Swedish Match: Q3 Nicotine Pouch Strength Hidden By Post-COVID Weakness In Older Products

Summary

• Swedish Match stock has lost 7.9% in 4 days since Q3 2021 results, after disappointing group EBIT and U.S. Smokefree sales figures.
• ZYN nicotine pouches grew U.S. volume by 8.7% since Q2 and kept a 64% category share; but investors fear this was done with discounts.
• Instead, we believe weak U.S. Smokefree sales and EBIT were due to older products like moist snuff losing their volume boost from COVID.
• Weak U.S. Cigars EBIT was likewise due to a tough pandemic-year comparable and COVID-related external supply chain issues.
• Swedish Match's growth engine is intact. With shares at SEK 74.58, we expect a total return of 69% (18.7% annualized) by 2024. Buy.

Andrii Atanov/iStock via Getty Images

Introduction

We review our investment case on Swedish Match AB (OTCPK:SWMAY) (referred here as "SWMA") after Q3 2021 results were released last Wednesday (October 27). Investors have reacted negatively, with SWMA shares falling 4.9% on the day of the results and having now fallen by 7.9% over 4 days:

SWMA Share Price (2021 YTD) NB. USD/SEK has risen 5.4% YTD as of 31-Oct. Source: Google Finance (01-Nov-21).

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We initiated our Buy rating on SWMA in September 2020. After the recent correction, SWMA stock has returned 5.1% (in SEK, after dividends; 8.6% in USD) in 13 months, including 19.3% year-to-date (14.0% in USD).

We believe SWMA's growth engine is intact, and strong profitable growth in nicotine pouches in Q3 was hidden by post-COVID weakness in snus and cigars. Our forecasts show a total return of 69% (18.7% annualized) in SWMA stock by 2024, including a 2.0% current Dividend Yield.

Swedish Match Buy Case Recap

Swedish Match is a Sweden-listed tobacco company that has a $13.6bn market capitalization and currently generates nearly two thirds of its EBIT in the U.S.

More than 70% of its current EBIT is from Smokefree products, including both traditional oral tobacco (moist snuff, snus and chewing tobacco) and nicotine pouches; another 25% is from its U.S. Cigars business:

SWMA Revenue & EBIT by Segment (2020) Source: SWMA results release (Q4 2020).

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As of our September update, our SWMA investment case included:

• The ZYN nicotine pouch business continuing to grow rapidly, especially in the U.S., where the category is still just 2% of the nicotine market
• The U.S. Cigars business, which has been growing strongly, will be spun off to shareholders via a U.S. listing during H2 2022 or after
• An exit P/E of 25.0x for the Smokefree New SWMA, 19.0x for the U.S. Cigars spin-off and SEK 7.3bn of cash to be returned to shareholders; this implies a blended P/E of 23.4x on current SWMA earnings
• On a pro forma (i.e. excluding the spin-off), group EPS to grow to above SEK 5 by 2024, with growth initially at mid-teens but decelerating to 10%

Q3 2021 showed weak headline numbers in both group EBIT and U.S. Smokefree sales, but we believe due to one-offs in some businesses, while the long-term drivers of our investment case have remained intact.

Weak Group EBIT & U.S. Smokefree Sales

SWMA's Q3 2021 results included low EBIT growth and sequentially flat U.S. Smokefree sales, which reawoke investor fears about competitive intensity.

Q3 group EBIT rose just 1.3% year-on-year, despite sales growth of 8.6%; this included, in USD, U.S. Smokefree EBIT rising just 3.3% and U.S. Cigars EBIT being flat. Compared to Q2, group EBIT was 6.1% higher, but this was led by the Scandinavian Smokefree business; in USD, U.S. Smokefree EBIT fell 4.1% sequentially and U.S. Cigars EBIT rose just 1.9%:

SWMA Sales and EBIT by Segment (Q3 2021 vs. Prior Periods) Source: SWMA results release (Q3 2021).

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U.S. Smokefree's EBIT margin fell both year-on-year and sequentially and, measured in USD, its sales were flat between Q2 and Q3.

SWMA has attributed these negative datapoints to the reversal of COVID benefits, pre-planned increases in marketing and other COVID-related developments, instead of any deterioration in its underlying businesses.

We believe this to be a reasonable explanation overall.

U.S. Smokefree: ZYN Is Winning Profitably

ZYN has continued to win in volume and market share in the U.S., and U.S. Smokefree's weak EBIT in Q3 was due to the one-off reversal of COVID volume benefits. Promotions and costs remained under control.

