Scandinavian Tobacco Group A/S (STG) Earnings Call Transcript & Summary

Yes. Thank you, and good morning. And welcome to this conference call for our third quarter result. Please turn to Slide #2. As said, my name is Torben Sand, and I'm Head of Investor Relations. And with me today, I have, as usual, our CEO, Niels Frederiksen, and our CFO, Marianne Rørslev Bock. Today, we will present the highlights for the quarter. We will give you an update -- business update on the impact of the COVID-19 pandemic on our business and present a status of the Agio Cigars integration. Following this, we will give you an overview of the quarterly performance in our 3 commercial divisions and the group as a whole, including an update on our group funding structure and the share buyback program. Finally, we will take you through the outlook for 2020 and take your questions at the end. But before we start, as usual, I ask you to pay attention to our disclaimer on forward-looking statements in the back of this presentation. Now please turn to Slide #3, and I will leave the word to Niels.

Thank you, Torben, and a very warm welcome and good morning to everyone on the call. So overall, Scandinavian Tobacco Group delivered a strong third quarter of the year. At the backdrop of increased tobacco consumption across categories and markets, we delivered double-digit growth in net sales, earnings and free cash flow before acquisitions. Net sales grew organically by 12% to DKK 2,231 million. EBITDA before special items was DKK 614 million versus DKR 446 million last year, displaying a 33% organic growth. And free cash flow before acquisitions improved to DKK 609 million compared to DKK 503 million last year. The results continue to be driven by changes in consumer behavior following the outbreak of the COVID-19 pandemic and higher tobacco consumption across product categories and markets. Specifically, we continue to see a positive development in the important U.S. market with overall increased consumption of handmade cigars and strong volume growth in the online business. Additionally, sales of pipe tobacco and fine-cut have performed better in several markets. Based on the strong Q3 numbers, our performance for the first 9 months of 2020 is better than expected with a 7.5% organic net sales growth to DKK 6,084 million versus DKK 5,020 million last year. We have 25.6% organic growth in EBITDA before special items at DKK 1,429 million versus DKK 1,083 million last year. And with -- we have free cash flow before acquisitions of DKK 1,156 million versus DKK 819 million last year. We are, however, maintaining the group's full year guidance as we expect a weaker fourth quarter, negatively impacted by lowering of net sales of an estimated DKK 100 million in previous quarters, very strong comparison numbers for the fourth quarter of 2019 and a temporary increase in the OpEx ratio in the fourth quarter of 2020. All in all, for 2020, we continue to expect organic EBITDA growth of more than 9%, and we also expect free cash flow before acquisitions of more than DKK 1 billion. Based on this overview of the third quarter, let's turn to the update on the continued impact of COVID-19 pandemic to our business. Please move to the next slide. On the sales side, we see that restrictions and actions taken to counter the outbreak of COVID-19 has changed consumer patterns and behavior. These changes persisted into the third quarter of 2020, with impact on most product categories and markets. In the handmade cigars and smoking tobacco categories, smoking opportunities for consumers increased, as a large part of the workforce is still working remotely, while personal consumption has been supported by aid packages fueling increased demand. And the overall trend toward online commerce also impacted our U.S. online business positively where we continue to see increase in the number of active customers and the average order size, and we also see improved customer retention rates. While we expect increased cigar consumption in the U.S. to continue in the near term, the long-term sustainability of these new consumer patterns remain uncertain. If we turn to the supply side, we have -- we continue to have most of our factories up and running, and we have been able to increase capacity with more than 1 million premium cigars per week over the period. The overall supply of premium cigars has been under pressure as a result of the strong demand in recent months, and inventories throughout the supply chain have been reduced. However, with increased production output, inventory levels are expected to normalize early next year, assuming no material disruptions and lockdowns to disrupt supply chains. With the recent worsening of the pandemic in several countries and regions, especially in Europe, preparations and precautions have been reintroduced to ensure the continued running of our business. Please go to Slide #5. This brings me to an update on the integration of Agio Cigar. The integration is progressing well and as planned. The commercial integration is expected to be finalized in the fourth quarter, and it is encouraging that the combined like-for-like market share improves quarter-by-quarter. The expectation is to deliver total net synergies of an estimated DKK 225 million by the end of 2022, and cost savings of about DKK 70 million to DKK 80 million in 2020 remain unchanged. Special cost in relation to the integration of Agio Cigar of DKK 61 million has been expensed in the third quarter as well as DKK 13 million impairment cost. The expectation is maintained that total special costs until the end of 2022 will be at the level of DKK 450 million with cash impact and DKK 122 million with noncash impairments. The latter were primarily expensed in the first quarter of the year. Now please turn to the next slide and the overview of the 3 commercial divisions, which Marianne will take you through.

