Description

Highlights

1. ToughBuilt Industries (TBLT) essentially is a publicly traded growth-stage startup, whose stock has underperformed during its rollercoaster ride to complete the “zero to 1” phase.  It trades at a EV/sales CY21E of 0.3X despite an expected 52% topline CAGR from CY19 to CY21, an extreme discount vis-à-vis profitless consumer stocks with similar sales growth (peer average is 2.7X).  Just getting to 1.0X sales implies a $1.60 stock for over 2X upside.

    

2. Its strong second quarter earnings report suggests that the company has entered the “one to ten” phase with early success of e-commerce with Amazon and new distribution channels with partners Lowe’s and Tractor Supply.

3. Near term catalyst: both the common stock and warrants (TBLTW) could get a significant boost from the quarterly Amazon sales update in the next week or so and the 3Q20 earnings report in mid-November.

4. TBLTW may enjoy an additional boost if TBLT decides to revamp its cap table via an exchange offer to consolidate the different tranches of outstanding warrants.

Investment Thesis

ToughBuilt Industries, Inc. (TBLT), founded in 2012, designs, develops, manufactures, and distributes home improvement and construction products, with offerings including tool belts, utility pouches and knee pads. TBLT offers its products under the TOUGHBUILT brand name through various home improvement big box stores, online platforms, professional outlets, and direct marketing to construction companies and trade/wholesale outlets. The company’s business model is similar to that of Nike or Apple, i.e. the U.S. team focuses on design, marketing and distribution while outsourcing the manufacturing to suppliers overseas, primarily in China. The home improvement market has huge growth potential, in the U.S. alone, the market is over $350 billion with over 4 million contractors.

The stock of TBLT has underperformed since its IPO in November 2018 primarily due to the dilution overhang of the follow-up equity offering to fund the business growth. From a business lifecycle perspective, TBLT is similar to a startup in that it just completed its “zero to one” phase as a publicly traded company. 2020 seems to be a turning point as it established both on line and offline distribution channels and sales have ramped up both domestically and internationally. The stars have aligned for a long-awaited rally as the company enters the phase of from one to ten. TBLT is like a venture capital investment but in the public market, offering investors significant upside over time but with meaningful volatility in the near term.

TBLT Price History

Source: Bloomberg.

Our investment thesis is built on several drivers and catalysts that TBLT may benefit from both near term and longer term:

1. Cheap valuation. With an enterprise value of only $13M the stock trades at an EV/sales ‘20E of less than 0.5X and EV/sales ‘21E of less than 0.3X per consensus (Maxim) with sales expected to grow from $19M in 2019 to $28M in ‘20E (+47%) and $44M in ‘21E (+58%).  While the closest comp is SWK, it is not a good proxy as sales are only growing at low-to-mid single digits.  Still, it trades at an EV/sales ‘20E of 2.4X.  As shown in the chart below, a basket of consumer stocks growing sales at a greater than 20% CAGR for ’20 and ’21 and negative EPS, like TBLT, trades at an average EV/sales ‘CY21E of 2.7X.  At that valuation, TBLT would trade at above $3.50  (up about 4.5X). 
2. Strong liquidity. The company had over $19 million in cash on the balance sheet at the end of second quarter 2020. With the current annual cash burn rate of $13 million, the cash balance and the future operating cash flow should at least cover the cash need for the next 12-18 months before the company becomes self-funded.
3. High profile online and offline distribution partnerships. TBLT has developed both its online and offline distribution channels with high profile retailers, including Amazon, Lowe’s and Tractor Supply etc. TBLT has showed strong momentum in scaling up its sales with these channels during the first half of 2020. With the tailwind from COVID-19, we expect this positive trend to continue into the third quarter and the rest of the year.
4. Global expansion. While all eyes are on TBLT’s sales momentum on Amazon.com, its potential overseas is somewhat overlooked. Per the company’s latest 10Q, TBLT generated 32% of its sales from outside the U.S. during the first half of 2020, with the top three overseas markets being South Korea (9%). Canada (7%) and Australia (6%). Potentially TBLT could have significant growth also in emerging markets, such as South America and Asia as the distribution cost could be much lower than the U.S. It is worth noting that on TBLT’s Amazon storefront, there are quite a few positive reviews in Spanish from Latin America which seems to suggest a growing brand awareness in that market.
5. Well-defined catalysts.  TBLT has disclosed its quarterly sales on Amazon.com in the U.S. and Canada one or two weeks after the quarter end (well before the earnings release). So we should expect TBLT to provide this sales update within a week or so. TBLT will announce its third quarter earnings on November 19th, 2020 which should provide a lot more detail about its distribution channel results. Both announcements could be significant catalysts for a stock rally.
6. COVID-19 beneficiary.  The pandemic has provided an unprecedented tailwind for the home improvement and construction industry.  Mandatory lockdowns, social distancing and work from home have significantly boosted the home improvement sectors during 2020 so far.  The tailwind is spread across the industry’s supply chain, including tool manufacturers, strong retailers and troubled retailers. 

