Keeping the cash machine lean

Strong cash generation in the business could hardly be called a problem, but how to choose between building a war chest and capital discipline? Swedish Match CEO Lars Dahlgren (LD) and CFO Anders Larsson (AL) tell Johan Trocmé (JT), Director of Nordea Thematics, about 15 years of transparent and consistent financial strategy to minimise WACC (weighted average cost of capital) and optimise the company's value. Investors know what they will get, with leverage kept within the policy range and recurring share buybacks to shed excess capital, which are allowed to vary according to circumstances.

JT: Do you have a high-level thinking and view on the company's capital structure? Does it take into account factors such as stability and capital intensity of the business, regulatory or technology risk, the relative costs of debt and equity and potential M&A?

AL: Our general aim is to minimise our cost of capital. And we weight in all the factors you mention when we try to make our WACC as low as possible.

LD: When we articulated our view in conjunction with the introduction of our new financial policy in 2005, differences in cost of capital between the different types of credit and general risk profiles were bigger than they are now. At the time, we presented a comprehensive review and analysis to our board, simulating the consequences for our WACC should we take on more debt, and evaluating tools for shifting out excess capital to shareholders. We did sensitivity analyses and stress tests for events like a sudden profit decline or major acquisition. And we ended up with a set of parameters we were very comfortable with for our leverage and our payouts to shareholders.

Our review was prompted by a strong balance sheet that was starting to trend towards becoming debt-free, which made us stand out very sharply from our peers. We have always has a sizeable international owner base, and back in those days there was a disclosure on capital structure where Sweden was arguably lagging international investors. Local dialogues were more oriented around the equity ratio, whereas private equity and international investors focused on cash flow-oriented measures such as net debt to EBITDA. We took inspiration from this in our view on our capital structure, and our financial policy and targets.

JT: How have you decided on the split between ordinary dividends, share buybacks and extraordinary dividends for your payouts to shareholders?

AL: We think we have a very good mix of payout tools, and we like the flexibility of share buybacks which allow us to without delay accelerate or pause that element of our payouts, according to the circumstances we find ourselves in. We see the ordinary dividend as a base which should be attractive enough to appeal to all equity investors, and which we aim to grow continuously over time. Share buybacks are the tool for paying out excess capital from the strong cash generation in our business.

LD: Comparing Swedish Match with our peers, we noted that they tended to have very generous dividend policies. Our profile was already then more growth oriented, and has since become even more different, with our emphasis on harm reduction through smokeless tobacco. And we also saw a potential negative signal value from having a too high dividend payout ratio, which could indicate that your business has little or no investment opportunities. The credit rating agencies and bond investors also see ordinary dividends as a commitment, which in their eyes means that a high payout ratio policy limits a company's financial flexibility when a big chunk of generated cash flow is automatically funnelled into dividend payments.

We have used extraordinary dividends in addition to ordinary dividends on a couple of occasions, in conjunction with divesting our holding in Scandinavian Tobacco Group (STG).  Reasons included the magnitude of excess capital, which would have required years of share buybacks until it had been paid out, with an elevated WACC in the meantime. Also, we offered a choice for shareholders with different preferences. Those who wanted to maintain the mix of Swedish Match's smokeless tobacco and the cigars of STG could take the money from the extraordinary dividend and buy shares in STG, which had not been possible with only buybacks. We did consider the negative impact on our earnings per share and our ability to keep growing our ordinary dividend per share from divesting STG, and the possibility to at least partially offset this through using some of the proceeds for share buybacks. But in the end we anticipated a strong enough performance in our core business for it not to be needed.

JT: How has your financial policy evolved over the years, since you first introduced it in 2005?

LD: Our financial policy has largely stayed the same since we introduced it, with only some fine-tuning over the years. We have reduced our targeted external credit rating by one notch. We used to have both interest cover and net debt to EBITA as target metrics for our leverage, but we have dropped the former. Our original net debt to EBITA target was 2x. When we exceeded that level after some cigar acquisitions, we did a review and raised the target to 3x just before the global financial crisis of 2008. And we think that crisis highlighted the validity of our financial policy. It was a turbulent time, but we did not change our dividend policy. Instead we opted to halt our share buybacks for some time, as we needed to manage refinancing risks when corporate bond markets froze up during the crisis. This took us through the crisis, and made it possible for us to be one of the first companies to issue a new corporate bond after the most dramatic phase of the crisis had passed. The financial crisis did not prompt any changes to our financial policy.

