|Shares Out. (in M):||20||P/E||NM||NM|
|Market Cap (in $M):||236||P/FCF||10||9|
|Net Debt (in $M):||204||EBIT||47||50|
Turning Point Brands is a relatively unknown high quality tobacco consumer name based in Louisville, Kentucky trading at 10x pro forma free cash flow of $1.20 per share. Using an 18x pro forma FCF valuation and adding roughly $0.50 per share in NOLs yields $22 per share of intrinsic value which equates to ~80% upside. This is what I believe the asset is worth today. Over the long term, it has the potential to compound well beyond $22. It is rare for a high quality, high ROIC consumer staples asset with a strong management team to be trading this cheaply. My firm owns shares, but is not one of the large investors and exercises no control over the company.
Why does the opportunity exist?
TPB is a recent (May 2016), unfollowed IPO.
The company has a fully diluted market capitalization of only $236 million so it is below the radar of most tobacco investors who prefer the large cap tobacco names such as Altria, Philip Morris, Reynolds, etc.
The stock is very illiquid given that the top 3 owners own over 70% of the shares and likely plan on holding TPB for the long term. The largest owner controls the company and is a highly regarded investment firm which had great success in building up Media General. TPB stock rose to $16 a few weeks ago, but has since come down on no news and low volume.
The investor group was not a net seller of shares in the IPO and is committed to the asset long term, so the investor group was likely more focused on obtaining a public listing and building value over time than on where the IPO priced.
The revenue trend for the last few years appears flattish. 2 primary reasons for this.
It is important to keep in mind that organic growth since 2008 is very impressive. Revenue has gone from $118 million in 2008 to $197 million in 2015. No acquisitions were done over this period.
The cigar business has suffered from price competition. Unlike most of the spaces in which the company competes, cigars are not dominated by large, rational players.
The high leverage of the past few years has constrained investments in growth. A debt for equity swap was done concurrent with the IPO and leverage now will not limit growth.
The company is focused on the OTP (other tobacco products) market which is attractive. The company’s products, on average, are growing volumes. This is in contrast to traditional cigarette makers which generally lose 1-2% volumes per annum but get 3-4% price. The cigarette makers (Altria, Philip Morris, Reynolds, etc.) trade above 20x P/E.
Different types of growth create varying amounts of value. The highest value-creating growth method is to introduce new products, followed by expanding in an existing market, increasing share in a growing market, competing for share in a stable market, and lastly acquisitions. TPB’s impressive growth since 2008 has primarily been driven by new product introductions, followed by growing its market share in various categories, some of which are growing, some of which are stable.
The company operates in 3 segments: smokeless products, smoking products, and NewGen products.
Smokeless Products (42% of Q2 2016 net sales)
This segment consists of MST (moist snuff tobacco, i.e., dip) and chewing tobacco. On the MST side, for the most part over 20 years sales in the market have grown 3-5% and have had mid-single digit increases in price. Altria has been taking 7-10% price in some years. This was a new category for the company in 2009 - they took the Stoker’s name and now have 2.5% share.
They are the #6 discount and #7 overall player in dip. There is a big gap between TPB’s overall dip share of 2.5% and its 6.8% market share in stores in which it has distribution. The company is making investments in the salesforce to close these gaps. A salesperson for TPB generally has sales coverage of about 600-1000 stores, and he can get to about 400 of those a quarter. So introducing a new product can take 12-18 months as one often has to visit a store more than once. The large cap tobacco players on the other hand can roll out a new product in 2 months.
So in MST, we have a nice triple play: growing market, pricing, and share gains. TPB has an excellent MST product - their dip is created by a proprietary soft fermentation process whereas most players use hard fermentation. Instead of breaking down the cellular structure of nicotine and placing it under a lot of pressure and heat, the company uses time and natural heat. This has a huge benefit: one can cut the product longer, and it lasts much longer in your mouth since the cellular structure is still intact. The company has a superior product, solid packaging, and started with a tub and now has had success with its 1.2 oz can.
The chewing tobacco market over the long term has had 4-5% volume declines and 5-6% pricing. Margins rise since less product is made and packaged over time. The company has done a good job here - it has outperformed the category and grown share in chew in all but 1 year out of the past 7-8 years. The company bought Stoker’s in 2003 and had 4% share - Stoker’s now has a 15% share in chewing tobacco. Stoker’s chewing tobacco is the #1 discount brand and the #2 brand overall. The team put Bobby Stoker on the can and improved the appeal/image of the product. The company’s Beech-Nut chewing tobacco has a 3.7% share and is the #3 premium player. Even though Swedish Match manufactures the chewing tobacco products for TPB, the IP belong to us since TPB sources tobacco, has its own proprietary flavorings, and has the product blend to its specifications.
