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

Good day, and thank you for standing by. Welcome to the Scandinavian Tobacco Group Q2 2023 Results Webcast. [Operator Instructions] Please be advised today's conference is being recorded. I'd now like to hand the conference over to your first speaker today, Torben Sand. Please go ahead.

Thank you. Welcome to Scandinavian Tobacco Group's webcast for the second quarter results of the 2023. My name is Sand Torben, I'm Director of Investor Relations and Group Communications, and I'm, as usual, joined by our CEO, Niels Frederiksen; and CFO, Marianne Rørslev Bock. Please turn to Slide #3 for the agenda for today's webcast. The agenda is as follows: First, highlights of the second quarter, followed by comments on our revised outlook for 2023. Then we'll go into a business update, we'll focus on developments that feed into the wider Rolling Towards 2025 strategy. And these insights will be followed by an overview of the performance in our 3 commercial divisions. Key financial developments for the group, including an update on net debt and leverage, and then we will conclude the webcast with a Q&A session, where we will be pleased to take any questions you might have. And before we start, I ask that you pay attention to our disclaimer on forward-looking statements at the end of this presentation. And with this, please turn to Slide #4, and I'll leave the word to Niels.

Thank you, Torben, and welcome, and good morning to everyone on the call. We've seen a more volatile environment than we expected in 2023, and we have had to make an adjustment of our full year outlook to reflect this. Net sales are trending lower than expected as some of our handmade cigar customers are cutting down on inventories. The recovery of our market share in machine-rolled cigars in Europe is taking more time than we anticipated and the plan to open new retail stores in the U.S. is somewhat delayed. We don't expect net sales to fully recover during the rest of the year, which is why we have revised our net sales guidance for the full year. We still aim to report sales growth for the year. Before going into detail with the guidance and the progress of our strategic agenda, I would like to give you a few key financial highlights from the second quarter results announcement. Net sales decreased by 2.3% to DKK 2.2 billion. The EBITDA margin declined to 23.1% versus 23.9% last year. Free cash flow before acquisitions was DKK 159 million versus DKK 143 million last year. And adjusted EPS came in at DKK 3.5 versus DKK 3.6 last year. In organic terms, net sales declined by 1.8% and EBITDA declined by 2.9%. For the 6 months period, net sales were negative by 0.7%, the EBITDA margin was 23.6% compared with 25.5% last year, and free cash flow before acquisitions was negative by DKK 20 million versus DKK 272 million last year. Marianne will give you more details on the financial performance in a moment. I will now turn to the revised expectations for 2023, and please turn to Slide #5. As mentioned before, the main reason for net sales trending lower than expected is primarily that some of our handmade cigar customers have been cutting down on inventories and the volume recovery and regain of market share in machine-rolled cigars in Europe is taking more time than anticipated. The delay in our plans to open new retail stores in the U.S. and changes in exchange rates have also had some impact as has the overall normalization of consumption of handmade cigars after COVID. As a result of these developments, we have revised our expectation for net sales to DKK 8.7 billion to DKK 9 billion from previously DKK 9 billion to DKK 9.3 billion. With changes in the product with a -- sorry, with changes in the product and market mix, the revision of net sales also impacts EBITDA margin negatively. France and the U.K., which are 2 of the machine-rolled cigar markets where market share has not recovered, are high-margin markets and combined with the scale effect from lower volumes as customers have adjusted inventory, means that we have revised the expectations for the full year EBITDA margin to 23.5% to 24.5% from previously 24% to 25%. The revision of both the free cash flow before acquisition and earnings per share follow the revisions of the expectation for net sales and the EBITDA margin. Now whereas the decline in machine-rolled cigars followed a structural decline rate of 2% to 3%, the consumption of handmade cigars in the U.S. declined by more than a structural decline rate of 2%. However, we have seen more consumers moving online and the consumption of products in our category is still perceived as resilient despite the impact on current performance of the recent adjustment of inventories with some customers and distributors. Now given these considerations, the revised guidance for '23 is now reported net sales in the range of DKK 8.7 billion to DKK 9 billion from -- down from DKK 9 billion to DKK 9.3 billion. EBITDA margin before special items in the range of 23.5% to 24.5%, down from 24% to 25%, and free cash flow before acquisitions in the range of DKK 1.1 billion to DKK 1.3 billion, down from DKK 1.2 billion to DKK 1.4 billion. Adjusted EPS is now in the range of DKK 14 to DKK 16, down from DKK 14.5 to DKK 16.5. The guidance is based on current exchange rates. Please turn to the next slide. I'll now give you an update on our progress with the ongoing Rolling Towards 2025 strategy. Our ambition to grow the company through a combination of acquisitions, geographic expansion, and further experimentation in next-generation products remains intact. During the second quarter, we have