Something's amiss in the world of Scandinavian Tobacco Group (STG), and it's not just the lingering scent of fine-cut tobacco. While the company's Q1 2024 earnings call highlighted the usual suspects – a volatile market, the allure of Next Generation Oral products, and the steady hum of US retail expansion – there's a deeper story buried in the transcript, one that could spell trouble for STG's long-term dominance in the European machine-rolled cigar market.

On the surface, STG's narrative is one of temporary setbacks and confident optimism. They acknowledge the "unusually low volumes" in their European machine-rolled cigar business, attributing the decline to an overly aggressive pricing strategy in the face of unyielding competitors. They point to a similar situation in their US online business a year ago, where price adjustments successfully stemmed the tide of volume loss. The message is clear: Don't worry, we've seen this before, and we know how to fix it.

However, a closer look reveals cracks in this seemingly reassuring facade. STG's claim that they were "surprised" by competitors' reluctance to raise prices raises more questions than it answers. After all, haven't they been operating in this market for decades? Shouldn't they have a firm grasp of competitor dynamics and pricing strategies?

Furthermore, the company's assertion that the Q1 European market decline of 5.1% is an anomaly, a blip on the radar of a stable 3% structural decline, feels suspiciously like wishful thinking. This ignores the trend evident in their own data, which shows European machine-rolled cigar volume declines fluctuating significantly over the past two years, ranging from a relatively modest 1.6% to the alarming 5.1% in the most recent quarter.

Here's where things get interesting. STG admits that their market position is strongest in the very segments experiencing the most significant declines. They're essentially trapped in a shrinking fortress, their dominance becoming a liability as consumers gravitate towards other products or leave the market altogether.

While STG boasts about gaining market share in growing segments, they concede that these gains are "still not material in the overall context." This translates to a company desperately trying to plug holes in a sinking ship while the lifeboats remain frustratingly small.

The implications are stark. STG's reliance on price adjustments to regain market share might be a short-term fix, but it fails to address the deeper issue of evolving consumer preferences and the company's vulnerability to market shifts. Their commitment to a 2025 EBITDA margin of 24% hinges on the success of this strategy, a gamble that looks increasingly risky given the volatile market trends and the company's own admission of limited visibility for the remainder of the year.

Delving into the Numbers

Let's delve into the numbers. Looking at STG's rolling 12-month EBITDA margin, we see a trajectory that paints a worrisome picture. Pre-COVID, margins hovered around 20%. During the pandemic, they surged to a peak of 27%, buoyed by pricing power and a surge in online sales. However, as the world returns to a semblance of normalcy, margins have steadily eroded, settling at 22.5% in Q1 2024.

STG argues that this decline is "temporary," a necessary sacrifice to fuel investments in their Growth Enablers. But what if these investments don't yield the expected returns? What if the Next Generation Oral market proves less lucrative than anticipated, or their US retail expansion encounters unforeseen challenges?

The company's reliance on a return to pre-COVID margin levels by 2025 seems increasingly optimistic. The market landscape has shifted, and STG's traditional strengths might no longer be enough to guarantee their continued success.

EBITDA Margin Trend (Rolling 12 Months)

What Does This Mean for Investors?

STG's Q1 2024 earnings call offers a cautionary tale, a reminder that even the most established companies can falter when they fail to adapt to evolving market dynamics. While the company's optimism about the future is understandable, their reliance on short-term fixes and a rosy outlook for their Growth Enablers warrants skepticism.

The coming quarters will be crucial. STG needs to demonstrate that their European machine-rolled cigar strategy is more than just a smoke screen, a temporary reprieve from the deeper challenges facing their core business. If they fail to do so, the company's long-term growth story might go up in smoke.

Hypothesis and Key Metrics to Watch

Hypothesis:

STG is underestimating the long-term decline in the European machine-rolled cigar market. Their reliance on historical averages and price adjustments might not be sufficient to offset the impact of changing consumer preferences and competitive pressures.

Numbers to Watch:

Will they revert to historical averages, or continue to exceed them?

Will STG's gains become "material," or remain insignificant?

Will it improve as promised, or continue to trend downwards?

Will this category become a significant driver of growth and profitability?

The answers to these questions will determine whether STG's story is one of resilient adaptation or a slow fade into irrelevance.

Q1 2024 Earnings Call Transcript

The full transcript of the Q1 2024 earnings call is available here: https://seekingalpha.com/symbol/SNDVF

Financial Data

Current Financial Data: See table below

Reference: https://seekingalpha.com/symbol/SNDVF

"The company Scandinavian Tobacco Group has a rich history dating back to 1750, making it older than the United States!"