Swedish Match Stubs Out The Cigars

Swedish Match recently announced its intention to separate the US cigar division from its smoke-free and lights segments. The company is planning to spin off its US cigar business through a distribution of shares in a new, publicly listed US entity to existing shareholders. Swedish Match will realize value from the transaction by transferring existing debt to the new entity. The expected finalization date of the transaction is estimated to be in the second half of 2022, but could be later. Swedish Match’s cigar business has a number two (volume) position in US mass market cigars behind Swisher, with the other main competitors Altria-owned John Middleton and ITG (owned by Imperial Brands). Its product line consists of both homogenized tobacco leaf and natural leaf cigar brands like White Owl, Game, 1882, Garcia y Vega and Jackpot. The division sold approximately 1.9 billion sticks in 2020, with revenues around $493 million and $195 million in operating profits. Manufacturing takes place in its US facility in Dothan, Alabama and in a facility in the Dominican Republic. 

Post-separation, Swedish Match will retain two operating divisions. The smoke-free division generates its revenues from Swedish snus, US moist snuff, nicotine pouches and chewing tobacco sales. The only other operating division is the lights business, which makes up less than 10% of sales and generates its revenues from sales of lighters and matches. I have put recent volume developments for the company’s most important product lines in a bar graph. In recent years, the rapidly increasing contribution from nicotine pouch sales in the US has been an important contributor to the company’s growth, as has the cigar division. Traditional oral tobacco sales volumes have developed far more moderately. 

Annual product volumes for Swedish Match’s main product lines. Snus, moist snuff and nicotine pouch volumes are expressed in the bars (mln cans, left axis), while US cigar volume is illustrated by the orange line (mln sticks, right axis). Chewing tobacco volumes and lights are not included in this illustration because they are reported using different metrics. This table is my own work with data from SM annual reports 2016-2020.

Ashes to Cashes

In my opinion, there are a couple of things that make the cigar separation remarkable. First of all, the US cigar division has delivered excellent financial results in recent years, both in terms of growth and of profit (see illustration for volume developments). Changes in consumer behavior during the pandemic have provided the US cigar category with a particularly strong backwind during 2020 and 2021. Secondly, the US cigar division has been a good strategic fit with Swedish Match’s other operations, both in terms of distribution and customers. Thirdly, the conventional way to discard a business of this size is through a sale. Instead, the cigar business will become a separate legal entity, the shares of which will be distributed to Swedish Match’s existing shareholders. Shareowners will end up with two holdings instead of one, a smokeless tobacco business focused primarily on the US and Scandinavia, and a cigar business focused on the United States. This begs the question why Swedish Match is proposing the transaction at all? The press release included the following explanation:

“This announcement is another milestone toward achievement of our aspiration to become an entirely smokefree organization with a clear leadership position in oral reduced risk products, including ZYN, the largest modern oral brand in the US and globally.”

Which was followed by this observation on the cigar business specifically:

“The cigar business continues to perform very well and is seeing positive industry dynamics, which we believe will make it an attractive stand-alone company, balancing strong cash flow generation with attractive growth. The new cigar company will have the ability to explore a wider scope of growth opportunities within its autonomous and focused strategic agenda and to establish efficient and tailored operational and legal structures, geared for long-term value creation.”

This is a peculiar statement because it leaves unmentioned the fact that a significant amount of regulatory uncertainty currently hangs over the US cigar business. In April of this year, the FDA announced its intention to issue a ban on all characterizing flavors in cigarettes and cigars. Currently, the only characterizing flavor allowed in cigarettes is menthol, while cigars at present have no regulatory restrictions on added flavors. This imbalance has led some smokers who are interested in flavors other than menthol to look for them in cigars. The positive volume developments in the US mass market cigar category are likely due at least in part to this regulatory asymmetry. If a flavor ban is successfully introduced by the FDA, this would logically mean the end of this asymmetry, as all cigarettes and cigars marketed in the US would no longer be allowed to have non-tobacco flavors. It seems likely that the end of this advantage for the mass market cigar category would meaningfully impact sales, and potentially see some consumers move back to cigarettes or other alternatives. 

Smoke-free and the Bandit

Cigars are usually placed at the higher end of the tobacco health risk spectrum, although somewhat lower than cigarettes. Given that  high-risk tobacco products are increasingly confronted with the threat of regulatory intervention, the uncertainty has increasingly weighed on tobacco valuations. In my opinion, the regulatory overhang is likely the main reason why Swedish Match is moving to separate the cigar business from its other operations. A cigar separation will allow the company to become a completely smoke-free products company, in fact it will be the only publicly-listed tobacco company that derives no revenues from combustible tobacco products. I have noted in an earlier article that tobacco companies with high exposure to lower-risk products are trading at higher valuations in the market than those with high exposure to traditional products like cigarettes. Swedish Match currently trades at an above-average multiple relative to sector peers, and this transaction may help it solidify its premium valuation. 

Its higher exposure to smokefree sales also makes it more attractive as an acquisition target for one of the industry majors who are looking to expand smokefree sales. For a couple of reasons, the most obvious suitor would be Philip Morris International. First of all, PMI has been especially outspoken about its goal to achieve at least 50% of its sales from smoke-free products by 2025. During its last reported quarterly financials, the company achieved close to 30% of its net revenues from smoke-free sales, which means it needs to continue growing its smoke-free sales at a very high pace in order to meet its goal (about 20% per year between 2020 and 2025, assuming a CAGR in combustible net revenues of -5%). The recent string of acquisitions helps but does not move the needle in a big enough way.

Secondly, there is remarkably little overlap between Swedish Match’s current operations and those of Philip Morris. PMI primarily relies on cigarettes and heated tobacco and is barely represented in oral tobacco at all. Acquiring Swedish Match would hand PMI an oral tobacco platform at scale, with the potential to dramatically expand nicotine pouches through PMI’s international sales organization. Third and last, Philip Morris would be one of the few tobacco companies able to afford a cash bid for Swedish Match, which at a market capitalization over $15 billion does not come cheap. For these reasons, I suspect there will be a lot of number crunching going on in Lausanne over the coming months.

(Disclosure: at the time of publication the author did not have any position in the companies mentioned in the article)

Photo credits for the headline picture.

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