EXECUTIVE SUMMARY
This report has been prepared for the exclusive use of Mr. Lars Dahlgren, the CFO of Swedish Match, to assist him to convince their board members and shareholders for a recapitalization share purchase funded by debt. In the analysis presented below, we took the existing financial condition of Swedish Match as of Dec'04, and predicted the results of additional debt of SEK 4 billion, which they would have to take up in order to finance the recapitalization, on this financial condition.
During our analysis we found out that taking up the new debt would give Swedish Match a tax saving of SEK 50.4 million every year amounting to a total debt tax shield of SEK 399 million. After the recapitalization though the book value of equity would reduce considerably i.e., by SEK 4 billion, the market value of equity will decrease by a lesser amount due to the debt tax shield leading to an overall increase in the share price.
The current leverage and coverage ratios of SM suggest that they have the ability to take up new debt without having huge repercussions. The team found out that the new debt would slightly raise the leverage of the firm, but they would have the full ability to pay the interest and not default even in the worst case situation of EBITDA falling to around SEK 1.5 billion, based on the coverage ratios of the firm. This would also reduce the credit rating of the firm from A- to a very well sustainable BBB.
Overall, we believe that SM can afford the additional debt of SEK 4 billion and the recapitalization intended. When compared to the risk associated with the debt and recapitalization such as cutback in acquisitions, in dividend payments, and increased government regulations, the overall benefit of share price increase and shareholder value appreciation is much more valuable. There is also an added benefit of Managers not being able to do value disruptive acquisitions just for the sake of growth as the overall cash flows of the firm would reduce due to the increased debt payments. Having said this, we also advice Swedish Match not to increase the size of their recapitalization, as it would reduce the credit rating of the below BBB, which can impose bigger problems in the future. This would also create a huge pressure on the firm, as any drop in the operating margins of the firm could lead to risk of default of payments leading to financial distress and even bankruptcy.
The report below gives a detailed analysis of the basic result presented above.
Q1. Assuming Swedish Match faces a 28% tax rate on income and can issue bonds at foxed krona yield of 4.5%, how much will the company save in taxes for SEK 4 billion recapitalization? What is the value of interest tax shield?
Tax Saving
Since the rate of interest to be paid on the debt (D) issuance of SEK 4 billion is 4.5% and the tax rate is 28% the saving in taxes would be – Rate of interest (i) * SEK 4 billion * tax rate = 4.5% * 4000 * 28% = SEK 50.4 million.
Tax Shield
Interest paid on debt – i * D
Tax benefit of Debt – i*D*tc
Since the bond yield of Swedish Match most closely matched to the bond yield of a 10-year maturity bond of a company having rating between A and BBB, we assume that the tax shield would be an annuity of 10 years.
Debt Tax Shield = (i*D*tc)*a(i ,10) = 50.4*[(1/0.0045) – 1/(0.0045*(1.045)^10)] = SEK 398.8 million.
Q2. What will SM's book value balance sheet look like after it completes the debt issuance and share repurchase?
To calculate the effect of the debt issuance and share repurchase on the book balance sheet, we first restated the given balance sheet to get the value of total capital invested (Net Debt + Equity), and the total capital employed (Net of Assets). The restated balance sheet, before debt issuance and share repurchase, is shown in Table 1 below
Table 1 – Restated book balance sheet before issuance of debt and repurchase of shares.
After the debt is issued and the repurchase is done, in the above balance sheet the value of total debt will increase by SEK 4000 million, due to the debt issuance, and the value of book equity will decrease by SEK 4000 million due to the repurchase of the shares. The restated book balance sheet, after these transactions have happened, is shown in Table 2 below.
Table 2 – Restated book balance sheet after issuance of debt and repurchase of shares.
Q3. What will SM's market value balance sheet look like
Right after it announces the levered recap
The market value of equity for SM is given to be SEK 28,454 million and the number of shares outstanding is 322.1 million. Hence the existing share price of SM would be = 28454 / 322.1 = SEK 88.34. The market value balance sheets of SM before and just after the announcement of levered recap would be as shown in Table 3 below. The market premium mentioned in the table refers to the difference between value of market and book equity.
