TURNING POINT BRANDS INC TPB
September 14, 2019 - 1:06pm EST by
straw1023
2019 2020
Price: 26.70 EPS 0 0
Shares Out. (in M): 20 P/E 13 12
Market Cap (in $M): 531 P/FCF 0 0
Net Debt (in $M): 200 EBIT 68 73
TEV (in $M): 731 TEV/EBIT 11 10

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Description

Thesis: The upheaval in vaping has taken the buzz out of TPB (and accordingly, SDI) and provided the market with an inexpensive tobacco stock and a free option on their NewGen (Vaping/CBD) segment, which includes vaping distribution; CBD; and a proprietary pod vaping system. The technicals here are pretty obvious: this traded up as a fast-money, public-market way to play vaping and CBD. And now the story is clouded, and fast money is dumping without regard to valuation.

 
This write-up involves three parts:
 
1) Valuing the traditional segments of TPB
2) Discussing and valuing the NewGen segments
3) An aside discussing the spread between SDI and TPB
 
TPB Valuation
 
As of June 30, 2019,
 
shares: 19.9mm * $26.70 = $531mm
net debt = $200mm
 
So TEV = $731mm
 
But there have been some significant events in Q3 thus far:
 
- Acquired Solance for $15.3mm -- $8.3mm in cash plus $7.0mm in performance-based stock (New Gen)
 
- Invested $3.0mm in Canadian distribution company (NewGen)
 
In analysis below, one scenario is to assume that NewGen is worthless. In this case, the performance-based stock will be worthless so these will add $11mm to TEV for these acquisitions.
 
So adj TEV = $742mm
 
Also, there was a $173mm convert offering (less capped call that cost $21mm) . . . conversion price is $83. Use of proceeds: $21mm for capped call; $36mm to pay off debt; $6mm fees; $110mm cash. Interest is 2.5%. Given drop in stock, I am going to call this neutral to TEV. Of course, the concern might be that management will make more NewGen acquisitions that turn out worthless.
 
So what is the Traditional (super-)segment (combo of smokeless and smoking segments) worth?
 
Starting in 2018, TPB stopped allocating all expenses to the segments. As well, their EBITDA reconciliation is complicated and so we cannot derive an exact answer.
 
However, we can extrapolate using two different methods and come pretty close to the answer.
 
First, let's look forward in time from 2017, when they did allocate all expenses. In that year, the company produced $60mm of EBITDA (including stock comp). The NewGen segment was only beginning to ramp up and produced about $2mm of EBITDA. We can look across apples-to-apples operating income for the Traditional segments from 2017 to 2019 to see that op income has improved $2mm. Further, this period involves a hit from Canadian packaging regulations, and this business bottomed in May '19 and should now rebound. Taking all this into account, normalized EBITDA for the Traditional segment is about $61mm
 
Second, we can start with management's $74mm EBITDA midpoint for 2019. This excludes Nu-X ventures, but it includes NewGen sub-segment for vaping distribution. First, let's subtract $4mm for stock comp. And then we need to subtract the NewGen EBITDA and then add back the Nu-X EBITDA. We do not have this information directly, but if we look at how un-allocated expenses have grown and the relative size of the NewGen business, $11mm of EBITDA for the vaping distribution business seems reasonable. This implies $59mm of EBITDA. And then add back some for the rebound from Canadian packaging regulations, and $61mm seems very reasonable.
 
One may question the validity of TPB's EBITDA reconciliation. But other than stock comp, only the Canadian packaging regulation writedowns affect the Traditional segment. I think this is a legitimate add-back because it is one-time and does not deserve a multiple.
 
So I assert that if we shut down all the NewGen businesses, the Traditional business would produce $61mm of EBITDA. Capex is $1mm. Interest is $16mm (added $1mm for add'l TEV). And this business would produce $35mm of FCF-to-Equity (Mkt cap is 15x FCF-to-Equity).
 
This is a very reasonable price for a tobacco business that is growing (smokeless tobacco) and flat (smoking products). The smokeless segment is particularly valuable as a hedge against both the social stigma of smoking and the anti-vaping panic. Smokeless tobacco is a discreet source of nicotine and an alternative to vaping and smoking. And if we assume that vaping is outlawed, where are these new nicotine addicts going to turn? Smokeless tobacco is certainly one alternative.
 
As well, smoking products, due to their niche nature, have not seen the declines seen by well-known cigarette brands. And again, outlawing vaping is only going to produce more smokers.
 
I like the Traditional business at 15x. It is not an incredible value in this scenario, but if this is the downside, it anchors a great situation. FWIW, I originally got involved in TPB three years ago when the stock traded in low teens and it was about 12x FCF-to-Equity, and I had assumed just-ramping NewGen was worthless. I think the current setup is better but riskier.
 