continued the integration of Alec Bradley, we've started the integration of XQS following its acquisition, we've opened another cigar store in Texas, and just a few weeks ago, we had the grand opening of a new Cohiba cigar lounge in California, the first of its kind and we've made further progress in our sustainability strategy rolling responsibly. Please turn to Slide 7, where I'll give you more details to these milestones. In this slide, we have outlined 3 important pillars for our road ahead: mergers and acquisitions, our growth enablers and sustainability. Firstly, acquisitions have been and remain a key lever for Scandinavian Tobacco Group to grow the company and to create value for shareholders. With the acquisition of Alec Bradley and XQS, we have during the first half of the year, invested DKK 583 million in expanding our portfolio of handmade cigars in the U.S. and in our growth enablers. The integration of both companies is progressing well and will make important contributions to financial performance this year and in the years ahead. The growth enablers covering retail expansion as well as our experimentation in next-generation products accounted for slightly more than 3% of group net sales during the second quarter of the year as compared to less than 2% in the same quarter last year. Our growth enablers are still not material to the group performance, but we believe they will, over time, become increasingly important to our financial performance as well as the long-term development of our company. We are confident that these categories can complement our core categories and then allow us to evolve with the changing demands and trends of our consumers. For STRÖM and XQS, the white pouch products and the modern actives product containing no tobacco and no nicotine, the sales force continues -- or sorry, the sales performance continues to progress as planned. XQS performed especially well with double-digit sales growth. For all 3 brands a rollout to new markets is being considered. In June, Cigars International opened its ninth retail store -- retail cigar superstore in Katy, Texas and the implementation of the strategy to expand retial network in the U.S. continues. Although as mentioned, the opening of additional stores during 2023 has been delayed into next year. Each of the 7 cigars superstores opened before 2023 are developing well, and all stores are expected to deliver valuable contributions to net sales and profits during the coming years. Our sustainability agenda Rolling Towards -- Rolling Responsibly continues to make good progress. Last quarter, I already mentioned our new data collection methods and reporting processes to be implemented. And our center of excellence is continuing to assist environmental, social and governance initiatives for the communities in which we operate. This quarter, we have initiated a more detailed work on Scope 3 emissions and we've completed CDP disclosures for climate and water. We are proud of the way in which we support local businesses across a number of our operational areas. We strive to encourage and implement a circular economy wherever we can to improve our carbon footprint and our social license to operate. Please turn to Slide #8. It's a while since our last statement update on regulatory developments. And let me start by mentioning the most important development, which is only a few weeks old. On August 20, the U.S. District Court for the District of Columbia has ruled in favor of the premium cigar industry to remove premium handmade cigars from the Tobacco Control Act. This means premium cigars will no longer be regulated through the FDA's deeming regulation, which otherwise has been the case since 2016. The ruling can be appealed by FDA up until October 9. In reality, and assuming the decision is not appealed, this implies that all non-flavored premium cigars will be exempt from applying for substantial equivalent and there will be no predicate requirement for the launch of new products. We believe that the decision supports our view that premium cigars are a unique product category with both different product characteristics and consumer profiles than other tobacco products. Now the potential ban of characterizing flavors in the U.S. remains in process with no material news. The FDA has already released its proposal for a ban on flavored tobacco products, including flavored cigars. I would like to repeat that our exposure to flavored tobacco products in the U.S. is limited and with pipe tobacco not being included, the exposure will be well below the 5% impact we have previously mentioned. In Europe, the 2 major pieces of legislation related to Scandinavian Tobacco Group are, as you might recall, the Excise Tax Directive and the Tobacco Products Directive, both remain in process. A proposal for the Excise Tax Directive is now expected during the second half of the year and the Excise Tax Directive relates to potential revisions on the tax differential between the tobacco categories, potentially renewed minimum excise duty rates and taxation of new product categories and now seem to be postponed slightly. An impact from the directive is at the early as expected at the end of 2026. For the Tobacco Products Directive, there are no new updates. The Tobacco Products Directive could relate to characterizing flavors and ingredients, product labeling and next-generation products. The formal proposal for changes is expected by the end of 2024 or early 2025 with an impact expected at the earliest in 2027. We'll now turn to focus on the performance by division, and I'll leave the word to Marianne. Please turn 2 slides to Slide #10.