Thank you, Niels. For the division North America Online & Retail, the reported net sales increased by 21% to DKK 746 million during the quarter, composed by a 27% positive organic net sales growth and a negative exchange rate effect of 6%. Driven by the overall demand increase in handmade cigars and the shift of consumers to online platform, our North American online channel experienced a solid increase in the number of active customers, an increase in average order size as well as improved customer retention rates compared to the third quarter of last year. EBITDA before special items increased by 41% to DKK 151 million with an EBITDA margin before special items of 20.2% versus 17.3% last year. The margin improvement was driven by an improved gross margin, reflecting lower competitive pressure and scale benefits as well as continued efficiency improvements, lowered OpEx ratio compared to last year. The EBITDA margin declined, however, slightly versus the same quarter of 2020 where marketing expenses and other costs were exceptionally -- were exceptional and unsustainably low as well as the second quarter is the largest quarter for North America Online & Retail. We successfully finalized the first phase of the U.S. retail expansion under the Cigars International brand. In July 2020, we opened the second Texas store in Fort Worth, and in September 2020, the first store in Florida opened in Lutz Center. A second store in Florida was opened in October 2020. This brings the total number of Cigars International-operated stores in the U.S. up to 7. With this, please turn to Slide 7. The division North America Branded & Rest of the World, the reported growth in net sales was 12% to DKK 734 million, composed by 12% organic net sales growth and 5% positive impact from acquisitions and divestments and a negative exchange rate effect of 5%. The development was driven by strong demand in handmade cigars and smoking tobacco, including fine-cut tobacco. The combination of personal consumption being supported by the governmental aid packages and the consumers working from home and having more smoking locations has positively impacted total consumption on several product categories. While demand for handmade cigars from the online channel continues to be strong, the reopening of the brick-and-mortar retail channel in the U.S. also impacted total sales volumes positively. EBITDA before special items increased by 30% to DKK 279 million, with an EBITDA margin before special items of 38% versus 32.7% last year. The margin improvement was realized with an improved gross margin driven by product mix and general price increases and an improved OpEx ratio, which decreased due to lower sales and marketing spend and a general efficiency improvement. This brings us to the update of the last division, Europe Branded. Please turn to Slide 8. For the division Europe Branded, the reported net sales increased by 40% to DKK 752 million during the quarter, composed by 0.4% negative organic net sales growth and a 40% positive impact from the acquisition of Agio Cigars. During the quarter, the overall market for machine-made cigars returned to pre-COVID-19 declining trends, while minor market segments such as like border trade and sales in regions with a traditionally strong tourist economy continued to be profound negatively impact by the pandemic. Organic growth in net sales was stable, with market shares in machine-made cigars slightly down and smoking tobacco delivering positive growth. EBITDA before special items increased by 56% to DKK 213 million, with an EBITDA margin before special items of 28.3% from 25.4% last year. The integration of Agio Cigars progresses according to plan, with the commercial integration expected to finalize during the fourth quarter. Overall, the combined market share of machine-made cigars in the key markets have been maintained or improved since the acquisition. The combined market share in the largest European markets, which are France, Belgium, the Netherlands, U.K., Germany, Spain and Italy, was 33% versus 33.3% in the second quarter of 2020 and 32.9% in the fourth quarter of 2019, with especially France delivering good progress but with market mix lowering the weighted market share. Please turn to the next slide. In the third quarter, net sales increased by DKK 423 million compared with the same quarter last year. Gross profit before special items increased by DKK 270 million and EBITDA before special items by DKK 168 million. During the comparable quarter last year, Agio Cigars, which was acquired in the beginning of the year, delivered DKK 