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.

Philip Morris and Altria: High Noon in Marlboro Country

Ever since the separation of Philip Morris International (PMI) from its former parent company Altria in 2008, the scenic Marlboro Country promoted in the famous ad campaigns has in fact been two countries. On the one hand there is the United States, birthplace of the modern reincarnation of the Marlboro brand, and on the other hand there is the rest of the world. PMI owns the Marlboro brand, as well as several others, in all non-US markets, while Altria markets the Marlboro brand in the United States through its ownership of Philip Morris USA (PMUSA). 

The separation of PMI from Altria was designed to untangle the international business from the tobacco litigation liabilities faced by PM USA, which weighed down the earnings multiple the market applied to Altria’s shares. Unmoored from Altria’s legal problems, the thinking went, PMI would be free to chase growth in emerging markets, unencumbered by the endless meetings focused on US legal strategy. After engineering and executing the PMI spin-off, former-CEO and chairman Louis Camilleri and then-PMI President Andre Calantzopoulos both left Altria to head Philip Morris International, then as Chairman/CEO and COO respectively, leaving Altria and its legal headaches behind. 

The plan didn’t work out nearly as well as intended. Tobacco regulation spread much faster across the rest of the world than was anticipated at the time. In some cases, developing markets have become far more restrictive in their tobacco regulations than the United States. Steep and sudden excise tax raises have also surfaced with increasing regularity, disrupting consumer behavior by impairing affordability and giving rise to large illicit tobacco markets. 

only A Fistful of Dollars

The most fundamental flaw in the separation of Altria and PMI, however, has been the lack of significant dollar earnings at Philip Morris International. For a company with its shares priced in US dollars, paying dividends in dollars and carrying part of its debt in dollars, the lack of a dollar earnings base should have been a serious concern before the separation. But with significant revenue streams in dozens of other currencies, PMI may have felt adequately diversified to withstand currency fluctuations. And this notion may well have been true if the company reported in any other currency than the US dollar. 

Unfortunately, the US dollar is not just any other currency; it is the world’s de facto reserve currency. It is both used and held widely by commercial and government parties outside the United States. This reserve status means that other currencies have often shown significant correlation in their movements versus the dollar, oftentimes as a result of (changes in) US central bank policy. The correlated movements of dollar exchange-rates quickly exposed the lack of a US earnings base as a major underlying weakness of PMI. As visualized in the graph below by the yellow bars, foreign exchange movements served as a drag on PMI’s revenues every year between 2012 and 2020. In 2015 for example, PMI suffered a ~$4.7 billion hit to its topline from adverse foreign exchange movements, approximately -16% of its prior year revenues net of excise taxes. After a positive foreign exchange contribution in 2021, the issue resurfaced in 2022 when the Federal Reserve began to more seriously tighten its monetary policy, leading to a resurgent US dollar. 

Philip Morris International: contributing factors in net revenue changes since the separation from Altria (left axis, in mln’s). The percentage change in overall net revenue per annum is visualized by the orange line (right axis). Please note that the contributing factors do not add up to a net cumulative revenue change as negative factors and positive factors are always shown below and above the $0 line respectively. All data from PMI financial filings. Graphics by the author.

The foreign exchange headwinds have been exacerbated by declining cigarette volumes, which were a negative contributor for 7 of the 10 years since 2012. Together, those two headwinds more than negated that traditionally reliable staple of tobacco company resilience: pricing power. As evidenced by the blue bars, PMI managed to raise prices on its products every year during its existence as an independent public company, oftentimes substantially so, but because of the negative forex effect higher local prices still translated into flat, or lower, dollar sales and earnings. In dollar terms, cumulative upward pricing totaled roughly $15 billion over the 2012-2021 period, while volume/mix was negative by approximately $3 billion. Adverse foreign exchange movements meanwhile shaved a cumulative $11.6 billion off net revenues over this period, while other other factors (acquisitions/disposals/etc) were negative by $1 billion. The net result of these contributing factors has been a flat topline for PMI between 2012-2021, which serves as the major culprit in PMIs languishing share price.

I have made the argument before that the Altria-PMI separation was a significant strategic error, and have advocated a merger between Philip Morris International and Altria. PMI actually proposed an all-share merger transaction in 2019, with the support of Altria’s board, but the proposal was quickly withdrawn for lack of shareholder enthusiasm. Since then PMI has lost its appetite for a combination with Altria, at least according to its current CEO Jacek Olczak. Tobacco litigation risk in the United States apparently still sits in the back of PMI shareholders’ heads. 