It is important to note that the chewing tobacco and MST segments are dominated by the large players. Competition is very rational, and TPB is a price follower here.
Smoking Products (52% of Q2 2016 net sales)
This segment consists of cigarette papers, cigar wraps, and cigars. The cigarette paper segment has flat volume trends and pricing is modest but consistent. The company’s Zig-Zag cigarette papers have a 33% market share and are #1 in the premium segment. I will also point out that the company’s cigarette papers are also popular with cannabis users. The cigarette papers are sourced from Bollore - Bollore does not have the marketing & distribution capability in North America. TPB has an exclusive relationship with Bollore with regard to cigarette papers in the U.S. and Canada.
Turning Point entered the cigar wrap category in 2009 and now has 80% of the market. This was a sleepy, fringe category with relatively unsophisticated players with no regulatory infrastructure and no salesforce. The company took the Zig Zag name from papers to here. It is now a growing category. The company owns the tobacco mark for Zig Zag.
The cigar piece of the smoking products segment is less of a focus for the salesforce. The large players do not dominate this space and pricing is not great. It used to be a nice segment but then Swedish Match and Swisher started a promotional spiral. When TPB entered the category, it was doing well and clipping a 4% share of machine made cigars. One used to buy a cigar for 99 cents, now one can buy 4 cigars for 99 cents. Larry re-directed the salesforce away from cigars and towards a focus on maintaining/building shelf space and distribution with its more profitable products.
NewGen (6% of Q2 2016 net sales)
This is the smallest segment and a segment with low barriers to entry. The company is losing money in this segment but believes the segment can generate profits next year. They are proceeding cautiously here, as the focus is on the smokeless and smoking segments. The company’s V2 e-cigarettes have 6% market share and are #5 overall. It’s Zig-Zag e-liquid offering has a 4% share and is #6 overall. Initially, TPB did a good job building a presence in convenience stores with its closed systems, but now 50-75% of the category is now in specialty & vape shops due to the market transitioning from closed to open systems. In open systems, once the liquid is freed from the device, there is a great expansion of devices, battery sizes, and tanks. Additionally, each liquid product now has 3-4 nicotine levels, 5-25 flavors. A larger salesforce will benefit here.
Recent Results (Q2 2016)
The most recent quarter had solid results. Total net sales were up 7.5% and gross profit was up 10% and expended 110 bps.
Smokeless sales were up 16.1%, driven by the ongoing roll-out of Stoker MST 1.2 oz cans, driving MST retail penetration, and by pricing in both chewing tobacco and MST. Volume was up 10.9% and price accounted for 5.2%. Gross profit for the segment fell from 50.9% to 50.2%, primarily due to the shift in mix from chewing tobacco to MST and introductory discounts associated with the MST expansion. TPB gained share in both chewing tobacco and MST.
Smoking products net sales were up 8.8%, with volume up 5.8% and price/mix adding 3.0%. The quarter exhibited continued growth in MYO (make-your-own) cigar wraps and strong orders in cigarette papers. Initial shipments of Zig-Zag cigars to Canada also helped. Zig-Zag held share in cigarette papers and grew its share in cigar wraps.
NewGen sales were only $3.1 million, down 34% year over year. Volume was down 20.8% and price/mix contributed to a decline of 13.4%. New products in the marketplace and the continued shift from convenience stores to vape and accessory shops drove the decline.
The CEO, Larry Wexler, joined the company in 2003 and was elected COO in 2005 and CEO in 2009. From 2005 to 2008, he rebuilt the infrastructure of the company. When Larry took over, the company had $320 million of debt and $20 million in EBITDA. He was able to increase EBITDA by $30 million simply by improving processes. The company then did a comprehensive review to understand the best areas on which to focus.
Larry went to Yale and after Stanford business school worked at Altria for 20 years and was running strategy for them towards the end of his time there. Larry has a respect for the capabilities of the large tobacco players. Larry played a key role in the strategy group when Altria executed “Marlboro Friday.” Marlboro Friday is a popular business school case which mentions Larry by name. As some of you remember, on April 3, 1993, Philip Morris USA announced plans to slash the retail price of its premium-priced Marlboro cigarettes by 20% in the U.S. for an unspecified amount of time. In addition, PM USA also announced plans to freeze the list prices of all its premium brands and compete more aggressively in the discount segment. When that happened, Philip Morris stock dropped by 23% in a single day, and the Dow dropped as many consumer names experienced double-digit declines in their share prices. In any case, over the long run it was a smart move for Philip Morris as it taught the discounters to behave in the market. The point is that Larry is a very experienced tobacco executive who can maneuver thoughtfully in a market dominated by large players.
The CFO, Mark Stegeman, also has solid experience having worked in the finance department of Brown-Forman as a VP and Assistant Treasurer. He is willing to talk to investors and is a capable and smart CFO who understands capital allocation. He is bringing more sophistication to the finance department. He has a background in accounting and was VP/Treasurer of La-Z-Boy prior to working at Brown-Forman.