273 million in net sales, and the sales activity in Slovenia and Croatia, which were divested in the third quarter, delivered DKK 23 million in net sales. Adjusted for these transactions and a negative forex effect of DKK 74 million, the organic growth in net sales was DKK 247 million or 12%. The increase in gross profit was driven by the acquisition of Agio Cigars, the organic growth in net sales and margin improvement. The gross margin was 50.4% versus 47.2% last year and was impacted by the volume increase and a favorable product mix. The improvement was driven by all 3 divisions. The EBITDA margin before special items, 27.5% versus 24.7% in the third quarter of last year. The margin expansion was driven by gross profit improvement. Underlying cost efficiencies across our operations continued to improve the OpEx that was in the quarter offset by the integration of Agio Cigars running at a higher cost level. Special items was negative by DKK 80 million, with the majority of the cost, DKK 61 million, expensed in relation to the Agio integration; another DKK 13 million is expensed as an impairment; and the remaining DKK 6 million being expensed in relation to Fueling the Growth and the closure of our factory in Tucker, U.S. We now expect special costs to be in the level of DKK 375 million to DKK 400 million for the full year. This is about DKK 40 million lower than previously anticipated due to timing of certain costs, primarily in relation to Agio integration but also in relation to Fueling the Growth. The expectations for special cost in relation to both Agio integration and Fueling the Growth remain unchanged. Adjusted earnings per share was DKK 4.2 per share compared with DKK 2.6 per share for the third quarter of last year. And finally, the free cash flow before acquisitions increased by DKK 106 million to DKK 609 million for the quarter, leaving the cash generation for the first 9 months at DKK 1.156 billion. Working capital contributed positively to the cash flow by DKK 237 million in the quarter, with inventories declining throughout the supply chain as well as continued positive timing of payables. It is expected that a normalization of working capital will take place by year-end 2020, implying a cash outflow during the fourth quarter. With this, please turn to the next slide. During the third quarter, the net interest-bearing debt decreased by DKK 595 million to DKK 3.34 billion. The reduction was driven by the operating results and a DKK 237 million positive contribution from working capital. Compared with the second quarter, the leverage ratio declined by 0.6x to 1.8x. However, given our cash flow projection for the fourth quarter, we expect a slightly higher leverage ratio by the end of the year but still well below our financial leverage target of 2.5x. In September, we refinanced our funding structure by the issuance of a EUR 300 million unsecured corporate bond. The issuance was well received by the market with more than 2x oversubscription. The bond, which matures in 2025 and holds a coupon of 1.375% unlisted on the Copenhagen Stock Exchange. In relation to the bond issuing, both Scandinavian Tobacco Group and corporate bonds were signed with an investment-grade rating, Baa3, by Moody's Investor Services with a stable outlook. We are very pleased by having finalized our funding plan following the acquisition of Agio Cigars earlier in the year, but also by having secured our long-term and strong funding structure for the next 5 years. Now please turn to Slide 11. As part of our financial policy, we have stated that any excess capital, taking into account potential acquisitions and other liquidity needs, will be returned to shareholders. As part of this commitment, we initiated a share buyback program on the 31st of August. The size of the program amounts to a total value of up to DKK 300 million with a purpose to adjust the capital structure and to meet obligations in the share-based incentive program. Shares not used for the incentive program intended to be canceled. As of the third quarter 2020, we had repurchased about 550,000 shares at a total value of DKK 53 million. As of October 30, we have repurchased 1.029 million shares at a total value of DKK 98 million. Including the ordinary dividend we paid in April of DKK 6.10 per share, we have returned DKK 706 million to our shareholders in 2020, corresponding to 8.7% of the market capitalization by the end of 2019. With the listing in 2016, we have now returned almost DKK 3.3 billion to our shareholders. Please turn now to Slide #12, and I will leave the word back to Niels.

