Could Gallaher fall to BAT in new round of tobacco industry consolidation?

Analysts think competition concerns could be overcome despite UK market dominance

These are busy times for investment bankers advising tobacco companies. As the anti-smoking brigade strengthens its case against tobacco in the West and consumers become more health savvy, declining markets have forced the tobacco giants to step up the pace of consolidation. Yesterday Gallaher, Britain's third-biggest tobacco group, became the latest cigarette maker to fall under the acquisition spotlight as the City bet that the company could make a tasty catch for British American Tobacco.

A bid by BAT for Gallaher, best-known for its UK brands Benson & Hedges and Silk Cut, would help the world's number two in its aim of knocking Phillip Morris, the maker of Marlboro, off the top cigarette slot. It would also soothe BAT's investors who have been clamouring for the group to spend some of its cash pile ever since Martin Broughton, its chairman, said he would chase acquisitions to help the group to grow its 15 per cent global market share.

The chances of BAT approaching Gallaher with a takeover offer, which industry sources suggest could top £5.3bn, were boosted last week after the European Commission's competition authorities had their knuckles rapped for being too quick to ban mergers. An unprecedented ruling from Europe's supreme court overturned a 1999 veto that prevented the tour operator Airtours joining forces with its smaller rival First Choice on the grounds that Brussels had misjudged the likely post-merger market. Competition lawyers predicted that the decision opened a window of opportunity for companies keen to grow through consolidation but wary of likely regulative hurdles.

This, combined with comments from BAT on an analysts' trip to Canada last week that some sort of deal was imminent, fanned the embers of market speculation surrounding BAT and Gallaher, at one point sending shares in the possible bid target to the top of the FTSE 100 risers. Negative noises from both companies prompted sentiment to cool slightly, however, and Gallaher yesterday closed up 3 per cent at 669p.

While a move for Gallaher would put the British back in British American Tobacco, how sensible would a bid be?

One tobacco analyst, who did not want to be named, summed up the weight of investor thinking yesterday when he said: "You can't rule [a bid] out. There are only a limited number of things out there." And consolidation has undeniably hotted up. Already 2002 has sounded the death knell for Reemstma, the privately held German tobacco group that recently became part of Britain's Imperial in a transforming deal worth £3.6bn. Last year Austria Tabak, the former state monopoly, fell to Gallaher. In 1999 a trio of mergers saw BAT snap up Rothmans International, the world's number three (Japan Tobacco) link up with RJR International and the Franco-Spanish group Altadis created through a merger between Seita and Tabacelera.

Fans of the BAT/Gallaher merger argue that the Gallaher portfolio would provide a compelling fit for BAT, not least in the UK where the recent loss of the rights to distribute Marlboro for Philip Morris sent BAT's market share tumbling to 7 per cent from around 14 per cent. Buying Gallaher, which just lags its larger rival Imperial in terms of UK market share, would give BAT around 47 per cent of one of the world's most profitable cigarette markets. Signs that the Government is finally getting a handle on the thorny issue of contraband cigarettes – with the duty-paid market recently showing its first rise in over a decade – have further increased the UK's attraction as a place to sell cigarettes.

Fans also reckon that there is enough difference between the two groups' brand portfolios to merit a takeover. Other pluses include cost savings from combining BAT and Gallaher's UK head offices and their distribution and marketing teams. A merger would also unite the premium Benson & Hedges brand, which Gallaher owns in most European countries but BAT owns elsewhere.

But there the bull case ends. Frances Murphy, a competition partner at the law firm Mayer Brown Rowe & Maw, says that on competition grounds alone the case for a takeover bid is sketchy. "I would suspect the OFT [Office of Fair Trading] would be very nervous. Unless [BAT] could give material undertakings to appease the Competition Commission the deal would be blocked." This would include a pledge to divest some of its UK brand portfolio, which would include Gallaher's value-for-money Mayfair and Dorchester brands.

While she doubted that last week's decision to quash Brussels' veto of the Airtours bid had any direct relevance on a BAT takeover deal, Ms Murphy added: "In light of Airtours [the European Commission] will be incredibly more cautious in its approach to review of mergers and joint dominance.... It would look straight at [the] issue of dominance and would analyse the extent to which the creation of a dominant position would have an adverse effect on competition for a considerable time into the future."

This could mean more brand sales, particularly in countries such as Germany where the combined market share adds up to more than 30 per cent. In Austria, the two groups would have 55 per cent of the market and in Ireland their share would top 70 per cent.

Michael Smith, a tobacco analyst at JP Morgan, said a deal "was a lot less likely now than two or three years ago". He pointed to Gallaher's recent leaps into Central and Eastern Europe with the purchase of Russia's Liggett-Ducat in 2000 and Austria Tabak in 2001, which created the competition concerns that could put a deal on Brussels' radar screen. Significantly, BAT passed on the opportunity to acquire both of these companies, which makes it less likely that it would want to pay a premium to buy them now as part of Gallaher.

The merry-go-round of speculation surrounding BAT and Gallaher started up in the midNineties when Gallaher's owner, American Brands, decided to quit its tobacco habit for good. The US company, which was trading at a discount because of the growing litigation risks, sold its US tobacco unit to BAT's Brown & Williamson arm and decided to demerge Gallaher. At the time, BAT cast its slide rule over Gallaher's business but decided not to bid. It was later precluded from launching a hostile bid by a standstill agreement in Gallaher's listing particulars.

Since then BAT has been perennially linked with a bid for Gallaher, although the maker of Lucky Strike, Dunhill, Pall Mall and Kent has never commented publicly on its intentions. Indeed, BAT's recent acquisition strategy – of chasing opportunities in emerging markets, not least of which is its quest to become the first Western tobacco company to crack China – suggests that it would have little interest in any pluses on offer from Gallaher.

One sector analyst said: "The City and media are reading more into the situation. BAT is in a comfortable position, generating a lot of cash and has a lot of options. It is looking at a lot of alternative choices, one of which is returning money to shareholders, another is an acquisition and another is greenfield investments."

JP Morgan's Mr Smith points out that the timing of a bid at Gallaher's current share price would be unlikely to curry favour with its own investors. Gallaher is already trading at a clear premium of nine times underlying earnings compared with BAT's six times. "Investors wouldn't really see the merit," he said.

Yet another analyst questions whether Gallaher would help BAT to boost its top-line growth, which along with cost savings is the key driver behind the current consolidation frenzy. He argues that while Gallaher is growing its own sales internationally, it is often competing against BAT. "As part of BAT, Gallaher could even slow down the growth of the Gallaher business because BAT wouldn't push the Gallaher brands," the analyst said.

All of which suggests that the "degree of optimism" displayed by BAT in Canada last week that they would find a deal in "the not too distant future" was directed at opportunities outside the UK.