Zach Savidge [Ying Jiang] Hugo Ou [Gabriel La Spada] ECO 363 4/13/2014 Swedish Match Case
1. The company will save SEK 50,400,000 annually.
We assume the debt Swedish Match issues is a 10-year maturity coupon bond as the average BBB corporate bond (the CFO believes Swedish Match will receive a BBB+ rating) with the yield closest to that of Swedish Match’s debt is the 10-year maturity. Moreover, we do not assume that this th is debt will be refinanced into perpetuity because the financing decisions of Swedish Match are clearly dynamic d ynamic - the board will only decide de cide on the issuance of this one bond as the upcoming board meeting, not whether the fixed debt level will be maintained through refinancing once the proposed bond reaches maturity. Thus the value of the tax shield represents a 10-year annuity. Lastly, we assume the risk of the tax shield is equivalent to that of the debt because we are estimating the value of the tax shield of a fixed dollar value level of debt (as opposed to a level of debt that is a fixed percentage of Swedish Match’s enterprise value). Hence the discount rate for the
annuity is the 4.5% yield to maturity of the debt.
Value of Tax Shield =
50, 50, 400, 400, 000 .045
(1
1 1.04510
) SEK 398,800,996.13 =
2. Post-Recap, Swedish Match will have an additional SEK 4 billion in debt and have SEK 4.5 billion less in book value equity. The pre and post recap balance sheets as of 2004 are shown below. Balance Sheet Cash & Short Term Investments Current Assets PP&E Other Assets Total Assets
Pre-Recap $3,002 $4,884 $2,712 $4,300 $14,898
Post-Recap $3,002 $4,884 $2,712 $4,300 $14,898
Current Liabilities Total Interest Bearing Debt Of Which: Long-Term Debt Other Liabilities Equity including Minority Interests Total Liabilities & Equity
$3,776 $3,529 $2,559 $2,533 $5,060 $14,898
$3,776 $7,529 $6,559 $2,533 $1060 $14,898
3a. Immediately after announcing the leverage recap, Swedish Match’s market value of equity will increase by the value of the tax shield (assuming there are no transaction costs to issuing the debt and there are not distress costs associated with the additional debt load). We assume that the book values of all tangible assets are equal to their market values since we are provided with no information about their market values and, hence, attribute the difference between the market and book values of equity solely to the intangible assets of the company. The pre and post announcement market-value balance sheets are provided below: Balance Sheet Cash & Short Term Investments Current Assets PP&E Other Assets Intangible Assets Total Assets
Pre-Announcement $3,002 $4,884 $2,712 $4,300 $23,394 $38,292
Post-Announcement $3,002 $4,884 $2,712 $4,300 $23,793 $38,691
Current Liabilities Total Interest Bearing Debt Of Which: Long-Term Debt Other Liabilities Equity & Minority Interests Total Liabilities & Equity
$3,776 $3,529 $2,559 $2,533 $28,454 $38,292
$3,776 $3,529 $2,559 $2,533 $28,853 $38,691
3b. After it completes the debt issuance, the total interest bearing debt figure will increase by SEK 4 billion and the cash figure will increase by SEK 4 billion. Balance Sheet Cash & Short Term Investments Current Assets PP&E Other Assets
Pre-Issuance $3,002 $4,884 $2,712 $4,300
Post-Issuance $7,002 $4,884 $2,712 $4,300
Intangible Assets Total Assets
$23,793 $38,691
$23,793 $42,691
Current Liabilities Total Interest Bearing Debt Of Which: Long-Term Debt Other Liabilities Equity including Minority Interests Total Liabilities & Equity
$3,776 $3,529 $2,559 $2,533 $28,853 $38,691
$3,776 $7,529 $6,559 $2,533 $28,853 $42,691
3c. After it completes the share repurchase, the cash figure will decrease by SEK 4 billion and the market value of equity will decrease by SEK 4 billion. Balance Sheet Cash & Short Term Investments Current Assets PP&E Other Assets Intangible Assets Total Assets
Current Liabilities Total Interest Bearing Debt Of Which: Long-Term Debt Other Liabilities Equity including Minority Interests Total Liabilities & Equity
Pre-Repurchase $7,002 $4,884 $2,712 $4,300 $23,793 $42,691
Post-Repurchase $3,002 $4,884 $2,712 $4,300 $23,793 $38,691
$3,776 $7,529 $6,559 $2,533 $28,853 $42,691
$3,776 $7,529 $6,559 $2,533 $24,853 $38,691
4. Though the recapitalization will significantly increase Swedish Match’s leverage, even in the worst-case scenario - EBITDA declining to SEK 1.5 billion - Swedish Match should have sufficient cash flows to cover interest payments given th e low level of maintenance capital expenditures suggested by past capex spending (in 2004 it spent SEK 468 million on capex and will have annual interest payments totaling 446 million assuming it pays the same interest it did in 2004 on existing debt. Assuming its declining EBITDA is not couple with a large increase in net working capital in a downturn, an EBITDA of 1.5 billion suggests it will have sufficient cash flow for a similar level of capital expenditures while covering its increased interest obligations). Furthermore, the
additional debt would only increase debt to 24% of Swedish Match’s enterprise market