Thank you, Marianne, and I will now give you a short update on the regulatory developments in our key markets. As we mentioned, in relation to the second quarter results announcement, the filing date for substantial equivalent applications for premium cigars was lifted and therefore not implemented as at -- in September. Premium cigars remain regulated by FDA with manufacturers still subject to inspections, ingredient and other reports and other FDA requirements. For Europe, the topics to mention are more or less the same as previously discussed. First, the Tobacco Excise Directive, which is set to undergo a statutory review. The process has started, but a formal proposal is not expected before the earliest at the end of next year. The timing of completion of the review and the effective dates for potential changes remain uncertain. The Tobacco Products Directive, where our first proposal -- the first draft proposal might see the light during the first half of 2021 but where approval and implementation still is some years ahead. I would also like to comment shortly on plain packaging where the recent updates are that in Denmark, plain packaging is likely to be introduced on cigarettes and fine-cut during the first half of 2021. And in the Netherlands, it seems increasingly likely that the existing plain packaging legislation also will include cigars earlier than previously anticipated. Please turn to Slide #13. While the numbers for the third quarter are strong and our performance for the first 9 months of 2020 is better than expected, we expect a weaker fourth quarter, negatively impacted by the lowering of net sales in previous quarters, very strong comparison numbers in Q4 2019 and a temporary increase in the OpEx cost base. We estimated that about DKK 100 million of net sales have been billed in the previous quarters with an anticipated negative impact in the fourth quarter. The temporary increases in cost is mainly related to higher marketing spend, positively impacting next year's sales; costs for expanded retail footprint; and increased cost in online following the higher activity. We expect a negative cash flow in Q4 due to a significant increase in inventories to support the growth in North America and for preparations ahead of Brexit, just as timing effects in payables also will impact working capital negatively. Finally, higher CapEx related to the Agio integration and retail expansion will also impact the cash flow negatively in the fourth quarter. Therefore, the financial guidance remains unchanged with expectations of organic EBITDA growth of more than 9% and free cash flow before acquisitions of more than DKK 1 billion. The guidance is based on assumptions that the change in consumer behavior in the U.S. will continue for the rest of the year, and no material disruptions to the supply chain will occur. Furthermore, the group expects a contribution from cost savings in relation to the integration of Agio Cigars of around DKK 70 million to DKK 80 million in 2020 as well as further benefits from Fueling the Growth restructuring program. Also, EBITDA before special items in the fourth quarter is expected to be below the same quarter last year. This concludes the presentation. And I hand back the word to the operator, and we are ready to take questions. Thank you.

