Description

Turning Point Brands was written-up back in September by Straw1023.  His piece was written in the midst of the vaping health scare.  Today, with the benefit of some distance, we have better clarity into how consumer demand has evolved in light of the health issues around vaping yet the stock remains attractively priced.  For that reason, along with the pending collapsing of its corporate structure, I feel it is worth revisiting.  

Turning Point Brands is an off-the-radar tobacco company focused on non-cigarette products such as chewing tobacco, moist snuff, and rolling papers.  These Other Tobacco Products – “OTP” in industry parlance – are the fastest growing segment of the tobacco industry and benefit from many of the same characteristics as traditional cigarettes, including strong brand loyalty and pricing power.  These features have enabled Turning Point to grow topline in its core businesses in the low- to high-single digit range, steadily increase margins, and grow free cash flow.  The company has a first-tier management team with a demonstrated track record of using excess capital to pursue strategic acquisitions at highly accretive prices.  However, because of its small size ($475m market cap), unusual corporate structure, lack of meaningful sell-side coverage, and lingering investor concerns about the future of vaping, Turning Point today trades for less than 8.6x 2021 free cash flow.  At current prices, investors can buy the core business, which is a highly predictable, growing cash flow annuity, at a very reasonable price, and get cheap call options on the company’s vaping business and nascent cannabis offering.  Based on the core business alone, shares are worth $32 to $37 (+28% from current), and higher in a blue-sky scenario; a successful outcome on vaping adds another $9/shr; and CBD even more.  Lastly, with the company in the process of collapsing its corporate structure and the September deadline for the FDA’s vaping-related PMTA applications, there are several catalysts which could accelerate a revaluation of the stock.  

Business Overview

Turning Point’s business consists of three segments, Smokeless and Smoking, which forms its core offering, and NewGen, which includes its vaping and CBD businesses:

• Smokeless (26% of LTM revenue, 35% of segment op. income):  Consists of two primary products lines:  chewing tobacco and moist snuff tobacco (“MST”), sold under a variety of discount-priced brands, the most prominent of which are Stoker’s, Beech-Nut, and Trophy. 

• Chew is a mature product category.  TPB is the second largest player in the U.S. with 20% market share, behind Swedish Match with 40%; the latter is focused on the premium end of the market while TPB dominates the discount end, with Stoker’s being the #1 discount brand.  Overall industry volumes are declining around 10% per year and are offset by 3% to 5% pricing increases.  The discount space has and continues to outperform the broader category but TPB’s chew business will likely continue to decline in the 3.5% range it has experienced the last few years. 

• MST:  While MST is also a flat to declining category, TPB has seen volume growth accelerate over the last two years, reaching north of 30% y/y YTD, as a result of broadening distribution and increasing wallet share.  Despite significant growth over the last few years, TPB’s Stoker’s brand is still small today at around 4.5% market share, however, it commands a higher share of doors where it is sold (8.1%) and continues to expand its points of presence. 

• Smoking (31% of LTM revenue, 51% of segment op. income):  TPB’s Zig-Zag brand is the #1 premium cigarette rolling player in the U.S. (35% share) and Canada and dominates (75% share) the make-your-own (“MYO”) cigar wrap markets.  Over the last few years, topline in this business has been flat as a result of declines in non-core products offsetting gains in the core; with these issues behind it, the business should grow revenue low- to mid-single digits and operating income in the high-single digits or low double digits.  With half of Smoking revenue derived from rolling papers, this business is an under-the-radar play on the proliferation of legal cannabis sales in the U.S. and Canada, where rolling papers are often sold alongside cannabis flower in dispensaries.