Table 3 – Restated Market Balance Sheet prior to and just after announcement of levered recap.
Right after announcement of the deal the market premium will increase by the debt tax shield hence increasing the share price.
When it completes the issuance of SEK 4 billion debt?
After the issuance of the debt the value of the total debt would increase by SEK 4 billion and the Cash and ST investments will also increase by SEK 4 billion. The balance sheet is as shown in Table 4 below
Table 4 - Restated Market Balance Sheet after issuance of debt.
When it completes the share repurchase?
After the share repurchase is complete the cash on the balance sheet will decrease by SEK 4 billion and so would the equity value, because the repurchased shares would be cancelled. The value of equity will reduce by SEK 4 billion – SEK 399 million (Debt Tax Shield) i.e., SEK 3.6012 billion.
Table 5 - Restated Market Balance Sheet after issuance of debt and share repurchase.
Q4. Can Swedish Match Afford to borrow this much money? What are the risks? Is it realistic to expect a BBB+ rating? Should the company go ahead with the leveraged recap? If so, would you approve a larger recapitalization?
To check, whether SM can afford the new debt we first calculated the leverage ratios as of end Dec'14 and then compared them with the leverage ratios after the issuance of new debt in 2005. To forecast the EBIT and EBITDA of 2005 we used the historic average of the annual growth rates, and to calculate the interest payment for 2005, we added the interest payment as of end Dec'14 and the interest payment of the new debt. Table 6 below, shows the leverage multiples before and after the debt issuance.
Table 6 – Leverage Ratios before and after the debt issuance.
From the table above, we can deduce that principally speaking, SM can take up the debt. Even though their book value based gearing would increase a lot, their EBIT coverage ratio is above 3. Even if the worst case scenario of EBITDA being reduced to SEK 1.5 billion occurs, then also the firm would have enough cash flows to afford the necessary interest payments and the EBITDA coverage ratio would still be above 3 (somewhere around 3.36). Also their market capitalization is still at a very safe level of around 24%. This means that their asset value would have to drop down by more than 75% for liabilities to overtake assets, which is very unlikely to occur. Even if there is a considerable decline in the EBITDA, SM would still be able to cover its interest payments and hence the probability of default is low, and hence, we SM can go forward with taking up the loan.
But, when we compared these ratios with the ones given in Table 7 below, which define the credit ratings of organizations based on these ratios, we found out that the credit rating of SM will drop down to somewhere between BBB and BB, and the targeted credit rating of BBB+ might not be achieved. This is because all the ratios for 2005, except for market leverage, from the Table 6 fall between BBB and BB in the table below. When we compare these ratios to the competitor companies having rating BBB+ and BBB rating i.e., BAT and Gallaher respectively, we see that a BBB rating for SM would be more suitable.
Table 7 – Financial Ratios Vs. Credit Ratings
Though its affordable for SM to take up the debt, there are some risks associated with the new debt. An increase in the amount of interest payments, would lead to reduction in cash flows, and hence, SM might have to cut back on its capital expenditures and acquisitions. SM would also have to reduce its dividend payout, which would eventually lead to a fall in the share price. There is also some risk of government regulation against smokeless tobacco or tobacco as such, which might further worsen the worst case scenario, and a possibility of default might occur.
ALL IN ALL, we recommend that Swedish Match goes ahead with the recapitalization. Due to the recapitalization SM will generate increased cash flows in the future due to the debt tax shield, and hence increase shareholder value. It is also mentioned that institutional investors think of raising debt as a sign of strength, and have supported the share repurchase. Hence, this may further increase the share price. The decrease in the cash flows due to the increased interest payments, can also be a blessing in disguise as it controls the managers from doing value disruptive acquisitions just for the sake of growth. We do not advice SM to do a bigger recapitalization because further increase in debt would definitely push the ratings below the BBB mark, increasing further borrowing costs substantially. This will also create a lot of pressure on the firm as even a minor drop in margins could lead to a situation of default, leading to financial distress, which would imply more costs and even bankruptcy.
