Hedge Funds Play Chicken With a Smoking Giant

Hedge funds have become a big obstacle to Philip Morris International Inc.’s 161 billion Swedish krona ($14 billion) deal to buy nicotine pouch-maker Swedish Match AB. The US cigarette giant must choose between several unattractive ways around.

PMI aims to generate a majority of its revenue from smoke-free products by 2025. That translates into increasing sales of less harmful alternatives to cigarettes. Swallowing Swedish Match would help the business mix adjust: Smoke-free products were two-thirds of its revenue last year.

The acquisition would also give PMI its own US distribution network, whereas today the firm relies on a partnership with former parent Altria Group Inc. That could accelerate sales of its “heat-not-burn” products. On top, Swedish Match’s Zyn pouch could be sold through PMI’s network where regulators allow.

So there’s substantial scope for the combination to generate stronger sales. At first glance, these benefits aren’t coming cheap. Add net debt, and the offer values Swedish Match at 16 times next year’s forecast Ebitda (earnings before interest, tax, depreciation and amortization), well above where major peers trade.

But the initial reaction to the deal talks and agreed terms suggests PMI is a long way from overpaying. Swedish Match gained $4 billion in value, reflecting the takeover premium on offer. PMI’s market capitalization rose $7 billion.

The implication is that investors saw around $11 billion of value creation. Some of that could come from PMI commanding a higher earnings multiple as the company secured its future beyond cigarettes. Some could come from the additional earnings generated once the transaction is bedded down.

PMI’s shares have fallen since, along with the wider market. But the initial assessment is being revised probably because Swedish Match investors want a bigger payday, so PMI may have to raise its 106 kronor-per-share bid. Hedge funds have amassed a 25% stake in PMI’s target, Bloomberg News reported earlier this month. Some, including Elliott Management Corp., are resisting.

Certain long-term shareholders are vigorously opposed too. Framtiden Management Company LLC, which says it owns 1%, reckons 200 kronor per share is a more suitable price given the prospects for Zyn. Combine this opposition with foot-dragging retail investors, and the naysayers have real leverage.

PMI has three main options in this game of chicken.

One, hold the price and take the substantial risk that the deal fails. Low bids can seem more attractive in falling markets, and PMI boss Jacek Olczak would look tough. But this would be foolish given the asset has huge strategic value.

Two, try a slow deal in stages. PMI currently wants to acquire at least 90% of Swedish Match, the level where it can compulsorily buy out remaining shareholders. Its current offer would proceed only after securing that support. Instead, PMI could amend the condition and go ahead once it got over 50%. At that level, it would at least gain control of the board and could try establishing an arm’s length agreement to utilize Swedish Match’s distribution.

To pile on some pressure, PMI could then raise its bid. Swedish Match shares closed Friday 3% above the May offer. A 10% sweetener would give merger arbitrageurs a quick buck and PMI might in return gain a majority holding. The stronger dollar would help pay for it.

The snag is that such a bump may not be enough to persuade the most demanding hedge funds and longer-term investors to sell. PMI would have to keep Swedish Match as a separate listed company and look after these minority shareholders, who could be disruptive. It would want to make another offer to buy them out eventually. That could be costly.

Which brings us to option three: Cave and do a bigger raise now, with the aim of nipping past 90% ownership. PMI could harness the deal’s benefits immediately, mitigating the higher price.

This might not be much more expensive than a smaller sweetener combined with a follow-on offer to mop up minority investors later. Indeed, it may be the least-bad approach in the long run. It just wouldn’t feel that way. Colossal price-jumps are rare in M&A and buckling risks damaging PMI management’s credibility. If Olczak took this path, he’d want prior assurances that it would work, so he could present the revised deal as a victory.

The hedge funds have a decent hand. But they need to be prepared to play a long game to push PMI to its pain barrier.

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This column does not necessarily reflect the opinion of the…

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