Rising Volume, Stable Share But Lower EBIT

In USD, U.S. Smokefree Q3 sales were 11.9% higher year-on-year but flat from Q2, and its EBIT was flat year-on-year and 4.1% down from Q2:

SWMA U.S. Smokefree Revenues & EBIT (in USD) (Since Q2 2019) NB. Q2-3 2019 USD sales figures converted from SEK using the same rate as Q4. Source: SWMA company filings.

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The weak Q3 financials were in spite of strong growth in ZYN's U.S. volume, up 43.0% year-on-year and 8.7% from Q2:

SWMA U.S. ZYN Volume (Since 2019) Source: SWMA company filings.

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ZYN maintained its dominance in the U.S., with a category share of 63.8% in Q3 (up 20 bps sequentially); Altria's (MO) On! also gained share, but British American Tobacco's (BTI) (referred here as "BAT") Velo/Dryft stagnated:

U.S. Nicotine Pouches Volume & Market Share (Since Q2 2019) Source: SWMA results presentation (Q3 2021).

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SWMA stated that there was "continued broad-based and deep promotional activities from major competitors" in Q3, and that it had its own promotions as well. A possible negative interpretation of the data above is that SWMA has sacrificed price and/or profit margin to maintain volume share. However, based on management comments and other data, we believe this was not the case.

Weak Traditional Oral as COVID Boost Reversed

Instead, SWMA blamed weak traditional oral tobacco for dragging down EBIT:

"The relatively sharp volume declines that we report from moist snuff and chewing tobacco naturally had a negative effect on the earnings development."

Lars Dahlgren, SWMA CEO (Q3 2021 earnings call)

This explanation is supported by data. U.S. volume for moist snuff fell 7.1% sequentially in Q3, and that of chewing tobacco fell 7.0%; both were down double-digits year-on-year:

SWMA U.S. Smokeness Volumes (Q3 2021 vs. Prior Periods) Source: SWMA company filings.

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The 7.1% sequential decline in moist snuff volume was the largest such decline since 2019, except Q4 and Q2 2020 which were affected by one-offs (SKU rationalization and Q1 COVID-related hoarding respectively); Q3 moist snuff volume was back to just 1% above the pre-pandemic Q3 2019:

SWMA U.S. Moist Snuff Volume (Since 2019) Source: SWMA company filings.

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We believe older products' volume boost from stay-at-home consumers during the pandemic is now reversing. Year-on-year growth in the oral tobacco industry's rolling six-month volume decelerated from 5% to 3% in Q3:

U.S. Oral Tobacco Industry Volume Growth Year-on-Year (Since 2020) Source: MO results presentation (Q3 2021).

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As we described in our review, Altria's Oral Tobacco Q3 EBIT was 8.0% lower year-on-year and 14.1% lower than Q2, again consistent with a general deceleration in older products and much worse than SWMA's performance.

U.S. ZYN Promotions & Costs Remain Disciplined

While ZYN had some promotions, these were smaller than peers, limited in duration and did not change its premium positioning. As SWMA explained:

"During the quarter, there were also certain summer promotions for ZYN that calibrated to well aligned with the premium profile of the brand, which implied a promoted discount for cans at retail level well below rebates typically seen from major competitors."

Lars Dahlgren, SWMA CEO (Q3 2021 earnings call)

Management stated the summer promotions will not be repeated in Q4 and ZYN has "also implemented list price increase for ZYN recently as well".

Similarly, while U.S. Smokefree marketing expenses have increased relative to 2020, this was partly a result how they were suppressed by COVID lockdowns. Total costs had an 11% sequential step-up in Q2, but only rose 4% in Q3:

U.S. Smokefree Total Costs (Since 2019) Source: SWMA company filings.

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Overall, we believe U.S. Smokefree's weak EBIT growth in Q3 could be explained by the one-off reversal of COVID volume boost in traditional oral tobacco products. We expect strong EBIT growth in the future.

U.S. Cigars Affected by COVID One-Offs

U.S. Cigars' Q3 EBIT was flat-ish from both the prior-year quarter and Q2, despite sales being 7.5% higher year-on-year 5.9% higher than Q2 (in USD):

SWMA U.S. Cigars Revenues & EBIT (in USD) (Since Q2 2019) NB. Q2-3 2019 USD sales figures converted from SEK using the same rate as Q4. Source: SWMA company filings.

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Widely reported COVID-related global supply chain issues are to blame. During Q3 SWMA U.S. Cigars suffered from higher costs in both raw materials and labour. There were also shortages in some raw materials, which reduced shipment volumes (especially in Homogenized Tobacco Leaf, or "HTL", cigars).