Thank you, Niels. I will start with the overview with Europe Branded. Net sales for the second quarter decreased by 1% to DKK 712 million, reflecting the organic development in net sales. The negative organic growth was driven by machine-rolled cigars and pipe tobacco within the category smoking tobacco. Handmade cigars and fine-cut tobacco delivered growth. And for all product categories, pricing remained a key contributor to offset volume declines. As an example, within the largest product categories, machine-rolled cigars, the price/mix impact was almost -- was positive by almost 80%. The overall market continues to decline by 2% to 3%, but as markets like France, the U.K. and Benelux decreased more than the European average and as these markets are our largest markets, we currently experienced a larger volume decline than the market average. In addition, as flavored cigars performed better than unflavored cigars, where we have the strongest volume positions and as our market share takes time to recover following our out-of-stock issues last year, we have experienced a somewhat stronger volume decline than in previous quarters. This is particularly the case for markets like France and the U.K. EBITDA before special items decreased to DKK 164 million with an EBITDA margin of 23.1% versus 24% in the second quarter of 2022. The margin development was driven by changes in market and product mix, especially the declining net sales in France did impact the overall margins, but also the scale impact of lower volumes did reduce margins in the quarter. The OpEx ratio increased slightly, driven by cost inflation and the investment in next-generation products. Our aim remains to regain market share over time, driven by our strong brand portfolio, although it does take longer time than we originally anticipated. Having said so, pricing is a key priority to grow our value share of the market, thereby offset the structural in volumes and any inflationary effects. Additional levers for Europe Branded to deliver margin improvement over time is our simplification initiatives to reduce the number of stock-keeping units and brands within the portfolio. This initiative continued during the quarter, and we aim to simplify our portfolio further. With this, please turn to Slide 11, where I'll speak to the North America Branded and Rest of the World. For the second quarter, both reported an organic net sales in North America Branded and Rest of the World decreased by 6% to DKK 773 million as a result of inventory adjustments across handmade cigar customers, including contract manufacturing customers as well as comparison is impacted by the change in distribution model in Australia, which impacted net sales positively in the same period last year. The acquisition of Alec Bradley and general price increase did partly offset this. EBITDA before special items decreased to DKK 265 million, with an EBITDA margin of 34.2% versus 37.2% in the same quarter last year. The decrease in profitability is driven by an increase in the OpEx ratio. The gross margin was slightly up compared to the second quarter of 2022. The increase in the OpEx ratio relates to cost inflation and the lower sales from contract manufacturing, which carry limited operating expenses. Consumer demand for cigars is still considered resilient, although volumes of handmade cigars in the U.S. continued to decline by more than the expected structural decline rate. However, an improvement might be on its way with signs of a stabilization of the online sales channels taking place in recent reports. I will now turn to the attention -- I will now turn the attention to the performance of our North America online and retail division. Please turn to Slide #12. Net sales for the second quarter increased marginally to DKK 740 million compared to the second quarter of 2022, and the EBITDA margin improved to 16.4% compared with 13.7% in the same quarter last year. Organic net sales increased for the second quarter in a row, driven by good performance in the online business, continued growth in the retail business and the distribution of ZYN. The performance of the division has started to improve as the dynamics between retail and online sales channels have started to move back towards pre-pandemic levels, an example to the benefit of the online sales channel to which we have a higher exposure. We expect the rebalancing between the sales channels to continue in the coming quarters, and we also expect the number of active customers on file finally have started to stabilize. Retail accounts for an increasing share of net sales in this division and delivered double-digit organic net sales growth versus last year, driven by new store openings. This resulted in retail accounting for close to 9% in the quarter. EBITDA before special items decreased to DKK 122 million from DKK 101 million with an EBITDA margin before special items of 16.4%, last year 13.7%. The margin development is primarily driven by the scale impact from higher net sales, but also as a result of efficiency improvements, most notably through the investment in our out-of-store facility in our Bethlehem warehouse last year. Now please turn 2 slides to Slide #14. Before I turn to the