Fidel Castro's Resignation: Changes in US Premium Cigars?

Source from:  19 February 2008 Lehman Brothers  02/21/2008

Fidel Castro has resigned as President of Cuba. There is currently an effective embargo on Cuban goods (including Cuban cigars) into the US; however, Castro's resignation may lead to some impetus for this to change. Swedish Match (1-OW) We currently have 7 SEK of downside risk in our price target of 171 SEK. (The value for the core operations is SEK 150 per share based on a DCF using a WACC of 7.2% and a terminal growth rate of 0.5% but we also include an option value, for future expansion, of SEK 20.5 per share). This 7 SEK assumes an ever increasing probability of Cuban cigar sales in US from 2009 and an assumption that once allowed, Cuban cigars take 50% share of premium cigars from Swedish Match. In a worst case scenario, that Swedish Match loses 50% share of US premium cigars tomorrow and does not lower fixed costs at all, we would see value reduction of c. SEK 17 per share (assumes contribution margin c. 50%). However, this ignores a lot of other offsetting factors: * Swedish Match owns a number of 'Cuban' brand names in the US including the arguably critical Cohiba * The Habanos JV (Imperial/ Altadis and the Cuban government) only currently covers non Cuban sales but this clearly has been excluding any possibility opportunity in USA. We do not know (but suspect) that the JV will not currently cover the USA market. This provides an opportunity for Swedish Match to try and negotiate a separate JV for the USA. After all, Swedish Match brings: - The best US premium cigar network (share of premium cigars c. 35%) - The Cuban brand names like Cohiba - An opportunity for the Cuban government to try and play off 2 partners against each other to maximise returns - A more receptive US government to a less monopolised entrant to the US market (i.e. Cuban Government seen to be more free market with more than one partner) * Imperial is now the partner in the Habanos JV and therefore has less established relationships than Altadis, which may improve Swedish Matches chances of a Cuban relationship * Cost of Cuban leaf will go up, internationally. This will force up the price of all Cuban cigars providing scope for more margin on Swedish Match non Cuban leaf sales. We also note that any change in US trade with Cuba is still likely to be some time away (if anything changes at all). A 2 year delay would reduce the 17 SEK value to c.15.5 SEK Overall, we think any reaction on Swedish Match on the downside is too one-dimensional and we see the market starting to see the huge opportunities any US-Cuban relationship change may have. Imperial (1-OW) From Imperial's stand point, this is arguably a zero sum game (i.e. Swedish Match loss is Habanos gain so 50% of value lost at Swedish Match goes to Imperial), we estimate this to be worth c. 20p a share to Imperial. Enditem