Philip Morris: Game, Set.. Swedish Matchpoint?

The takeover struggle for Swedish Match is nearing its endgame, but it is not at all clear who will emerge victorious, or what the final score will be. On October 4th, Philip Morris International announced a second extension of the acceptance period for the public offer it made for the company, this time to November 4th. The official explanation given for the second extension is that the proposed acquisition has not received regulatory approval in the European Union yet. However, gaining approval from EU regulators appears to be a minor issue compared with the opposition the deal is facing from market participants. 

A number of shareholders including several longtime holders, as well as several opportunistic operators, have publicly stated they will not tender their shares at the current offer price. Given the combined size of their stakes in Swedish Match, it seems increasingly unlikely that PMI’s offer will clear the 90% threshold required under Swedish law to start a squeeze-out of minority shareholders. Longtime holder Framtiden investment funds even published a white paper detailing their case for Swedish Match to remain an independent company. 

The gist of their argument is that PMI’s offer dramatically undervalues the long-term potential of Zyn, the nicotine pouch product that has seen remarkable success in the United States. Framtiden’s Dan Juran believes Swedish Match is worth close to SEK 200/share, while John Hempton of Bronte Capital believes the private buyer value of Swedish Match approximates SEK 175/share. Meanwhile PMI’s offer is for SEK 106/share, which of course constitutes a major price gap with the valuations suggested above. 

So what can be expected to happen going forward? PMI currently stands by its offer of SEK 106/share, which seems increasingly likely to fail under current conditions. In my estimate, PMI has three major options going forward. The first is to continue with the SEK 106/share offer and to waive the 90% threshold included in the offer proposal. This would likely mean Swedish Match will continue to exist as a publicly listed company, in this case with a substantial publicly traded free float. Philip Morris would simply become a significant shareholder in this public company. If more than 50% of the shares is offered at PMI’s price, PMI would become the majority shareholder and could exercise control over the company. This would also allow them to consolidate Swedish Match’s financial results into their own results, which I assume would be their bare minimum requirement. A controlling stake would also allow them to utilize Swedish Match’s US presence as a distribution platform for their IQOS product. 

A second option is to raise the offer price in an effort to lure a bigger percentage of Swedish Match shareholders into tendering their shares. However, given the difference between PMI’s offer price and the valuation appraisals of certain significant shareholders, it seems unlikely that PMI would raise their offer by enough to satisfy an overwhelming majority of Swedish Match’s stockholders. What would be the benefit to PMI of owning 80% of Swedish Match instead of 60% if it requires a substantially raised price?

A third option for PMI is to stick with the current offer, and if it fails to clear the 90% acceptance threshold stipulated in the offer proposal to simply walk away from this deal. Given the strategic benefits ownership of Swedish Match would confer to Philip Morris, I think this option is rather unappealing at this moment. PMI’s chief executive officer has warned on a number of occasions that Swedish Match is not the only option for Philip Morris International to pursue in the US, including in the latest press release regarding the extension of the agreement period

“We believe our offer remains very compelling – particularly given the current market environment,” said Jacek Olczak, Chief Executive Officer. “We look forward to completing the transaction, while also continuing to actively progress on our strategic alternatives to Swedish Match, should the offer ultimately prove unsuccessful.”

Of course such statements are a logical part of any negotiating game, but there is some truth to his words. After all PMI’s priority lies with IQOS, and building a US presence for this brand could also take place by using a different route. Let’s take a look at what Philip Morris International’s options are when it comes to developing a presence for IQOS in the United States. It could…

  1. Acquire ownership of Swedish Match and use its US presence as a distribution platform (a majority stake with a publicly listed minority stake is also possible)
  2. Acquire another company in the tobacco industry with an existing US presence
  3. Build US business platform for IQOS from the ground up
  4. Negotiate a renewed partnership with Altria for commercialization of next-gen products in the United States.

Suppose the first option fails and Philip Morris elects to drop its offer for Swedish Match, could the company decide to acquire another business with similar characteristics? Not easily. Swedish Match offers three attractive features that are difficult to find in another company. First, it has a significant smokefree business that aligns well with PMI’s strategic objective of becoming a majority smokefree company by 2025. Second, it has an existing US distribution platform with access to all the major sales channels that are relevant to PMI’s IQOS brand. And three, it has a significant US dollar-based earnings stream which PMI sorely lacks at the moment. 

As an alternative to Swedish Match, I think it would be very unlikely for PMI to pursue a significant acquisition in cigarettes or other combustible products such as cigars, as this does not align with their corporate strategy. Therefore most companies in the tobacco industry are ruled out as potential targets. This would leave smokeless product companies as the most logical candidates, but the major ones are already owned by competitors to PMI. The only exception would be Turning Point Brands, which is a comparatively small operator (no. 4 in smokeless tobacco products in the US). 

Another alternative is to pursue a vaping acquisition, such as Juul (currently the no.2 in non-disposable vaping products in the US), or NJOY (no. 3 or 4 in the same category). Both seem rather unattractive to serve as a US distribution platform for PMI. Juul has a tarnished reputation after it was implicated in marketing vaping products to teenagers, and is facing a mountain of challenges in the court systems and the marketplace as a result. NJOY is simply too small to really offer much attraction to a large operator such as PMI. So, while there are alternative acquisition candidates, none of them offer the same unique set of attractions as Swedish Match does. Turning Point Brands qualifies in theory as it has a US distribution platform, a high reliance on smokefree products, and a nicotine pouch product with a number of filed premarket tobacco applications with the FDA. The company is also very small when compared to Swedish Match, and its nicotine pouch product is unproven in the marketplace.