details to the financial performance from a group perspective, I would like to update you on the long-term trends in the EBITDA margins by group and by division. Each quarter, we deliver many details to the development of the actual quarter by division and to the development compared with the same quarter the previous years. In this slide, we have outlined the development in the second quarter EBITDA margins over the past 6 years since 2018. These trends give a different and better insight to the underlying progress in our strategy and financial ambitions. It appears from the long-term trends that '21 and '22 were exceptions to the underlying growth traction, which we have illustrated with arrows. Our financial ambition of increasing the EBITDA margin over time, subject to changes in business mix as well as acquisitions, is anchored in our strategy Rolling Towards 2025. And the ambition is based in the past performance and gives us comfort we will continue to deliver on the ambition in the years ahead. With this, now turn to Slide #15, please. As Niels addressed in his opening remarks, overall, we delivered financial performance during the quarter, which is impacted by a weaker-than-expected net sales development which turned out to be increasingly difficult to recover in the second half year -- in the second half of the year. The weaker net sales primarily relate to temporary issues like the inventory adjustments with some customers and the delay in opening of retail stores. The change in the exchange rates did also have a minor impact on our revised expectations for the full year. As we don't expect catch-up -- to catch up on issues during the second half of the year, the expectation for the full year net sales has been revised down accordingly, which also have impacted the outlook for our other guidance metrics. For the second quarter of 2023, reported net sales decreased by 2.3% to DKK 2.2 billion, while organic net sales growth was negative by 1.8%. Acquisitions impacted net sales positively by DKK 35 million or 1.5%, while exchange rate developments impacted net sales negatively by DKK 45 million or 2%. The decrease in organic net sales of 1.8% was composed by a 3% growth in North America online retail, a 1% decrease in Europe Branded and a 6% decrease in North America Branded and Rest of the World. The EBITDA margin decreased by 0.8 percentage points to 23.1%, primarily as a result of the lower gross margin in Europe Branded and a higher OpEx ratio in North America Branded and Rest of the World. For the first half of the year, net sales decreased by 0.7% with organic growth being negative with 1.3% and the EBITDA margin was 23.6% compared with 25.5% last year. The free cash flow before acquisitions was DKK 16 million higher than last year with DKK 159 million for the quarter. The development is driven by the operational performance, higher financial costs and taxes paid as well as an increase in working capital. The continued negative contribution from working capital was primarily driven by the increased trade receivables and lower payables. Inventory was reduced in the quarter, although I expect the level to be reduced further in the second half of the year. For the first half of the year, the free cash flow before acquisitions was negative by DKK 20 million compared with positive DKK 272 million in the same period last year. The cash flow is normally much stronger in the second half of the year, which will also be the case this year. Therefore, we remain on track to deliver significant improvement of the free cash flow before acquisitions in the second half of the year based on our expectations for operational performance in Q3 and Q4 and a material reduction of our working capital. With this, now please turn to the next slide. Before concluding the presentation, I will give you a brief update on our net debt and leverage position. During the second quarter, the net debt -- the net interest-bearing debt increased by DKK 643 million to almost DKK 5.1 billion by the end of June 2023. The increase is driven by the dividend payment in April of DKK 715 million whereas the combined cash flow from operations and investing activities, including acquisition of XQS, was positive by DKK 19 million. The leverage ratio increased to 2.3x versus 2.0x by the end of the first quarter. The leverage ratio is expected to approach 2x by the end of the year. Please turn to Slide #17. Finally, I'm pleased to announce the date for our next Capital Markets Day. The last time we hosted a Capital Markets Day was almost 2 years ago. We are excited about the opportunity to give all our stakeholders an opportunity to gain further insights into Scandinavian Tobacco Group, our strategy and how we intend to create value for our shareholders, our many partners, our consumers as well as our employees. The event will take place on the November 21 in London. It will be possible to follow the event both in person in London or through a live stream. The agenda and registration for the Capital Markets Day is expected to be ready by mid-September. This concludes our presentation for today's call. I'll now hand the word back to the operator, and we're ready to take any questions you may have. Thank you.