Other executives also bring great experience to a company of this size. Chuck Melander was an executive at Swedish Match and runs operations and R&D at Turning Point. The general counsel James Dobbins is from Liggett. The head of sales is from Philip Morris. The marketing fellow ran Copenhagen & Skoal for UST.
Health Considerations/Public Service Announcement
Over time, consumers have a tendency to migrate to forms of consumption which are cleaner, more discrete, and have lower perceived health risks. This is one reason why MST is such a great category. I have spent time looking at academic studies on this, and 98% of the health risks associated with smoking come from the combusting of the material which releases 3000+ compounds. For those of you who smoke, 70% of you will be unable to quit. For that 70%, I encourage you to use Stoker’s dip. It will give you the nicotine fix you need, and it eliminates the vast majority of the health risks. Moreover, it is less annoying to non-smokers. I was surprised to learn that even the incidence of oral cancer is lower with dip than with smoking. If you don’t use tobacco, I don’t encourage you to start. But if you smoke, you should switch to dip. You can discreetly dip while pitching your fund to LPs -- the nicotine fix will give you the confidence you need.
I expect capital to be used to pay down debt and M&A. Potential M&A falls into a few categories:
Tobacco products where because of increasing FDA regulations and lack of scale, a family- run business wants to sell to us. TPB can take those assets and increase profitability simply by cutting overhead. There are likely revenue gains due to distribution lift. People in the industry have told me those opportunities can be found for 4-7x EBITDA and often the seller is not asking to be paid for synergies.
The ideal situation would be a company with strong regional brands and brands that TPB can do something with. Stokers is a good example - TPB bought it in 2003 and took share from 4% to 16% in chewing tobacco by expanding and increased distribution. TPB also extended the Stokers brand to MST.
NewGen assets. Companies here could add infrastructure and capabilities with regard to products which sell though vape and accessory shops.
Share buybacks are not easy to execute, but hopefully the larger investors encourage management to execute them when the shares trade well below intrinsic value.
The company is targeting a 2.5-3.5x leverage level. I agree with this goal as most tobacco investors do not like leverage, and if management wants to use the stock as a currency to make acquisitions down the road, they will not want to be penalized for having leverage.
NewGen execution. While this is a small segment, it is an evolving category and I would want incremental capital deployed in this segment to be measured and thoughtful. A poor acquisition here could destroy significant value. The bread and butter of this company is the high ROIC tobacco business. Also, the regulatory environment is still evolving with regard to NewGen.
Liquidity. Depending on your fund’s mandate, size, and client base, it could be an issue.
Key man risk. The management team is strong - but if Larry Wexler were to leave Turning Point, that would be a huge loss for the company.
I look at valuation quite simply. The company is run-rating at above $50 million in EBITDA, but let’s use $50 million of EBITDA since it will likely have some incremental sales investments and some incremental public company costs. Maintenance capex is $2 million. The company has about $200 million in debt. Management understands that their interest costs are too high (a legacy from when TPB was more highly levered), and management is focused on a refinancing. They mentioned this on the Q2 call, though they did not pinpoint exact timing. But my view is that total interest expense pro forma for a refi should be $9 million (blended 4.5%). After applying a full-tax rate of 38% and using the fully diluted 19.6 million shares, we arrive at pro forma FCF per share of $1.20. Pick your multiple - I am using 18x pro forma FCF, and then add $0.50/share of PV for the NOLs, which gets me to $22 per share. Given the growth prospects, management quality, and high ROIC, this valuation is not aggressive. We estimate that the return on tangible capital employed is ~50%. Given that the company’s products are under-distributed relative to peers, return on incremental capital should also be high.
Again, the valuation is based on the current earnings power of the business, not a pie-in-the-sky forecast. If they execute and continue to grow volumes, take share, and improve profits, one can see the market pricing this at 20x FCF.
If the NewGen segment become profitable, which management says will happen next year, then it will no longer be a drag on EBITDA, though the drag is quite small.
Potential Acquisition Target?
Given the long term nature of the investor group, it is likely that cash flow is reinvested to acquire products to put through TPB’s distribution platform. However, TPB would be an attractive M&A candidate. A larger player could create large synergies and expand distribution, and while TPB is a small bite for a large player, larger players take every point of market share very seriously.
As the company continues to execute and the stock becomes more widely known, the valuation should become clear.
The cash flow will continue to build and there will be an intense focus on thoughtful capital allocation given the reputation of the controlling shareholder.
Expanded distribution of the company’s products. For example, TPB’s MST offering only has about 20% of the distribution that Copenhagen (Altria), Grizzly (Reynolds American), and Skoal (Altria) enjoy.