Management referenced elevated volumes last year and stated that Q3 mass market cigars category volume fell 3% year-on-year; we believe cigars are also seeing the reversal of COVID-related volume benefits.

Consistent with this, Altria (which stated it did not suffer from meaningful shortages), saw its Q3 cigars volume fall 9.8% year-on-year and 6.8% from Q2; its total cigars volume grew 2.7% in Q1-3, compared to 9.0% in FY20:

Altria Cigar Volumes (Q3 2021 vs. Prior Periods) Source: Altria company filings.

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SWMA has continued to gain share in the faster-growing natural leaf segment while losing share in HTL, resulting in a slightly down market share overall:

SWMA U.S. Cigars Market Share by Segment (Q3 2021 vs. Prior Year) Source: SWMA results presentation (Q3 2021).

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U.S. Cigars's weak Q3 EBIT growth was due to supply chain issues and the reversal of COVID volume benefits, and we expect solid growth in future.

Scandinavia Smokefree: Solid EBIT Growth

The Scandinavia Smokefree business grew EBIT just 3.5% year-on-year but 17.3% sequentially in Q3. Year-to-date, EBIT was up 15.1% year-on-year:

SWMA Scandinavia Smokefree Revenues & EBIT (Q3 2021 vs. Prior Periods) Source: SWMA results release (Q3 2021).

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The lower year-on-year EBIT growth in Q3 was due to both low prior-year costs during pandemic lockdowns and higher current-year marketing spend on nicotine pouches (including the new VOLT brand).

SWMA is losing market share slowly in both snus and nicotine pouches in Scandinavia, but while still growing volumes, revenues and EBIT solidly. Management has launched several initiatives in an attempt to reverse this, including the launch of VOLT in Q2 to target younger users.

We expect solid EBIT growth to continue in Scandinavia Smokefree.

Group EPS Up 18% Year-to-Date

Overall, for Q3 year-to-date, SWMA's group sales grew 9.4%, EBIT grew 14.0%, Adjusted Net Income grew 15.1% and Adjusted EPS grew 18.2%:

SWMA P&L (Q3 YTD vs. Prior Year) Source: SWMA results release (Q3 2021).

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Year-to-date Adjusted EPS of SEK 2.88 is 78% of our previous 2021 forecast.

Valuation - Is Swedish Match Stock Cheap?

At SEK 74.58, relative to 2020 earnings, Swedish Match stock is trading at a 22.5x P/E and a 3.8% Free Cash Flow ("FCF") Yield; relative to last-twelve-months ("LTM") earnings, it is at a 20.2x P/E and a 4.2% FCF Yield:

SWMA Net Income, Cashflow & Valuation (2017-20) Source: SWMA company filings.

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The Dividend Yield is 2.0%, with an annual dividend of SEK 1.50 per share (raised 20% year-on-year).

Share buybacks year-to-date have totalled SEK 2.23bn, equivalent 2% of the current market capitalization. Q3 share count was down 2.6% year-on-year.

Swedish Match Stock Forecasts

We continue to model SWMA's group EPS, until there is more clarity on the U.S. Cigars spin-off's timing and cost structure, but reflect the spin-off's valuation and cash return benefits by assigning SWMA stock a higher P/E (23.4x, was 22.5x standalone previously).

We reduce our 2021 share count slightly but keep all other forecast assumptions unchanged from our last update:

• 2021 Net Income growth of 12.5%
• 2022 Net Income growth of 10.0%
• 2023 Net Income growth of 8.5%
• 2024 Net Income growth of 7.5%
• 2021 share count reduction of 3.0% (was 2.0%)
• From 2022, share count to be reduced by 2.0% a year
• Dividend payout ratio of 50% in 2021, and 60% thereafter
• 2024 year-end P/E of 23.4x

Our new 2024 EPS forecast is SEK 5.09, 1% higher than before (SEK 5.03):

Illustrative SWMA Return Forecasts Source: Librarian Capital estimates.

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With shares at SEK 74.58, we expect an exit price of SEK 119 and a total return of 69% (18.7% annualized) by 2024 year end, in just over three years.

Is Swedish Match Stock A Buy? Conclusion

Swedish Match's growth engine is intact.

ZYN nicotine pouches are winning in both volume and market share. Weak group and U.S. Smokefree headlines were due to older products losing their volume boost from COVID and/or supply chain issues.

With shares at SEK 74.58, we expect a total return of 69% (18.7% annualized) by 2024.

We reiterate our Buy rating on Swedish Match.

Note: A track record of my past recommendations can be found here.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of SWMA, MO,BTI either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.