[Operator Instructions] We'll now take our first question. First question is from the line of Niklas Ekman from Carnegie.

Yes. A couple of questions from my end. Firstly, on the full year guidance, maybe if you could just clarify where you talk about the sales guidance. I think even the low end of the sales guidance requires at least 2% to 3% organic growth in H2. And you talked about how you did not expect sales growth to be strong enough in the second half to kind of meet your expectations. So can you just elaborate a little bit here? Are you expecting recovery in H2 or not? Or are you expecting growth in H2 or not? And the same question, I guess, on the margins because you seem to -- or rather the opposite question on the margins. You seem to expect a continued much lower margin in H2. And if you could again elaborate a little bit on these trends?

Yes. Thank you, Niklas. So yes, we do expect growth in the second quarter -- sorry, in the second half of the year, and it is composed of a number of factors. First of all, you can say that our online business has been turned around and is continuing to grow year-on-year. Secondly, we expect Europe Branded also to deliver growth, not least driven by the price increases already taken and which will have a higher impact in the second half of the year. So we are seeing growth. We're just seeing less growth than we originally anticipated, and we no longer feel comfortable that we can recover fully, and that's also why the guidance have gone down.

That's very clear. And the same on the margins because on the margins, it's kind of the opposite you expect. You seem to be guiding for a lower margin in -- or margins continuing much lower in H2.

Yes, and it's Marianne. Niklas, and that's the way. So we do anticipate to have some mix effect between markets and products also during the second half and then we are also seeing some catch-up on some additional costs in the second half.

And also on top of that, you also have the impact -- diluting impact from the full consolidation of the acquisitions we take on.

Fair point. And on the topic of margins, I'm trying to see where you are and where you're heading? Because you're now guiding for margins in the range of 24%. Margins before COVID were -- or least in 2018, they were around 20%, then they rose to 27%. Now you are back around 24%. So what is the long-term trend? I know you show this slide here with the rising margins, but there has been quite a lot of volatility in recent years. So what do you see as kind of a long-term sustainable margin?

Yes. So let me try to answer that, Niklas. Let me start with where we focus our energy on margins right now. It is primarily a focus on our Europe Branded division, where the sliding volume and market share has kind of a double impact because it grows our gross profit but also, as our volumes decline in our factories, it gives us less efficiencies. We are very aware of that. Currently, we are occupied about keeping the stability in our factories that we have finally established. And as we are also implementing the track and trace to be ready in mid of 2024, and we are also running towards second implementation of our ERP system, we are currently reluctant to -- we are cautious of taking costs out of the factories currently, but that will be the case when we come a little further down the road. I think also when we talk margins, we saw, as you also mentioned, an uplift of margins during COVID, simply the very higher net sales was leveraging our margins. So it is still our ambition to grow margins over time. And we have several initiatives to be part of growing those margins. One thing is, as I just mentioned, our ERP system is valuable and when that is globally implemented, we will see some efficiencies coming from that.