----
 
So what is the NewGen segment worth? If government outlaws vaping permanently, it would be worthless. I should note that Nu-X (part of NewGen) is developing some CBD products not related to vaping, but this is unlikely to produce tremendous value.
 
What is causing current situation in e-cigs?
 
e-cigarettes have been subject to scrutiny since inception because of the use rate among young adults combined with the marketing of sweet flavors that cater to young adults. Even though nicotine is addictive, it is not the most dangerous part of cigarettes. It is the tar in cigarettes that cause cancer. This gets a bit controversial, and there is disagreement over the danger of nicotine, but suffice it to say, no one would disagree that nicotine alone is nowhere near as dangerous as cigarettes. In fact, in the UK, the government has spent large sums to promote vaping as an alternative to smoking. 
 
However, opponents argue that e-cigs are a gateway to real cigs via nicotine addition. There are lots of opinions on this topic and various governments disagree as well. The tradeoffs are fairly well understood (it DOES help people quit smoking, but it also DOES create more nicotine addicts).
 
But this debate has been going on for years with the only probable action being the banning of "sweet" flavors and strict restrictions against marketing to teens.
 
But starting a month ago, the situation took a dramatic turn as there have been hundreds of reported cases of lipoid pneumonia reported in U.S. hospitals, and there have been six deaths in about a month from lipoid pneumonia. Most if not all of these cases appear related to vaping.
 
One reasonable assertion is that deaths/severe illness has been ongoing for years, but it has only now risen to the level of consciousness among doctors and scientists. This was my original hypothesis, but I now believe it is wrong. 
 
Lipoid pneumonia is a rare condition, and public health experts have stated it would not be missed if hundreds of young people were showing up in intensive care units with lipoid pneumonia. Relatedly, the situation in the U.S. has alerted authorities in other countries to search their records and ask their doctors, and the reply has been a big nothing. This appears to be a recent phenom found only in the U.S.
 
I see three possible explanations here:
 
1) There is something inherently dangerous in vaping that cannot be eliminated. If so, vaping worldwide will be outlawed and all legal vaping companies will be worthless.
 
2) There is something found in legal products that can be eliminated without altering the vaping experience. If so, there will be some lawsuits but industry will bounce back and thrive.
 
3) The cause of illnesses/deaths is bootleg ingredients or ingredients mixed in by vaper. In this case, this will be a boon for the legal industry as outlawing vaping would be more dangerous than ever and government would be forced to work with vaping companies to produce safe product.
 
There is a lot of evidence that the case here is number 3. There is a lot of evidence that the cases of lipoid pneumonia are related to bootleg or homemade cartridges, esp (but not exclusively) those based on THC.
 
The most important piece of evidence is the dog that has not barked. Regulators, journalists, and most importantly, plaintiff lawyers, are searching hard to find a case of lipoid pneumonia that is exclusively related to a legal closed pod system, like Juul. These three parties have every incentive to find and document such a case. And I cannot find a single example. If you read reddit boards, there are numerous such claims, but then then reddit users note that the user has no other posts . . . obvious red flag.
 
As a case in point, Adam Hergenreder https://www.cbsnews.com/news/vaping-illness-18-year-old-hospitalized-after-he-said-he-vaped-with-thc/
 
He has filed suit against JUUL, and the media has been blasting this story with dramatic headlines because attaches JUUL to lipoid pneumonia. So he is alleging that he only smoked JUUL and got lipoid pneumonia that almost killed him and has permanently destroyed his lungs, right?
 
Nope. He acknowledges he got lipoid pneumonia from vaping THC that he got from a drug dealer ("I got it off a drug dealer" is exact quote . . . his lawyer must cry every time he sees that). He is suing JUUL under the gateway argument. JUUL marketed to him and got him hooked on vaping . . . and so responsible for his injuries. This is a much tougher argument, and regulation will eventually provide a safe harbor here.
 
Further evidence here is the point I raised above. Where is the outbreak in foreign countries? https://www.politico.eu/article/us-vaping-illness-death-toll-rises-fear-reversals-anti-smoking-campaigns/
 
“We have not seen anything like what we’ve seen in the U.S. recently in Europe, to my knowledge as a scientist, and I’m pretty aware of the field,” said Constantine Vardavas, the European Respiratory Society’s scientific relations director with the EU.
 
Europe is much more strictly regulated, and street/homebrew vaping is much less common in Europe.
 
