Get hooked to this maker of tobacco alternatives

Turning Point Brands (NYSE: TPB) is a manufacturer and marketer of OTP (Other Tobacco Products) and hemp-derived CBD products. Attractive product economics, in the form of non-cyclical demand and strong brand loyalty, support pricing power, consistent margins and cash flows, and high returns on capital (~40% gross margin, ~10% FCF margin, 20% ROIC). TPB stock increased from $10 to $55 between 2016 and 2019 on the back of strong growth in vaping, but cratered to $20 after rising teen addiction and increasing lung injuries from illicit vaping products in Q419. The FDA banned most e-cig flavors on January 1 2020, and required manufacturers to go through an arduous, expensive approval process (ie PMTA) to continue sales of e-cig. FDA approval, though costing $10-20mm, will ultimately benefit TPB and other well-capitalized survivors by shutting numerous small players and legitimizing surviving vaping products. The vaping debacle had taken attention away from the established OTP segments that provide at least $50mm FCF (and may account for the entire current value of the company) and the company’s strong balance sheet ($140mm available liquidity), which provides ample liquidity for PMTA approval process and a free call option in the form of transformative M&A targeted at vaping products (ie NewGen segment). As proof of non-cyclical demand and brand loyalty, on April 2, TPB affirmed Q1 guidance, first made in February 26, implying that impacts from Covid-19 are minimal. Valuing the OTP segments as strong cash-flowing businesses and the NewGen segment at cost (ignoring the potential for transformative M&A), the stock provides 77% upside.

The OTP segments – Smokeless and Smoking – generate stable cash flows ($50mm FCF) that fund the growth engine, which is the NewGen segment housing proprietary brands and distribution of third-party brands related to e-cigarette, CBD, and other vaping products (50% revenue CAGR 2014-19 before disruption. More on this later). The OTP segments contain dominant brands in the categories below:

-Chewing tobacco (part of Smokeless). Brands: Stokers (20% market share, 2nd largest in industry), Beech-Nut, Trophy, Durango, Wind River. Collectively 29% market share. Chewing tobacco is cured tobacco in the form of loose leaf, plug, or twist, delivering nicotine without smoke associated with traditional cigarettes. Industry growth is about low single digits;

-Moist snuff (part of Smokeless). Brand: Stoker (4.5% share, one of fastest-growing brands in the market). Moist snuff, also known as snus, is cut tobacco that can be loose or pouched and placed in the mouth. Industry growth is about low single digits;

-Cigarette paper (part of Smoking). Brand: Zig-Zag (35% share in premium market, largest premium brand). Industry is shrinking in low single digits;

-Cigar wraps (part of Smoking) Brand: Zig-Zag (75% share overall).

Buffett said that one may assess the quality of a business by the ease with which it raise prices without losing customers. By this benchmark, the Smokeless segment is a quality business because it raised prices by 4.3% and increased volumes by 3.4% from 2016-19 on average, while expanding EBITDA margins to 38% from 32%. Moist snuff was the key driver, contributing 54% segment revenue. It is manufactured and packaged in the company’s Tennessee and Kentucky facilities in a proprietary process that results in a superior product. In addition, smokeless products align with increasing smoke-free ordinances and increasing consumer awareness of relatively lower health risks compared to traditional combustible tobacco. The Smoking segment is a lower quality business in which revenue has been stagnant since 2016, but it still delivers admirable ~40% EBITDA margins. Smokeless and Smoking collectively generated ~$50m FCF in 2019.

Standard DCF with conservative assumptions shows that the OTP segments are worth at least the entire company value ($400m mkt cap at time of writing). This implies that the market ascribes zero to negative value to TPB’s growth engine, the NewGen segment, and assumes the segment to be consistently loss-making. This dire assessment is very unlikely to play out because of a strong track record of execution, ample liquidity to survive the PMTA process, and favorable competitive dynamics post-PMTA.