Super. That's very clear. And finally, on the same topic here, when you talk about current trading, you talked about July and August, you say that, that supports the revised outlook. Does that mean that you've seen strong sales but a weaker margin in the start of Q3?

Correct.

Very clear. And also, can you just update us on your view on buybacks or rather the Board's view on buybacks at the moment?

Yes. So Niklas, as we have said all along, we evaluate ongoing buybacks, and we are committed to returning excess cash to shareholders by the ordinary dividend and buybacks. Currently, our leverage is 2.3% after acquiring 2 companies this year, and we expect it to be around 2% at the end of the year. So around year-end, we will evaluate potential further share buybacks at that point of time.

We'll now take the next question. And this is from the line of Sebastian Grave from Nordea.

Just a couple of questions from my side as well here. So just to come back to your net sales guidance, just to clarify here. As I hear it, the updated guidance does not assume any improvement in Europe Branded market shares or tobacco inventories coming more in balance in H2, is that correct?

Yes, it is correct that when we look at the inventory rebalancing in the U.S., then we think it will take the full 2023 before we see a normalized situation. With respect to Europe Branded, yes, we are not putting in market share improvements. But we are, of course, having this as one of the main focus areas for the remainder of the year to regain market share momentum. So -- but no, we have not included a market share improvement in the expectations.

Okay. That's very clear. And on the latter topic here, you stated in the report that flavored products are gaining grounds in key markets in Europe. And as such, I mean, to me, it sounds like these market share issues could be more sticky in nature. Do you share that perception? And maybe could you give some insights as to how do you work on improving this market situation? Is it simply a question of pricing? Or are you thinking about adding flavored products to the shelves as well? Or could you give some insight here?

So let me say, first of all, even though the traditional non-flavored products are losing ground to flavor, we are also looking forward to a potential flavor regulation in the future. So we are actually quite pleased with our strong position in the non-flavored segment, and we need to continue to strengthen that, but we also need to build market share momentum in the flavored segment. And we are trying to focus that both by introducing new products and by strengthening distribution and rotation of our existing flavored products in the market. So we do want to improve our position in the flavored segment, but we also want to maintain that stronghold we've got in the non-flavored.

And I mean now -- I mean, this market share trends challenges has persisted for a while. Have you changed your approach to solving these issues over the past quarters? Or what is the approach really, could you maybe elaborate?

Yes. So the first focus we've had has, of course, been to, let's say, regain distribution and visibility in the stores after a period where we have had very erratic supplies. And that we believe we have secured today. Then the second push is around raising rotation. And given also the many restrictions we have in this market, it's not that easy to raise rotation. And what we have been, let's say, surprised by is the level of effort required for us to regain the momentum. So we are increasing, let's say, the resources behind these key markets like the U.K. and France because we need our market share to get back on a more positive trend.

Okay. That's clear. And then the last on my side here, on your inorganic growth activity. So you had only a modest DKK 35 million revenue impact from acquisitions in Q2 which I assume primarily relates to Alec Bradley. However, compared to the reported Alec Bradley full year 2022 performance of plus USD 25 million, which corresponds to around DKK 170 million at current exchange rates. I think the DKK 35 million sounds a bit soft here. So is that a result of Alec Bradley also being impacted by this destocking or maybe that the '22 figures are elevated from sell-in effects? Or what is the reason here?

Yes. There's no doubt that Alec Bradley is also impacted by the inventory readjustment. And there's also -- when we took over Alec Bradley, we took over a brand that was performing well but also one that, to be honest, during the acquisition had not been maintaining an innovation pipeline. So we have had to invest more resources in, let's say, reestablishing an assortment of innovation required to compete in the market. So we're not super nervous about this, although it's always not what you would optimally want to find. What we do and what we have been encouraged by is when you look at our Alec Bradley's performance in our online channel what we have, then we are delivering growth year-on-year on Alec Bradley.

[Operator Instructions] There are no further questions coming through at the moment.

Okay. But then thank you very much to everyone for participating, and we wish you all a good day. Thank you.

Thank you. This does conclude the conference for today. Thank you for participating, and you may now disconnect.