• NewGen (42% of LTM revenue, 13% of segment op. income):  As recently as mid-2019, many investors viewed the NewGen segment as the reason to own TPB stock.  Through a series of acquisitions, TPB had created one of the largest distributors of vaping related products, including a physical B2B business and a digital direct-to-consumer offering, launched RipTide, a promising closed/pod vaping system to compete with JUUL and NJOY, and was preparing to roll out a line of cannabidiol (CBD) products for sale at convenience stores.  However, the mysterious vaping-related lung illness that rapidly spread across the country in the summer of 2019 and subsequent actions taken by the FDA to ban all flavored closed/pod vaping liquids, sent shockwaves through the business.  In response, Turning Point initiated significant cost cuts, scuttled plans for its pod system, and refocused its distribution business.  As a result, NewGen, which was on track to do $170m+ of revenue and show dramatically improving operating income, instead finished the year with quarterly revenue down 37% from 1Q19 levels and an operating loss.  As of 2Q20, revenue has rebounded, surpassing year-ago (pre-disruption) levels, and the segment has returned to operating income profitability.

The Vaping Crisis and PMTA Process

With the benefit of present information, it is clear that the mysterious vaping illness that took hold last summer was caused by a substance called vitamin E acetate, a component found in bootleg vaping products used to deliver tetrahydrocannabinol (“THC”), the active ingredient in marijuana.  To date, there has been no conclusive evidence linking the illness to any commercially-marketed vaping products or vendors.  Nevertheless, the uncertainty at the time led to a material decline in industry-wide sales.  Furthermore, media coverage of the illness often conflated the issues of product safety with the offensive marketing tactics employed by manufactures, specifically market-leader JUUL.  As a result, though no commercially-produced products contributed to the epidemic, the FDA took action to ban the sale of all flavored vaping liquids in closed-loop systems.  For context, prior to the ban, 70%+ of JUUL’s sales came from such flavored liquids.  Flavored products can still be sold in vape and other specialty shops for use in open systems, but the damage to the industry has been significant.  Dollar sales, which had been growing at an annual pace of around 60% as recently as September were down roughly 30% Y/Y in June.

Regardless of the change in consumer appetite for vaping and the FDA’s ban on pod-based flavored liquids, the industry was already approaching a crossroads.  The FDA is authority to regulate all tobacco-based products, including vaping hardware and liquids.  Because the adoption of vaping happened in just a few short years and was viewed as a lesser evil than smoking combustible cigarettes, the FDA decided to postpone regulation of vaping products until May 2020 (since delayed to September 2020 due to COVID-19).  However, after the FDA’s premarket tobacco product application (“PMTA”) regime goes into effect in September, only products approved by the agency will be allowed to be sold in the U.S. 

Until now, the vaping market has been the Wild West.  While JUUL has dominated the closed-loop/pod side of the market, the open systems market is highly diversified with hundreds of vendors selling thousands of hardware, components and liquids, some of which of dubious quality.  The PMTA process, like any expensive regulatory requirement, should ultimately benefit the players in the market with scale, capital, and expertise in dealing with regulators, and weed-out the many mom-and-pop players that have subsided until now.  While it is impossible at this point to handicap which companies will receive PMTA approval, what is certain is that those that do will be well placed to seize market share in what is still likely to be a long-term secular growth category.

Investment Thesis

While the market has focused with laser precision on the problems in NewGen, the balance of the business, which generates the vast majority of earnings and cash flow, has flourished:  In the twelve months prior to the vaping-related illness becoming public, NewGen accounted for $13m of adj. operating income; Smoking and Smokeless combined for $75m.  In 1Q20, the Smokeless business put up its best quarter ever (+17.5%) and it should continue to outgrow the industry for years to come.  The business, which has grown at a 7.7% CAGR over the last five years, is accelerating as a result of a mix shift from the flat- to LSD-declining Chew business to the MST business, which is growing in the 20% to 30% range.  In 2017, Chew was 58% of Smokeless revenue and MST 42%.  By 1Q20, the two had flipped.  As MST continues to become a bigger piece of revenue, its robust growth will increasingly show through in overall segment sales.  Stoker’s MST has just 4.5% market share today, up from 2.9% two years ago.  That compares to 8.1% share in doors that carry the brand.  As the brand grows, it becomes increasingly necessary for retailers to carry it, or risk customers bypassing them for other stores that do.  I model MST up 18% through the balance of 2020 (vs. a 1Q print of +33%) and +15% in 2021 and 2022.  I think my numbers are likely to prove conservative given the recent trends in the business.  I model the Chew business declining 4% per year going forward, slightly worse than the 3.5% decline rate of the last two years.  This results in blended Smokeless revenue growth of 10% this year and high-single digit (“HSD”) thereafter.  Over the last 4 years, Turning Point has expanded Smokeless gross margins by 313 bps despite MST, the now dominant piece, carrying lower margins than Chew.  I expect the company to continue to leverage its cost base, enabling it to grow Smokeless operating income in the HSD to low double-digit range.