Once Upon a time… in america

Besides the lack of dollar-based revenues for PMI, there is another problem with the current situation. Lacking direct access to the US market makes the commercialization of PMI’s next-generation products substantially more complicated. This has become a more pressing issue in recent years because increasingly strict tobacco regulations globally have impaired the industry’s freedom to operate. Simply put, governments around the world are pulling the noose around the tobacco industry’s business model ever tighter. The uncertainty around the long-term viability of the industry’s current business model has put a substantial dent in the earnings multiples of tobacco company shares, which consistently trade at substantial discounts to consumer staples peers. This has made the transition to so-called reduced-risk products, such as heated tobacco products (HTP), far more urgent.

PMI and Altria have tried to work around this problem through a US partnership for PMI’s heated tobacco product IQOS, whereby Altria distributes and markets the product in the US while PMI continues to own the intellectual property and manages sourcing. However, the IQOS brand only achieved a tiny US foothold under this partnership, and its commercialization in the United States is currently on hold because of a ruling by the ITC. The ruling banned IQOS products from being imported into the United States because of a supposed infringement on  patents owned by Reynolds American, a subsidiary of British American Tobacco. 

The current situation is highly undesirable for PMI for a number of reasons. First, the US market is the world’s largest tobacco profit pool outside of China, which means PMI simply cannot afford to ignore the US potential for this product. Second, given the amount of R&D expenditures involved, heated tobacco products are a game of scale. Get to scale first and the virtuous cycle starts doing its work. Having the biggest revenue base means you can afford to have the biggest R&D budget, which significantly increases your chances of having the best product pipeline, which ultimately feeds back into your user acquisition, which feeds into your revenues etc. A significant US presence, through the sheer size of the American market, can significantly enhance IQOS’ global economies of scale.

Third, while PMI has a significant market leadership position in most heated tobacco markets, the US market is still up for grabs. Currently, PMI owns the only heated tobacco product with FDA-granted marketing authorisation. In other words, they could have the market entirely to themselves! But this window of opportunity will not last forever, as BAT filed a PMTA application with the FDA for its HTP Glo Hyper during 2021. Since BAT completely owns its US subsidiary Reynolds American, the company could move quickly to move its product to market once its PMTA application is approved. PMI is therefore operating under conditions of limited time if it wants to establish an early market lead for IQOS. This is important because an early market lead will likely prove to be a very valuable position as word-of-mouth endorsements serve as an important avenue for customer acquisition, especially since most advertising options are legally off limits. 

Fourth, the United States functions as a significant exporter of Western culture around the world; IQOS could derive substantial marketing benefits in other countries from being a relevant factor in America. Think of (social) media coverage, celebrity usage, or exposure to the millions of people visiting America from abroad. Since most markets now have restrictions on tobacco marketing in place, making the introduction of new tobacco brands and products quite complicated, this kind of exposure could be very valuable. 

A Fistful of Dynamite

Before the current halt of IQOS sales in the US, the product had only gained single digit market shares in a very limited number of metropolitan markets, primarily in eastern and southern US states. According to Altria the achievements made with IQOS in these markets met the performance targets agreed for IQOS under the joint marketing agreement. PMI however believes that Altria did not meet all of the performance targets, as surfaced in the fourth quarter earnings call (courtesy of Seeking Alpha).

Philip Morris CEO Jacek Olczak:

“I believe that that pre-ITC ruling IQOS performance in U.S. and you know how we perform with IQOS across all essential geographies. I mean it’s really well below what I would expect at this stage or characterize the potential of IQOS. And if I take into this, the fact that this is (an) inhalable FDA authorized product, you don’t really have a competition and the size of the market, et cetera, I think it’s fair to say that the expectations were much beyond where we are today.”

This rather unusual, public display of disagreement exposes an incentives problem underneath the US marketing partnership for IQOS. Whereas PMI has a clear incentive to maximize the addressable market for IQOS, and thus to establish a credible US presence for the product, Altria is looking at a very different strategic set-up. The latter is faced with a number of conflicting interests with regards to how it handles the IQOS partnership. First of all, the marketing of IQOS in the US creates a significant conflict with Altria’s existing cigarette business. After all, a majority of heated tobacco consumers around the world are converted cigarette smokers. Why would Altria want to convert smokers from its enormously lucrative Marlboro cigarettes to IQOS when the company has to share the margin with PMI?