There is a lot of evidence that the lipoid pneumonia illnesses are being caused by cutting/thickening THC with vitamin e acetate. https://www.rollingstone.com/culture/culture-features/vaping-honey-cut-mystery-thickener-vitamin-e-acetate-vapes-881896/
 
This is lots of interesting info from amateur drug scientists (perhaps in NoCal/Oregon area?), and this is representative: 
 
"People have been vaporizing cannabis plant material using purpose built vaporizers since the 1980s/1990s (mostly in the netherlands and other parts of europe with historically liberal laws)


Since the late 1990s/early '00s routinely in North America with the commercialization of cheap vaporizors (if you are aware of this type of thing.... think "Vapor Brothers" or "vapor Doc"; these were veeerrrryyy popular in 2002-2003)

With SB420 in CA, and the later CA AG memo on the definition of "marijuana" under SB420 that included concentrates (and excluded edibles) under the umbrella of weight standards and the accompanying explosion of solvent extracts, vaporization on very high THC content extracts became incredibly popular, basically everywhere, but certainly in CA.

No deaths.
No epidemics of severe hospitalizations....

Anecdotal stories of emergency room visits from people smoking/vaporizing "oil"... yes.  But anecdotes.  Handfulls of people over decades, not hundreds in a matter of months.

The problem is the advent of Cartridge vaporizers.

They require dilution of the cannabis extract (which is otherwise as thick as frozen molasses) to function properly.

Vitamin E has been used as a "supposed" safe solvent/stabilizer/suspension producing additive in the supplement and neutraceutical world for non polar/lipophilic molecules that people eat (example: conezyme Q10 suspended in either vitamin E and/or fish oil, or pattented liposome encapsulation)

Should we be surprised this was the go to?

No.  These companies rarely have full blown scientists as CTO/CSOs informing them... that....

Yes...

Vaporizing Vitamin E is like inhaling the fumes from a boiling hot pan of cooking oil."

 
----
 
Argument is not perfect:
 
There is one ding in the argument that this is all related to bootleg/homebrew cutting of THC. Authorities have stated that there are a small minority of cases that are purely nicotine based vaping. One possibility is that the vapers lied because THC vaping illegal in some locations. Other possibility is that there is more than one cause, but it is quite a coincidence that these are all happening at once. Stories have been anecdotal thus far, but I cannot find a single story from a journalist or regulator that asserts a case of lipoid pneumonia from legal pod-based vaping systems, where a legal company controls the vaping fluid.
 
----
 
The high-probability path is pretty clear:
 
- Trump (nor FDA) will not ban vaping; Sweet flavored vaping will be banned or severely curtailed; state and local movements will die out
- Legal/regulated companies will benefit from the recent outbreak
- Vaping use will continue to grow
 
At worst, there is some ingredient in legal vaping that causes problems in a small number of users and chemists will need to work out alternatives.
 
---
 
So what is the NewGen segment of TPB worth if my expected path happens? First, let's divide NewGen between established vaping distribution arm and new proprietary product development. The distribution arm is a combination of retail, B2B, and B2C. 
 
From 2016 to present, TPB has spent about $70mm to acquire the vaping distribution business. And that business will produce about $10mm of EBITDA in 2019 with very little capex required. The business is growing organically at a high rate. The B2B and B2C businesses are developing moats, and the runway is very long. I have no idea how to value such a company, but I would happily pay $200mm (or $10 per share) for it.
 
The Nu-X sub-segment is even more difficult to value. At present, it runs at a loss, and I am skeptical that anyone will develop powerful and valuable brands in CBD products. However, the RipTide proprietary pod system intrigues me as a possible hidden gem. They launched it in Q1 2019, and it has received favorable reviews. I bought one myself, and while no expert, it is very nice physically although not as small as JUUL. Reviews indicate much higher end experience than a JUUL or may other pod systems. Demand has not exploded, and most vapers I ask have never heard of it. 
 
There is one intriguing wrinkle: the Riptide system uses non-tobacco derived nicotine. This is interesting because technically this eliminates a lot of regulation. For example, the SanFran banning legislation refers directly to the FDA mandate, which seems to exclude the Riptide system from its coverage. I do not know how this plays out. It is a complicated legal and regulatory matter, but its non-tobacco status my provide it a huge advantage in certain regulatory environments.
 
-----------------------
 
Management
 
I have not mentioned management yet, but I have found this management team to be very strong, esp for such a small company. Their acquisition strategy (both tobacco and NewGen) has been conservative in its size but pointed and meaningful. I rarely say this, but I do not consider it a negative that they have a $100mm war chest from the convert offering.
 
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Aside (SDI vs TPB):
 
You can also play this through SDI, which owns a majority stake in TPB. This was explored by opco two years ago when ticker was SDOIA.
 
The spread between SDI and TPB implies it is being run by the Levan's of BBX Capital. The spread has gone from varied from about 15% cheap to 40% cheap. The cheapness percentage is highly correlated to TPB's share price as fast money drove up TPB stock without driving up SDI stock the corresponding amount. However, after taking into account this correlation, the spread is about at all-time highs of about 30%.
 

 

This is a write-up for TPB as SDI raises another level of issues. They are burning cash at the corporate level and its direction is unclear. The CEO was fired at the end of Q1 '19.
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Resolution of vaping issues that avoid worst case that is priced in currently.

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