Stock Charts

Using the stock price charts below as an indication, the rally broad-based (except TBLT), e.g. power tools maker Stanley Black & Decker (SWK), the homebuilders ETF (ITB), strong online and offline retailers Wayfair (W), Home Depot (HD) and Lowe’s (LOW), and once troubled retailers, Bed Bath & Beyond (BBBY) and Tuesday Morning Corp (TUESQ) have all run. 

TBLT vs Stanley Black & Decker, Inc. (SWK) Price Chart

Source: Bloomberg.

Homebuilders ETF ITB vs S&P 500 ETF (SPY)

Source: Bloomberg.

 Home Depot, Wayfair and Lowe’s Price Chart

Source: Bloomberg.

Bed Bath & Beyond and Tuesday Morning Corp Price Chart

Source: Bloomberg. 

TUESQ is a great example - it filed for bankruptcy right after the outbreak of COVID-19, but the equity bounced back and is in the money due to better than expected sales.

Both online and offline channels have started to bear fruit as sales have been showing strong and sustainable momentum.

TBLT’s storefront with Amazon.com is a key driver this year, reporting $5.4 million on annualized basis in the second quarter 2020. Its third quarter sales from the Amazon storefront could be even stronger as April and May were still negatively affected by COVID-19.

Screenshot of TBLT’s Amazon storefront

Source: Amazon.com

Besides Amazon, TBLT also struck a partnership deal with Lowe’s (LOW) in early April this year, in which LOW awarded a portion of its soft-sided tool storage business and all of the kneepad business to TBLT, which was launched at both brick and mortar stores and online at www.Lowes.com in October 2020. There will be 30 SKUs and a total annual forecast of $22.7 million dollars. TBLT’s products are already shown on Lowes.com now (see screenshot below).

TBLT’s share price could potentially benefit from two immediate catalysts over the next few weeks. TBLT should announce its third quarter sales from the Amazon storefront in the U.S. and Canada before the middle of October. Judging from the trends in the second quarter as well as recent results from other home improvement retailers (e.g. BBBY), the third quarter sales should remain strong. The second catalyst is TBLT’s third quarter earnings on November 19, 2020 which should provide more sales updates on other distribution channels.

Warrants

TBLT has a relatively complex warrant cap table with 21.9 million warrants outstanding but in several different tranches, including publicly listed warrants and privately held warrants. Per TBLT’s disclosure in its second quarter 10Q, there are four tranches of warrants outstanding (see table below), i.e. Class B warrants, 2020 offering warrants, placement agent warrants and the publically traded Series A warrants (TBLTW).

Based on the table above, TBLTW is subordinated to both 2020 offering warrants and placement agent warrants in terms of its exercise price of $55 per share. Given TBLT’s current share price, it would be very difficult, though not entirely impossible, for TBLT to hit $55 per share by November 2023. In other words, there is a very low likelihood that TBLTW will become in the money and exercisable at the expiration date in 2023.  What could potentially happen to TBLTW? In theory, there are three likely scenarios:

1. TBLTW expires worthless. If TBLT’s stock price is below the exercise price by the expiration date, the warrants will expire worthless. TBLT let its Series B warrants expire worthless at the end of 2019 so there is precedent for this scenario.
2. TBLTW gets exchanged into a new series of warrants with different exercise price and likely different expiration date. This scenario also has a precedent. On January 24, 2019, TBLT entered into an exchange agreement with two institutional investors. In the exchange a) investors exercised Series A Warrants to purchase 42,412 shares of TBLT common stock for $2.17 million and b) investors also exchanged Series A Warrants to purchase 50,894 shares of its common stock into 50,894 shares of its common stock and received new warrants to purchase an aggregate of 933,056 shares of TBLT stock. These new warrants have terms substantially similar to the terms of the “old” Series A Warrants, except that the exercise price of the new warrants is $36.70.
3. TBLT completely revamps its cap table, including both warrants and stock option plans. This scenario will address two issues at the same time, first, to grant management more ownership of the company so that they are properly incentivized and rewarded for creating shareholder value, secondly, the warrants could be consolidated and/or exchanged to clean up the cap table and strengthen the relationship with the institutional investors. This scenario might be a long shot and would require a lot of effort from the Board, management and legal team, but it’s not impossible.