At the same time, Altria has no incentive to decline the opportunity to sell IQOS in the US. This would only leave the product in the hands of a competitor, be it a US-based PMI-subsidiary or some other third party. This ties into the second consideration; like all cigarette companies Altria has an incentive to show regulators, and to some extent investors, that it is taking action to ameliorate the health impact of its business. 

Third, developing a proprietary heated tobacco product would take Altria a lot of time and capital, of which at least the first is in short supply. Fourth, as Altria does not own IQOS in the US, and is dependent on its partnership with Philip Morris International, it has to at least consider the possibility that PMI at some point excludes it from the IQOS business. If Altria achieves significant success with IQOS, at the expense of its cigarette business, only to be excluded by PMI at some later point, that would obviously be a very bad outcome.

Weighing those four considerations, it seems logical to conclude that Altria has an incentive to achieve at least some success with IQOS in the US, but not altogether too much. A cynic might propose that Altria may be incentivized to achieve only the bare minimum of its performance targets under the partnership agreement, as it stalls for time to develop its own heated tobacco product. At the very least this line of thought indicates that, although they are in business together, Altria’s and PMI’s interests are not at all aligned when it comes to the commercialization of IQOS in the US.

For a Few Dollars More

I believe that PMI has reached the point where it no longer sees either a merger or a US partnership with Altria as credible ways of establishing a successful American presence for IQOS. In fact, it has already sought an alternative way of reaching the US market by launching a bid for Swedish Match, a company which is focused mostly on selling oral tobacco products in the US and Scandinavia. In my opinion the buyout proposal makes perfect strategic sense from the standpoint of Philip Morris, since it offers the potential to address three of PMI’s pressing problems at once. First of all, Swedish Match has invested a lot of effort in developing alternative nicotine products that align well with PMI’s stated objective of becoming a majority smokefree company by 2025. A buyout of Swedish Match would allow PMI to include all of Swedish Match’s oral tobacco products, and not just the new ones, in its smokefree sales, making it far more likely to achieve its objective. It would also establish PMI as the leader in modern oral nicotine products, a small but quickly-growing category in which it currently has no significant presence.

Second, Swedish Match’s substantial US presence would give PMI an existing and already profitable sales platform through which it can distribute its IQOS product. This would give PMI the opportunity to end the poorly-performing partnership with Altria, and to take the US commercialization of IQOS into its own hands. If PMI contracts an American manufacturer for the IQOS devices and establishes a US-based manufacturing facility for the tobacco sticks, it could also sidestep the aforementioned ITC ruling, which after all only bans imports. Proceeding through this track would allow PMI to move the product back to market relatively quickly. Direct control over US-based manufacturing and sales should make for much faster progress than through the partnership with Altria. Third, the American operation owned by Swedish Match would give PMI a modest but expanding dollar earnings base, which could grow quickly if it successfully plugs IQOS into Swedish Match’s existing US sales organization. This would have the potential to ameliorate the company’s current sensitivity to foreign exchange rate fluctuations.

Of course, the acquisition of Swedish Match has not been closed yet, and may still run into problems. At the very least, there is the possibility that PMI will have to raise its offer for Swedish Match as some shareholders and other financial parties have voiced their opposition to the current buyout proposal. Given that Swedish Match shares have now traded, albeit modestly, above the price offered by Philip Morris, there seem to be more than a few market participants who are betting on a higher offer by PMI. The argument employed by some of the objecting parties is that the price offered by PMI is simply too low, although in the case of others it looks more like an arbitrage play on the prospective buyer’s estimated willingness to close the deal. 

From a financial standpoint PMI’s offer does not look particularly underpriced, especially not when we consider historical buyout valuations in the tobacco sector, the ever-present risk of regulatory disruption, and the fact that the multiple applied to the subject’s earnings includes not just the high-growth nicotine pouch business but also its profits from the more mundane cigars, moist snuff and lights business lines. Surely, PMI will not be particularly keen on paying a high multiple for profits achieved in those relatively small, moderate-growth businesses. It may even be considered likely that PMI will want to rid itself of Swedish Match’s cigars business, which would raise the effective multiple paid much further, since this business would probably fetch a much lower multiple on its own. 

