who has an ``underweight'' rating on Gallaher. ``We will see if others choose to become involved.''

In Russia, 61 percent of men were smokers in 2004, more than twice the U.S. and U.K. rate, according to the World Bank. Japan Tobacco said the purchase will double its market share in Russia to 34 percent. Altria leads the Russian market, which consumes 370 billion cigarettes a year, according to Gallaher.

Japan Tobacco, which reiterated today it aims to become bigger than rival British American Tobacco Plc, said it expects to conclude the purchase in the first half of 2007. The company said ``regulatory issues'' could change that time frame, though it doesn't expect any ``major'' antitrust concerns.

Break Fee

Gallaher has agreed to pay Japan Tobacco 52.6 million pounds if its board doesn't unanimously recommend its offer or recommends a rival bid, according to the statement. The board has agreed not to solicit any other bids.

Japan Tobacco shares closed 18,000 yen, or 3.1 percent, higher at 597,000 yen in Tokyo. Gallaher shares added 3.5 pence to 1,158.5 pence at the close in London, above the offer price.

``It's actually a very cheap price to pay because of the access that's going to be gained'' in growing markets, said Stephen Pope, an analyst at Cantor Fitzgerald in London.

Shares of Japan Tobacco have risen 18 percent since Dec. 6, when it was named as the bidder by the Financial Times. The Japanese company said Gallaher was a potential target last year after Turkey rejected its $1.2 billion bid for state-run Tekel.

Merrill Loans, Swaps

``We'll spend 700 billion yen in cash and we'll take out loans'' from Merrill Lynch & Co. to help pay the rest, said Hiroshi Kimura, Japan Tobacco's chief executive officer, at a press conference in Tokyo. He said the company may borrow about 1 trillion yen, and there was a risk of a counterbid from rivals. Merrill Lynch was Japan Tobacco's takeover adviser.

Credit-default swaps based on 10 million yen of Japan Tobacco's 150 billion yen in debt rose 29 percent to 9,000 yen from 7,000 yen, according to Deutsche Bank AG prices. The price implies the company would have less than a 1 percent chance of defaulting on its bonds over the next five years, according to a JPMorgan Chase & Co. valuation model.

Credit-default swaps are financial instruments based on corporate bonds and loans that are used to speculate on a company's ability to repay debt. A decrease signals an improvement in credit quality.

Credit Ratings

Standard & Poor's said it may lower Japan Tobacco's rating from AA-, the fourth-highest level, because of the acquisition. Moody's Investors Service said it may cut the company's ratings because the takeover may impair `` financial flexibility.'' Moody's rates the company Aa2, the third-highest level.

The cost of credit-default swaps based on 10 million euros of Gallaher debt fell 1,500 euros today to 17,667 euros, according to data compiled by Bloomberg.

Japan Tobacco paid $8 billion in 1999 for international rights to Camel, Winston and other RJR Nabisco brands, which remains the second-largest foreign takeover by a Japanese company next to NTT DoCoMo's $9.8 billion 2001 purchase of a AT&T Wireless Corp. stake, data compiled by Bloomberg shows.

That purchase ``was expensive because the transaction value was 15 times more than then RJR's Ebitda, and the assumed offered price for Gallaher was about 11 times,'' said Tokushi Yamasaki, a food and agriculture analyst at Daiwa Institute in Tokyo. That's ``not too expensive, as the acquisition price among cigarette makers is about 11 times,'' he said.

Japan Tobacco, whose brands include Seven Star, said in July it planned to raise production in Russia by more than 40 percent as demand in its home market shrinks. The company said it already has capacity to make 70 billion cigarettes a year at its plant in St. Petersburg.

``Japan owns 50 percent of the stock, but over time the company will be privatized,'' Japanese Finance Minister Koji Omi said today. The tobacco maker is the former state monopoly.

Kazakhstan

Gallaher's main brands include LD, one of the biggest tobacco labels in Russia, and Sovereign, the most popular cigarette in Kazakhstan. In the U.K. it sells Silk Cut and Mayfair cigarettes as well as Benson & Hedges.

It ``isn't a worldwide brand, but it's strong in Russia where Japan Tobacco is also expanding,'' Yamasaki said.

Emerging markets are attracting tobacco companies as western Europe cracks down on smoking.

``If you look at U.S. companies, what are they all trying to do? They are trying to diversify out of tobacco,'' said Edwin Merner, who oversees $1 billion as president of Atlantis Investment Research Corp. in Tokyo. ``It's a liability. It generates a lot of cash but you've got all the lawsuits.''

Smoking Bans

German Chancellor Angela Merkel is trying to persuade regional leaders to outlaw smoking in restaurants and other public places, and the U.K. and France plan bans this year.

Last year, Altria bought Indonesia's PT H.M. Sampoerna for about $5 billion. Six years ago, Gallaher bought Liggett-Ducat Ltd., Russia's biggest cigarette company.

First-half profit at Gallaher rose 17 percent to 185 million pounds, even as price wars in Spain and Austria weighed on earnings in western Europe. Profit in former Soviet nations jumped 52 percent to 35 million pounds as Gallaher gained market share in Russia, Ukraine and Kazakhstan.

Gallaher, which has roots going back to 1857, owns the rights to Benson & Hedges in the European Union and several other European countries. Altria controls the brand's U.S. rights, and British American Tobacco Plc owns the rights in more than 80 other countries, including Australia.

Sales Update

Gallaher today said that its business in the first 10 months of the year is meeting management's expectations as ``stronger performances'' from former communist countries are offsetting heightened competition in Poland, a decline in volumes in Sweden and other ``difficult'' trading conditions.

Tobacco consumption in western Europe has fallen 2 percent to 2.5 percent annually in the past several years, according to British American.

Japan Tobacco expects sales of cigarettes in Japan to fall 1.1 percent to 176 billion, while overseas sales may rise 0.4 percent to 239 billion in the year ending March 31. The company's return on assets was 6.7 percent as of March, compared with 1.2 percent in March 2002, according to Bloomberg data.

Altria may fight Japan Tobacco for Gallaher, according to Credit Suisse analyst Filippe Goossens. Buying Gallaher would also give Altria's Philip Morris unit a bigger operation in the U.K., where Imperial Tobacco is the leader, he has said.

Altria won't comment on speculation about Gallaher, spokesman Timothy Kellogg in New York said today in an e-mail.

Dresdner Kleinwort, Greenhill & Co., and Goldman Sachs advised Gallaher.