While it is impossible to tell how these theoretical scenarios will play out in reality, the price of TBLTW seems to give us a hint as to what the market is thinking. In chart 1 below which shows the price history since TBLT’s IPO, the prices of TBLT and TBLTW closely tracked each other until January 2020 when TBLTW started to outperform TBLT. In chart 2 which shows the close-up of the one year price history, the outperformance of TBLTW is even more striking: the warrant price was up 295% while the stock price was down 74% during the same period. 

Possible reasons for this decoupling could be

1. Illiquidity of the warrants. There are only 519,001 shares of TBLTW outstanding. Its price could be subject to big swings even with low trading volume.
2. Expectations of some kind of restructuring. Since TBLTW still has 3 years before expiration and TBLT has reported strong sales and has adequate cash cushion, TBLTW may have priced in a positive restructuring event in the future.

TBLTW could be a good candidate for an event-driven trade, however, given the number of shares outstanding and low trading volume, caution is recommended when trading this specific warrant. 

Chart 1 TBLT vs TBLTW Price Chart since IPO in November 2018

Source: Bloomberg.

Chart 2 TBLT vs TBLTW One Year Price Chart

Source: Bloomberg.

We’ll take this one step further to examine the potential theoretical price impact of a warrant exchange deal. The key assumptions for this exercise are

1. All outstanding warrants will be consolidated and exchanged into one single tranche with a single strike price and expiration date.
2. The consolidated single tranche warrants will be listed under ticker TBLTW.

Based on the above assumptions, we have done two price sensitivity tables by changing the strike price and expiration day while keeping the volatility the same as the current level of TBLTW.

We have to admit that these exercises are oversimplifying the situation and should not be used as the basis for investment decisions. However, any restructuring deals towards this end should have multiple benefits for both the company and the investors.

1. Capital structure. TBLT’s cap table will be much cleaner which will be helpful for management to manage the future dilution as well as future capital raising.

    

2. Liquidity. The vast majority of TBLT warrants are not listed. If they could be folded into TBLTW, such warrant holders would be able to benefit from the market liquidity and trade their warrants freely.

    

3. Investor relations. Different from the common stock which is primarily owned by retail investors, the warrants are owned by institutions who tend to have more bargaining power to renegotiate the terms of their warrant holdings. Since TBLT might still need to raise more capital down the road as its business continues to ramp up, a good relationship with institutional investors (warrant holders) will be critical. An exchange deal with some upside benefit will certainly serve that purpose.

Key Risks

1. Dilution of shareholders. TBLT might need to raise more capital in the equity market to fund its growth which might significantly dilute the existing equity holders. Additionally, TBLT also has warrants outstanding which, if fully exercised, could create further dilution.
2. Management ownership. Management ownership of the company is only a low single digit percentage, so management might not be properly incentivized to create shareholder value.
3. Warrants. TBLT has multiple tranches of warrants outstanding, each with different terms. TBLTW has the worst terms with a high strike price and near-term expiration date, which suggests it might expire worthless unless the company restructure its warrants over the next three years.

Conclusion

TBLT is a growth stage company that provides a risk/reward profile similar to that of a venture capital investment, with both significant upside and high volatility. If the stock traded at a still deep but less egregious discount to consumer growth peers, at 1X EV/sales CY21E it would trade at approximately $1.60 for over 2X upside.  Over the course of 2020, the company has made significant progress in both e-commerce and offline retailing channels in the U.S. and overseas which was already been reflected in the sales trajectory. The stars have aligned for the stock to reverse its downward trend should this momentum continue. The key risk of owning the stock is continued dilution from equity offerings before the company reaches free cash flow breakeven.

Catalyst

1. Quarterly Amazon sales update in the next week or so
2. 3Q20 earnings report in mid-November.