On the other hand of the argument; Swedish Match offers PMI at least three different avenues to create value from a buyout. First, the abovementioned option to use Swedish Match’s US sales organization as a distribution platform for IQOS. Second, by riding US market growth for nicotine pouches on the back of Swedish Match’s Zyn brand, the category creator. And third, but not last, by taking Swedish Match’s nicotine pouch products and plugging them into PMI’s international sales organization in those markets where market potential for these products may exist. First and foremost this would be a number of European markets, but in all likelihood this product can be introduced into many other markets over time. Taking all these things into consideration, my current estimate is that, given the amount of opposition to the deal at the current price, and the clear benefits PMI would gain from owning Swedish Match, the likelihood of a higher offer by PMI is significant.  

The Not-so good, The Bad, and the Ugly 

Of course, the current situation in the US with regards to IQOS is still a temporary halt in sales, and a partnership that by the original agreement will run through 2024 and is subject to extension. It is difficult to foretell what will happen to the partnership if and when the proposed acquisition by PMI of Swedish Match takes effect. Currently, PMI is planning for IQOS to return to the US market during the first half of 2023, presumably by using domestically manufactured products and through Altria’s sales organization. My guess is that PMI will plan to discontinue the partnership once it comes up for renewal in 2024, and to switch the commercialization effort to Swedish Match’s US platform. 

Altria seems to have very few heated tobacco products alternatives to the IQOS partnership. It does not have a market-tested HTP of its own, and developing one would likely take at least several years and billions of dollars in expenses. And as Imperial Brands has learned in Japan, successfully launching a heated tobacco product as a latecomer in a crowded market is a very difficult thing to accomplish. Buying a heated tobacco product is also an unlikely alternative; apart from some unproven products sourced from China, there are very few companies with a credible HTP product in the marketplace. Altria’s acquisition of intellectual property with regards to a heated tobacco product marketed by Poda Holdings does not serve to inspire confidence in Altria’s position in this field. The product in question had achieved only negligible sales, and similar pod-based HTP products marketed by BAT and JT achieved very limited market success in Japan and elsewhere. The reason for that limited success is that pod-based HTP’s do not produce a strong enough tobacco vapor to adequately mimic the smoking experience. There is no evidence to indicate that any product developed from the intellectual property acquired from Poda would make for a more attractive user experience.

The only market-tested HTP’s that somewhat approximate IQOS in user experience are owned by BAT, Japan Tobacco and KT&G, all three of which are established tobacco industry players. Of those three, BAT is Altria’s largest competitor in the US cigarette market, while KT&G already has an international distribution agreement with PMI for its heated tobacco product named lil. This leaves Japan Tobacco as the only remaining option for Altria, if it wants to establish a heated tobacco presence of its own. While Altria and Japan Tobacco show very limited geographic overlap, and a merger is therefore unlikely to face significant regulatory scrutiny, an Altria bid for JT still seems like an especially unlikely scenario. Not in the least because the Tobacco Business Act requires the Japanese government to maintain a substantial shareholding in Japan Tobacco. 

A more likely scenario is for Altria to acquire from JT the rights to manufacture and market the Ploom heating device and accompanying sticks in the United States. Another conceivable option is for Altria to expand its ownership stake in Juul from 35% it owns now to a controlling stake, and to then use Juul’s vaping IP as a bargaining chip in negotiations with Philip Morris International or other international players. This may be the most promising option for Altria to pursue given Juul’s currently weak negotiating position. Perhaps Juul’s other investors will even be glad to be offered an exit. The downside to this option is that Juul has a significantly impaired public image in the United States due to its controversial marketing practices. The regulatory interventions that followed from the ‘teen vaping epidemic’ included an FDA-issued ban on all vaping flavors other than tobacco and menthol, and a rather arduous application process to gain marketing approval from the FDA. 

Not only is there a significant chance of products being denied FDA approval, but the controversy and the regulations that followed from the teen vaping fallout have caused Juul to lose a lot of market share in the United States, not in the least to disposable products not currently subjected to the FDA’s flavor ban. Acquiring a majority stake in Juul means its problems become Altria’s problems. Given the size of the impairments Altria has already taken on its investment in Juul, further increasing its ownership stake in Juul may not prove at all popular with its shareholders. It is undeniable, however, that despite all the controversy Juul owns very valuable intellectual property with regards to its vaping products. Also undeniable is that both the heated tobacco and the vaping market show significant market potential around the world. The next few years will show which companies have positioned themselves most favorably to capture that potential.

Disclosure: author owned shares in both Philip Morris International and Swedish Match at the time of publication.