value. Thus the value of Swedish Match’s total assets would have to decline by approximately 75% for its total liabilities to be greater than the value of total assets – a unlikely occurrence even in the worst case scenario described above. Together, these facts imply that even under the worst-case operating scenario constructed by the CFO, Swedish Match would not default. Since there is a very low chance of default even with the additional debt, there is only a minimal increase in distress costs due to the issuance and Swedish Match can afford to issue the debt. Using 2004 pro-forma financials as if Swedish Match had preformed the recap in the beginning of 2004, Swedish Match has a lower interest coverage ratios and a higher Total Debt/EBITDA ratio than the average US industrial firm receiving a BBB rating. These estimates are fairly conservative, however, as 2005 EBITDA will likely be flat to slightly down given the stability in the tobacco industry and its historic trend but the level of pre-existing debt and the interest on this pre-existing debt (i.e. d ebt not raised for the recap), should be lower in 2005 than in 2004 given that the case states that Swedish Match’s pre-existing debt comprised of banks loans which are being rapidly repaid. More
importantly, tobacco firms typically have more stable cash flows than the average industrial firm, as, unlike many industrial firms, they are not very c yclical (even in downturns, consumers do not cut back on their tobacco purchases due to their addiction). Comparing Swedish Match’s ratios if it were to do the recap to the ratios of other tobacco firms suggest its debt is similar in riskiness to that of BAT, Imperial Tobacco and Gallaher, which are rated BBB+, BBB and BBB, respectively (see Figure 1). Moreover, as discussed above, the risk of default is incredibly slim. Therefore, it seems Swedish Match would be able to maintain either a BBB+ or BBB rating after the recapitalization. Figure 1: Pro-Forma Swedish Match Credit Ratios Compared with Benchmarks
Swedish Match Altadis (A- Rating) BAT (BBB+ rating) Imperial Tobacco (BBB) Gallaher (BBB)
EBIT Interest Coverage
EBITDA Interest Coverage
Total Debt/EBITDA
Leverage @ Market Values
4.2
5.3
3.2
23.3%
5.4
6.4
2.9
24%
6.8
7.7
2.5
28%
4.4
5.8
3.2
28%
3.9
4.5
4.3
36%
Average BBB firm Average BB firm
4.7
6.5
2.2
24.5%
2.5
3.5
3.5
35.5%
There are, of course, risks to the recapitalization. The increased debt load will require a large percentage of the Swedish Match’s cash flows to be used for interest payments, which will likely inhibit any further acquisitions. Moreover, though default is unlikely, it is very likely that Swedish Match would have to cut back on its annual share purchase program and dividend payments – it returned just shy of SEK 1 billion through share repurchases and dividends in 2004 – in a downturn due to high interest payment obligations. Cutting its dividend, in particular, would send its share price tumbling. Taking on the debt will also greatly increase Swedish Match’s exposure to the bond
markets. Especially if Swedish Match is raising all SEK 4 billion through a single maturity, bullet principal bond issuance, its ability to refinance and the cost at which it will be able to do so will depend greatly on interest rates and the global economy at the time its current debt matures. This poses a substantial risk. Lastly, it is worth revisiting the CFOs worst-case scenario. Often management is overly optimistic about the future of its own company. One particular scenario that could lead to an even further deterioration in profitability is additional regulation on smokeless tobacco. If the CFO’s estimate does
not represent a true worst-case scenario, Swedish Match may be at risk of default. Overall, we recommend that Swedish Match moves forward with the recapitalization. The tobacco industry produces huge cash flows but is in structural decline due to increased regulation and consumer education about the health risks of tobacco. The recapitalization utilizes the fact that Swedish Match will be able to produce large and stable cash flows to add value through tax savings and returns capital to shareholders so that they can reinvest it in growing areas of the economy. It also imposes
a necessary discipline on management – ensuring that they do not chase growth through value destroying acquisitions – something management teams globally are apt to do, especially when organic growth is implausible. These benefits seem to definitively outweigh the given the minimal risks involved. As a cherry on top, institutional investors, given that they have voiced support for the recap, may view the recap as a sign of increased emphasis on shareholder value by management, causing the stock to surge. That being said, we would not advise that Swedish Match does an even large recap. Additional debt will undoubtedly lead to a lower credit rating, especially since the company’s cash flows are barely sufficient to maintain a BBB+ rating with the proposed
level of debt, increasing the firms borrowing costs substantially. It will also greatly increase the risk of default, causing potential distress costs to most likely negate an y additional tax shield benefit. Lastly, it would give the company so little financial flexibility that even moderate margin or revenue pressures due to increased competition could result in the company having to cut back on dividend payments.