The Smoking business should grow topline low- to mid-single digits as expanded cannabis consumption and product innovation (cones vs. traditional rolling papers) offset industry volume declines.  The 2.5% topline decline in the business in 2019 belies the true trend as it was negatively impacted by a regulatory packaging change in Canada and the run-off of the legacy cigar business.  With those issues behind it, revenue grew 7.5% the last nine months, aided by both volume and price gains.  Further, with the benefit of the recent acquisition of Durfort/Blunt Wraps (more below), I estimate operating income should grow in the low-double digits the next two years, before moderating to MSD thereafter.

TPB’s business is recession-resistant:  Like most tobacco businesses, Turning Point should be resilient through a recessionary period as its products provide consumers with an inexpensive form of enjoyment.  Further, with people spending more time out of the office, consumers face fewer limitations on when they can consume tobacco products.  In fact, according to recent Nielsen data, Turning Point’s core moist snuff business has continued to grow in the 25% to 30% range since COVID-19 took root in the U.S. 

Investors are buying the core business at an attractive price:  Turning Point has a market cap of $570m.  Including $63m of cash, $317m of debt (pro forma for Durfort), $12m in earnouts, and $9m of additional PMTA investments this year, it has an enterprise value of $845m, or 9.3x 2021 core Adj. EBITDA, which gives zero credit to the NewGen segment.  On an earnings and free cash flow basis, the stock trades at 10.7x and 9.5x, respectively (both excluding one-time PMTA expenses).  I view this as attractive on both an absolute and relative basis.  Altria trades for 8.6x 2021 EBITDA and 9.1x EPS and Philip Morris International trades for 10.7x and 13.8x, respectively.  TPB deserves a premium valuation as both Altria and Philip Morris Int’l’s businesses are seeing flat to declining volume in their core segments, and are on the losing side of the secular shift to vaping.  TPB, by contrast, has zero exposure to the cigarette market, is growing volumes across its business, could be a beneficiary of the secular shift to vaping, and should grow FCF by around 40% in 2020 and another 24% in 2021.  If we look out a year and the market does nothing more than role-forward the current 2020 valuation (10.8x) on 2021 Core Adj. EBITDA, the stock would trade at $32 for 10% upside.  At 12.0x, it’s a $37 stock with 28% upside (this equates to 12.0x FCF).  All before including any value for vaping or CBD. 

Inexpensive optionality around vaping:  A year ago, when TPB’s vaping business was seeing mid-teens organic growth, shares traded for as high as $55.  Today, with the Smokeless and Smoking businesses posting record numbers, the stock trades at close to half that.  In the span of just a few months, investors swung from valuing NewGen at several hundred million dollars to assuming it is worthless.  While that might ultimately be the case, there is also the real possibility that TPB is able to successfully navigate the PMTA process and NewGen could be worth a considerable amount.  Management’s guidance for 2020 calls for approximately $100m of vaping-related revenue.  However, based on last week’s pre-announced 2Q numbers and the delay of the PMTA deadline until September, vaping revenue should be closer to $120m (for total NewGen revenue of around $138m)  Absent one-time PMTA-related expenses, the business should do around $8m of operating income this year.  In the event TPB receives approval for its most important products, I would expect the $120m of revenue grows to something more sizeable over the next couple of years as the market regains its footing and TPB takes share from the smaller players who don’t make it through the PMTA process.  Management has talked in the past about that business being able to achieve a 10% to 15% operating margin over time.  Assuming it can get to 10% margins on $150m of revenue over the next year or two, it would generate $17m of EBITDA that should be capitalized at a multiple of at least 10x, for $170m or ~$9.00 per share.  In a blue-sky scenario, the business could be worth more than twice that amount.  This compares to Turning Point’s anticipated PMTA-related cash costs of $15m to $18m, incurred mostly in 2020.  Should TPB fail to receive approval for any of its products, it’s fair to assume the $120m of vaping revenue and $8m of operating income go away.  There may also be some additional restructuring costs incurred to fully exit the vaping business.  Thus, TPB is risking $15 to $18m for the chance to own a business worth 10x+ that amount.  An inexpensive option, indeed.