Imperial Brands Becomes First Tobacco Major to Suspend Russian Operations

Imperial Brands issued a press release today stating it will suspend manufacturing and sales of its tobacco products in the Russian Federation. The company operates a manufacturing facility in Volgograd and is estimated to be the fourth largest tobacco company operating in Russia, holding approximately 8.4% share of the market during 2020. Imperial Brands stated the following regarding their decision;

“this decision comes amid a highly challenging environment in Russia as a result of international sanctions and consequential severe disruption. We will be supporting our Russian employees, who continue to be paid while operations are paused.”

Other international tobacco companies operating large subsidiaries in Russia, including Philip Morris Intl., Japan Tobacco and British American Tobacco, have so far not released public statements regarding their business operations in the country. A significant number of multinational corporations including IKEA, Apple and Coca-Cola have announced withdrawals or curtailment of business operations in Russia, following that country’s military invasion of its neighbour Ukraine.

Whether other tobacco companies will follow Imperial Brands remains to be seen. Imperial Brands’ Russian operations contribute only to a very modest degree to its sales and operating profits, estimated by the company itself at roughly 2% and 0.5% respectively. The modest financial impact likely made the decision to suspend operations somewhat easier. Companies like Philip Morris Intl. and Japan Tobacco are facing a different situation from a financial perspective; not only do they have larger financial exposure to the Russian market, but Russia has also been an important market for so-called ‘reduced-risk’ heated tobacco products. The large tobacco manufacturers have made large investments in marketing these products in an effort to distance themselves from controversial cigarette products.

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.

Philip Morris Adds A Piece To The Smokefree Puzzle

Last week Philip Morris International announced it has agreed to buy Fertin Pharma from current owners EQT (70%) and the Bagger-Sørensen family (30%). The transaction value is roughly $820 million, for a price/sales multiple of somewhat over 5x, and an EV/EBITDA valuation of approximately 15x (using fy2020 financial data). Fertin Pharma started as a candy business in Denmark in the early 20th century, and subsequently expanded its operations into chewing gum and nicotine gum (1996). Its regular chewing gum brands, including Stimorol and V6, were sold to Cadbury Schweppes in 2001 and are nowadays part of Mondelez International. Since the branded candy exit, the company has focused its operations on developing products for oral delivery of nicotine, most prominently with nicotine gum, but has also developed know-how for delivering nicotine through lozenges, liquefiable tablets and pouches. Additionally, these delivery systems can also be deployed to deliver other active ingredients to the human body, such as vitamins, cannabinoids and caffeine.

Given the attractive market developments in recent years in such product categories as energy drinks, alternative nicotine products and cannibanoids, Fertin’s product portfolio fits well with PM’s stated goals of growing smokefree sales to 50% of total revenues and non-nicotine sales to at least $1 billion by 2025. Currently, Fertin operates primarily as a contract manufacturer for third parties, and not as a an important owner of branded products. Philip Morris is therefore buying the company for its technological and manufacturing capabilities, in my opinion primarily with regards to nicotine pouches. Nicotine pouches are the largest category in the modern oral nicotine (or MON) space and have shown very significant growth in recent years, particularly in North America and the Nordic and German-speaking regions of Europe. The outlook for these types of products is generally regarded as excellent due to their affordable nature, availability of flavors, ease of use and the dramatically lower health risk associated with their usage (when compared to cigarettes).

Even though PM is a clear frontrunner in smokefree nicotine products, which comprises heated tobacco, vapor and modern oral, the company is trailing its competitors in the latter category. Swedish Match and British American Tobacco have taken a clear lead in modern oral, while Altria has acquired Burger Sohne from Switzerland for its on! brand of nicotine pouches. Imperial Brands and Japan Tobacco are small players in this category, and are mostly competing with products launched by their existing Swedish snus subsidiaries (Skruf and Nordic Snus). PM’s acquisition of Fertin is meant to close the gap with its competitors in modern oral products, with Fertin adding the expertise and manufacturing capabilities to develop oral nicotine products while PM will likely assume responsibility for branding and marketing strategy. I believe the development and market introduction of a branded nicotine pouch product will likely be PM’s first priority after the acquisition closes. Longer term, Philip Morris may also explore possibilities for developing products with other active ingredients, as well as nicotine products with other delivery mechanisms. The deal makes a lot of sense from a strategic standpoint, at an acceptable price point, and since it is still early days in the modern oral category, PM is now in a better position to become a serious contender in this field.

(Disclosure: the author owns shares of British American Tobacco)