The third option for PMI, to go it alone in the United States and to build a sales organization for IQOS from the ground up might seem feasible, but would probably require PMI to accept years of significant operating losses without the guarantee of eventual pay-off. Certainly given the precarious nature of their earnings profile, which lacks significant dollar-based revenue streams, the prospect of significant operating losses in the US, while at the same time facing currency weakness in most other markets, hardly seems like a tantalizing prospect. I think they would be extremely hesitant to explore this route as long as they have any reasonable alternative.

The fourth option is actually rather interesting since a partnership with Altria is how they originally started marketing IQOS in the US. This partnership did not produce the kind of results PMI was hoping for, and was further derailed when the ITC banned imports of IQOS devices over a patent dispute with Reynolds American. I have detailed the fundamental problems with the Altria partnership in an earlier writeup, which comes down to Altria not having the right incentives to make IQOS a success in the United States. It is conceivable that molding a cooperation with Altria in a different form could ameliorate some of these problems. So what shape could a renewed partnership with Altria take?

  1. Continue existing partnership whereby PMI owns intellectual property and is responsible for manufacturing and sourcing, Altria for marketing and sales. 
  2. A license model whereby Altria operates IQOS in the US and pays PMI a license fee for all IQOS sales in the United States
  3. An outright sale of IQOS intellectual property for the US market to Altria
  4. A joint venture whereby PMI and Altria co-own the IQOS business in the US

Given that option 1 has more or less been relegated to the bin by PMI, I assume the current partnership model will not resurface when the current deal comes up for renewal in 2024. This leaves three alternative options for PMI and Altria to potentially explore. A license model whereby PMI continues to own the intellectual property related to IQOS but Altria becomes the sole licensee for the US market is certainly a possibility. There are two important issues with this kind of model. First, it does not really solve the incentives problem with regards to Altria’s cannibalization of its existing cigarette business. Secondly, it seems unlikely that PMI would trust Altria to make IQOS successful in the United States under this type of deal. Ultimately, the upside for PMI would also be quite limited if Altria does succeed. So, this option does not seem particularly attractive for PMI. 

The same thing goes for an outright sale of intellectual property related to IQOS in the US market. The most important issue here would be the difficulty in bringing two estimates of long term potential together. PMI employs far more ambitious estimates for heated tobacco than its industry peers, including Altria. This means PMI would be likely to estimate the value of IQOS intellectual property for the US to be far in excess of what Altria would be willing to pay for it. After what happened to its investment in Juul, Altria may also find it problematic to explain the need for a large outlay of capital to its shareholders, especially when it is based almost entirely on assumptions of future potential. In other words, option three seems very unlikely to materialize.

The final option is a joint venture for the US market whereby PMI and Altria operate the IQOS business in the US market on a 50/50 basis. This option offers some important advantages. It would ameliorate Altria’s incentives problem, as they would own half of IQOS in the United States. This would still imply that they would have to share the profits from any converted Marlboro smoker, but having an equity stake in IQOS for the US market would certainly be an improvement from operating as a glorified distributor. 

The main advantages for PMI would be having access to Altria’s distribution network, the potential use of the Marlboro brand, and being able to share initial US operating losses with a partner. The main problem remains how to value the IQOS brand for the US market. Starting a joint venture whereby PMI contributes US ownership rights to its IQOS brand would imply that PMI contributes far more value to the JV than Altria, which has no equivalent IP in heated tobacco. Therefore, Altria would have to contribute other assets to account for its share of the JV, for instance assets related to its on! brand of nicotine pouches or an outlay of cash. 

How to value the potential of IQOS in the United States, which was also an issue under option two, would be somewhat less of a problem because Altria would only own half of the business, which necessarily also cuts the price tag in half. Contributing other assets related to next generation products, for instance its stake in Juul, or its ownership of Helix Innovations (on!), might further reduce Altria’s cash outlay. The main advantage for Altria would be that they would gain part ownership in the US of the most sophisticated next generation product portfolio in the tobacco industry. Additionally, it would make them far more attractive to Philip Morris International as an acquisition candidate. After all, if the US joint venture would become successful, PMI would naturally be interested to own it in its entirety. When it comes to exploring alternatives to a renewed deal with Altria, I believe this 4th option would probably be the most attractive of the four.

Now, let’s assign some probabilities to the different scenarios detailed above. I certainly believe that PMI believes ownership of Swedish Match is its best option for the commercialization of IQOS in the United States. A majority stake with significant minority shareholders might be acceptable to PMI if there is no other way, even though this would make the commercialization of IQOS in the US, and of nicotine pouches in new markets far more complicated than under full ownership. PMI might raise its offer modestly if it increases its chances of gaining a majority of the shares in Swedish Match, but I do not believe it will pay the valuation sought by some stockholders mentioned above. For comparison, in 2015 PMI opted to reduce its ownership in its Indonesian subsidiary to comply with new financial regulations, rather than to launch a high-priced offer for the minority shares, even though the minority position consisted of just 1.82% of the outstanding shares. For now, the odds I would assign to the options open to PMI would look something like this. Needless to say these are just guesstimates.

  • 70% probability that PMI pursues Swedish Match ownership, possibly through modestly raised offer. A majority stake (>50%) is the absolute minimum I assume PMI will accept.
  • 15% probability PMI establishes a US joint venture with Altria for next generation products
  • 5% probability of PMI pursuing another acquisition in the US for use as an IQOS distribution platform, such as Turning Point Brands
  • 10% probability of another option

Disclosure: at the time of publication the author owned shares in Philip Morris International, Swedish Match and Turning Point Brands.

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