Even before the vaping debacle in 2019, the NewGen segment has generated consistently positive EBITDA and FCF from 2016-18. Management balanced product and marketing investments in vaping with profits, displaying shrewd capital allocation. 2019 was the first year in which NewGen suffered EBITDA losses. When vaping sales were disrupted in Q419, management quickly shrunk exposure to the vaping distribution business. They consolidated 4 warehouses into a single facility, eliminated low-margin platforms, and wrote off unsalable inventories because of the FDA flavor ban. The PMTA process will likely cause a large reduction in vaping brands and declining distribution profits. Management has responded optimally by investing more in proprietary brands than in distribution capabilities moving forward. It is unusual for a small-cap company to display a strong track record of execution. This is likely made possible by executives who have decades of experience seeing major shifts in the tobacco business. Larry Wexler, CEO, spent two decades at Altria and 17 years at TPB. Graham Purdy, COO, spent 7 years at Philip Morris and 16 years at TPB.

A major transition in the vaping business is underway. In August 2019, the CDC reported increasing lung injuries associated with vitamin E acetate in THC-containing e-cigarettes and vaping products. It is essential to differentiate between THC and CBD because marijuana-derived THC is illegal (except in low concentrations and when prescribed in certain US states) while hemp-derived CBD is legal (See Appendix for technical information). TPB only deals with CBD, not THC, in vaping products. Furthermore, legal vaping products do not contain vitamin E acetate. TPB has clarified in a statement that it does not sell e-cigarettes and other vaping products containing THC or vitamin E acetate.

Yet TPB and other legitimate manufacturers are subjected to regulation designed to weed out illicit production. To protect consumers from illicit THC/vit E acetate-containing e-cigs and vape products, the FDA requires all vaping manufacturers to receive marketing authorization for vape products through a Premarket Tobacco Product Application (PMTA) pathway. The PMTA is an exhaustive and expensive scientific study that considers the risks and benefits of the tobacco product for public health. The US subsidiary of London-based British American Tobacco, an $83B company, submitted 150,000 pages for its VUSE vaping product. At an estimated cost of $120k per product, a standard vape manufacturer with 10 flavors available in 5 capacities and 3 levels of nicotine content can expect to spend $18mm (10*5*3*120k). Numerous legitimate, in addition to illicit companies, but under-capitalized companies in the fragmented vaping market will either shut down or curtail production, leaving well-capitalized peers with significantly reduced competition. For a $400mm market-cap company, TPB is well-capitalized with $95mm cash, ~$45mm in undrawn revolving credit, and ~$50mm FCF from its OTP segments, more than the $20mm expected in PMTA expenses. TPB has the management capability and liquidity to be successful in the PMTA process.

(As a side note, the FTC recently sued Altria to undo its $12.8B investment in Juul. Should the lawsuit succeed, the largest e-cig manufacturer with >70% market share will lose the backing of one of the largest tobacco companies, further tilting competitive dynamics in the favor of TPB.)

The strong balance sheet provides ammunition for transformative M&A. TPB might had completed deals in Q419 if not for the vaping disruption. Senior management appeared to be on the prowl for strategic acquisitions:

We are in deep dialogue in several potentially transformative acquisitions. That does not mean we are certain of the outcome, but we’ll most certainly continue to pursue accretive opportunities that can further propel company growth. We have the access to capital, and we will efficiently deploy those resources to accelerate the company momentum.” -CEO Larry Wexler, Q419 earnings call.

“And Jamie, at the end of the day, like I think you guys all are aware, like vape gate was extremely disruptive. We terminated 60 people, right? And we run a tight ship. And so we have real deals in the pipeline, but they require management to push them through. And if it wasn’t for vape gate, we would’ve had deals done in the fourth quarter. So we — the pipeline is, frankly, stronger. We did move management around where we’ve dedicated some resources solely to getting deals done. And those are moving forward.” -CFO Bobby Lavan, Q419 earnings call.