[Operator Instructions] You have the first questions coming from the line of Magnus Jensen from SEB.

Magnus here. My questions mainly go to the guidance -- or actually to Q4 where you have a couple of elements that makes you think that Q4 will be a weak quarter. First of all, on the phasing around the DKK 100 million that you mentioned, a couple of questions to that. First of all, you've been saying all along both in Q1 and 2 that there is phasing and that it will be impacting the coming quarter. It has not been the case, it seems, on neither Q2 or Q3. Why are you so certain that now you will see a loss of around DKK 100 million? That's one question. And then the other question is what divisions is it related to? And the final one for that is why do you see this behavior from -- I guess, from your retail customers? That's my first question.

So Magnus, thank you for that question. And let me start by the -- with the DKK 100 million. So what we have seen in several markets -- in some of the markets, Russia, Norway, Middle East, that they have been loading orders during the year, and the main reason for that is the closure of our main factory, and also, for Russia, the implementation of [indiscernible]. What we have seen during Q3 is that the loading has -- over the previous quarters and also in the quarter of 2019 been so high that for that segment, there are more or less no orders in Q4. And the division that is mainly impacted by this is the North America Branded division.

Thank you. And then, yes, two questions more to the Q4. You said that -- excuse me, it's a little bit weird question, but I haven't been following you that long. So the Q4 last year was a very strong quarter. Looking at the numbers, I can see that you had negative organic growth in basically all divisions. So why come -- why is Q4 a strong comparison?

Yes. So I think that when you look at the fourth quarter last year, it's important to remember that, first of all, we had the onetime positive impact from the French excise. So that's a significant number that raises 2019. Secondly, there was a number of orders in the fourth quarter which was related to excise increases in various geographies. This also makes the placing of orders stronger in that quarter. And finally, I think that what we did last year was that as we were progressing towards the end of the year, we also managed our cost base very tightly to make sure we could deliver the guidance, and we did that most of the quarter without knowing that a few weeks before Christmas, we got this French excise onetime benefit. So I think that's the main reasons why we are saying this is a difficult quarter comparison.

Okay. I guess, it answers my last question because you see an uptick of around 3% in your OpEx ratio, mainly driven by marketing. I guess, this is part of the explanation. And I guess, the other one is that you've not been using that much marketing for the last 2 quarters. But do you have further comments to that?

Maybe just a quick comment on that because you're absolutely right that in the last quarter of 2019, we took down the spend of marketing. And in this quarter, we -- or in the fourth quarter, we are going back to a more normalized level, which we believe is needed to invest in the revenue for 2021. But also that we do see some strategic projects also as part of executing our strategy, as an example, an evaluation of our portfolio that we will also have a cost expense on in the fourth quarter.

Our next questions come from the line of Niklas Ekman from Carnegie.

Yes. A couple of questions. Firstly, I'm curious about the COVID-19 impact here. It seems you've had a very positive impact to North America in both the Online & Retail and the Branded business, whereas in Europe, you're talking about a slightly negative impact. And I'm just curious why there are such big differences in consumption.

Yes. I think that if you look at the third quarter from a U.S. perspective, there are kind of 2 important points. One is that we've seen continued strong demand in handmade cigars where the online, obviously, is benefiting from more customer traffic and good sales growth. When you look at the Branded business in the U.S., it's also benefited from, let's call it, the recovery and reopening of stores that has taken place during the third quarter of 2020. So the Branded business has a strong quarter simply by retailers reengaging and actually placing higher orders than anticipated. When we look to Europe -- and sorry, and all of that in the U.S. is driven by this -- call it, this underlying consumption increase driven by working from home. In Europe, we do not see the same trend. And I think when we look at our mass market business across Europe, we lost some volume in the second quarter, which was really driven by lower consumption inventory changes. And although the total market has bounced back in the third quarter, we really lost some sales in the second quarter that is now coming back. So that is where we see a little bit of different dynamics between the 2 geographies.

Okay. And then generally, you're not seeing increased -- significantly increased tobacco consumption in Europe. Is that also the case?

Yes. That's our assessment of the situation right now.

Okay. Excellent. And the second question, just on the outcome here in the U.S. election. It's obviously uncertain, but if we do see a shift from Republicans to Democrats, do you see that, that could lead to any tangible shift in the regulatory environment from your behalf?

I think it's a little early to say. But I think what we have said before is that, clearly, it is in our best interest that there is not a one-sided Democratic control of both the White House, the Senate and the House. And at least with the latest update I received, the Senate seems to stay fairly balanced, which, in my book, would provide for a relatively neutral situation for us. But time will show. But that is the current reading.