Our impression is that both equity and debt investors have come to greatly appreciate the transparency and the consistency of Swedish Match's view of its capital structure over many years.

AL: In our planning, we look at our planned investments in the coming 12 months and our required minimum cash balance level, and need to be able to use our expected cash generation for this plus any debt maturities. Only after all this is covered do we start to buy back shares.

JT: How does the dialogue work between management, the board and major shareholders – is capital structure a topic that comes up frequently in management's dialogue with investors and shareholders?

LD: We clearly see the consequences of our consistent approach over the years, in that investors know what they will get. We occasionally meet investors with a particular investment philosophy who would prefer that we have higher ordinary dividends, or that we would use share buybacks for an even bigger share of our payouts. But for the most part, the dialogue more has the nature that we are asked if there any changes in our well-known view on payouts.

The same applies for the credit rating agencies, who are very familiar with our view and our policies. As regards the board of directors, we have an annual review of our financial policy, our WACC and our dividend proposal. We further update the board ahead of every meeting on our progress for share buybacks, and how we envisage them for the coming quarter.

JT: With a highly cash-generative business, is it ever tempting to just keep accumulating a big cash pile? To keep for a rainy day?

LD: We try to be very rational in everything we do. I do not think we have it in us to build a war chest just for the sake of it. We try to put what is in the best interests of our shareholders at the forefront. With the strong cash generation in our business, and with a ceiling of 3x net debt to EBITA, we do not feel like we are severely constrained regarding any potential M&A opportunities. Especially if we allow for being temporarily able to go above 3x leverage to pursue an attractive acquisition opportunity. When we slow or halt our share buybacks, our indebtedness normally falls quite rapidly.

Ultimately, in the event that we identify a very big and attractive M&A opportunity, we might need to raise new equity capital to pursue it. If that were to happen, we believe our track record on capital structure and governance would benefit our valuation and access to the equity market. A good M&A case should attract interest and support from investors. And if you consider the alternative, being able to act quickly for an acquisition by using a war chest could be heavily outweighed by a lower valuation from a governance discount if you have a bloated balance sheet and an elevated WACC.

JT: Is the perceived sustainability profile of Swedish Match a factor in your view on availability of funding? Does it play any role in your view of what is the optimal capital structure for the company?

AL: The importance of sustainability for investors is continuing to grow rapidly. Here in the Nordic region there seems to more of a 'binary' approach, where companies which do not pass an investor's sustainability filter are simply excluded from their investment portfolios. That approach is a disadvantage for a company like Swedish Match, with our compelling case for harm reduction from smokeless tobacco being arbitrarily overlooked when we are categorised just as any tobacco company with all the health issues from smoking.

We would consider it very interesting to issue an ESG-linked debt instrument by means of, for example, a public health bond. But this would require a more nuanced sustainability analysis of us as a company. Some geographies are more receptive to facts and our message and vision for harm reduction, while our Nordic home turf is presently more stuck in its simplistic exclusion-based sustainability approach. We saw this contrast when we issued our latest Eurobond, which was met with very strong interest and heavily oversubscribed.

Overall, we see untapped potential here in the Nordic region in the event of an evolution to a more sophisticated sustainability screening and analysis which would better reflect the nature of our business. But in the meantime, international bond markets are working well for us.

JT: Do you face different capital structure preferences from creditors and equity investors, or from different shareholders? How do you balance such differences?

AL: If anything, our capital structure approach is even more appreciated on the debt side, with bond investors appreciating our continuity and consistency.

LD: On the equity side, our impression is that the balance in our financial policy has a very broad appeal. Some specific investors have specific wishes because of their investment mandate, but we rarely if ever hear that those are in complete contrast to our approach. We feel very comfortable both from a governance point of view, and in not discouraging any major parts of the investor universe.