The topic of transformative M&A deserves attention because studies show that the majority of deals destroy value. TPB appears to have defied the curse so far. It has spent ~$50mm in acquisitions since 2016, of which $26mm was spent to develop the NewGen segment from scratch and the balance in a bolt-on acquisition for chewing tobacco (part of Smokeless segment). The NewGen segment was created with three M&A deals, thus it serves as a useful benchmark in assessing management’s ability to create growth from M&A. Against roughly $166mm ($26mm acquisitions + $115mm debt increase from 2016-19 assuming that new debt is taken solely for NewGen + $25m cumulative interest expenses 2016-19) invested on building NewGen since 2016, TPB generated a cumulative ~$393mm revenue and ~$93mm gross profit. This means that in 3 short years, TPB has recouped about 55% of its investment in NewGen before operating expenses (~18% “return on capital”). Excluding expenses associated with the vaping disruption, the figure would be 70% (~23% “return on capital”). We used gross profit as a measure here because TPB reports low capex relative to revenues (capex ~1% revenues), so “growth capex” is likely to be in operating expenses. Gross profit can then be thought as a proxy to profits before growth investments.

The high “return” metrics showed that NewGen had excellent product economics similar to the OTP segments. Shareholders should feel assured that TPB management would continue to engage in value-additive deals. CFO Bobby Lavan seemed eager and excited yet careful about the deal pipeline (likely to be focused entirely on NewGen):

“But deals, you never want to be forced to do deals. The pipeline is strong. The — frankly, it’s — there are a bunch of companies that I bid for in sort of late summer that have come back and said, is that offer still on the table, which is an interesting dynamic. And so we are sort of evaluating that. I will tell you, there is carnage in the street, blood everywhere when it comes to these cannabis in CBD companies. It is — the opportunity set is massive. We’re just — it’s just a capacity issue … So we’ve got this quarter through. We’ve cleaned up our books, reset the business. We moved Jim Murray straight to deal making, which is awesome, and it’s — we’re going to get stuff done.”-CFO Bobby Lavan, Q419 earnings call.

Because the PMTA process is likely to reduce the number of vaping manufacturers significantly, TPB has made the logical decision to pivot from solely being a distributor to a manufacturer and marketer of proprietary vaping brands. Future deal-making is likely to focus on acquiring growing vaping brands. There is little doubt that vaping would continue to grow in popularity, despite the interruption from lung injuries. Stimulant drugs like nicotine are very difficult to quit because of withdrawal symptoms. That is why nearly 40mm Americans still smoke after a 30-year nationwide campaign against smoking. Smokers are always looking to minimize harm when feeding their nicotine addiction. Vaping reduces harm by delivering much less carcinogens and no secondhand smoke compared to combustible cigarettes. The vaping population grew 7-fold from 2011-18, and is likely to continue growing.

In thinking about the valuation of TPB, it’s best to see the company as having 3 businesses with separate risk and growth profiles. The Smokeless segment is established with ~40% EBITDA margins, above-industry growth, and a clear expansion pathway in moist snuff. The Smoking segment is also established with ~40% EBITDA margins, but has a weak industry backdrop and no clear growth drivers. The NewGen segment arguably has the best growth potential, but also the most uncertain future with M&A integration and developing regulations. Each segment is valued below. Summing the below, TPB provides ~77% upside, which excludes the upside potential of transformative M&A in NewGen.

-Smokeless: r=9%. g=4% (2x global GDP). TV multiple=20.8. NPV=$626mm based on historical 7% revenue growth and 40% EBITDA margins.

-Smoking: r=10%. g=0%. TV multiple=10.0. NPV=$288mm based on historical 0% revenue growth and 40% EBITDA margins.

-NewGen: NPV=$166mm (at cost approximated using cash spent on M&A, debt, and interest expenses). Shareholders should be at least confident that management won’t destroy value.

TPB makes products with great economics but unloved dynamics in the current social context. Chewing tobacco and moist snuff are profitable but dirty. Vaping presents great growth prospects but involves addiction, death, federal agencies, and the revival of Big Tobacco. Investors ought to look past the smoke of temporary dynamics, and stare at the long-lived economics of TPB products.

Appendix

Cannabidiol (CBD) is a compound found in hemp plants and most commonly used to produce CBD hemp oil products. CBD is non-intoxicating and, when derived from hemp, is legal under U.S. federal law. Tetrahydrocannabinol (THC) is a compound found in marijuana plants and is responsible for the euphoric “high” that people experience when they ingest or smoke marijuana. The legal status of THC products differ from state to state.