Free optionality around CBD:  NewGen also includes a nascent CBD business that may or may not be worth something.  Management doesn’t disclose much in the way of metrics for the business, but the 2020 guidance appears to factor in around $20m of CBD-related revenue.  Since being legalized at the federal level in 2018, a host of products have flooded the market, many of debatable quality.  To some, CBD is snake oil, to others, a life-changing solution for chronic pain, anxiety, insomnia, and other ailments.  I have no view on the matter.  TPB is betting that by designing products priced to fit the needs of its core convenience store customer and leveraging its existing distribution network, which sells into 185,000 retail doors, the company can establish a leadership position in the nascent market.  According to management, c-store reception of the products has been solid and initial sell-through has been strong, but it is far too early to reliably predict what the future holds for the business, and unlike the core tobacco business, we aren’t yet able to see intra-quarter scanner data on these products to corroborate management’s comments.  Company guidance anticipates the business being around break-even on $20m of revenue this year.  To put that in perspective, Charlotte’s Web (ticker:  CWEB), the most direct comp, is expected to lose $19m this year on $112m of revenue coming from 8,000 retail doors; it is currently valued at $600m or 5.3x revenue with revenue expected to grow 19% this year.  Given TBP’s CBD business is already at breakeven, the downside risk is minimal; however, should it grow into something meaningful, the upside could be substantial.

The company is in the process of collapsing its corporate structure:  One of the clear investor concerns regarding TPB has long been its lack of trading liquidity.  Until last week, the company was 50.2% owned by Standard Diversified (ticker:  SDI), a public company that is itself controlled (81%) by Standard General, a New York-based hedge fund.  In April, TPB and SDI entered into a merger agreement by which SDI holders will exchange their interest in SDI for TPB shares equal to 97% of the TPB shares owned by SDI.  Put differently, without spending a dollar, Turning Point will retire 1.5% of its shares (3% of the 50.2% of shares owned by SDOI).  More importantly, this transaction should:  1) improve liquidity as all owners (direct and indirect) of the stock will now hold a single security; and 2) alleviate the technical shorting resulting from investors buying shares of SDOI and simultaneously selling shares of TPB to lock-in the spread between the two.  Last week, in advance of the merger closing, TPB announced an underwritten secondary offering in which SDI sold 1.8m of its 9.8m shares of TPB, and Standard General sold 200k of its shares.  This had no impact on TPB’s share count nor did it receive any proceeds.  What it did do was help to improve TPB’s float, by placing previously closely held stock in the hands of several new mutual funds, and reduced Standard General’s effective ownership to 42.5%.

Acquisition of Durfort:  In June, TPB announced the acquisition of certain assets of Durfort Holdings, TPB’s long-term partner on make-your-own cigar wraps and cones.  In exchange for $46m of consideration (6.5x EBITDA), TPB will acquire Durfort’s IP and remove a royalty it has historically paid.  In addition, TPB will receive distribution rights to Blunt Wraps, a MYO cigar wrap offering sold primarily into urban markets in which TPB has not historically participated.  Financially, the deal adds $7m of EBITDA immediately as the royalty expense comes out of COGS.  Longer term, TPB should see a revenue benefit from cross-selling Blunt Wraps into its existing channels and its own products into Blunt Wraps’ markets. 

Solid balance sheet provides the ability to do additional M&A:  The Durfort deal is typical of the smart, strategically-relevant, and economically sensible transactions TPB has completed over the last few years, and will likely continue to pursue going forward.  In July 2019, the company issued $172m of convertible senior notes.  Though the deal was botched by the underwriters, leading to a material sell-off in the stock, the benefit to the balance sheet was clear:  the company swapped out an expensive second lien term loan (L+7%) and revolver borrowings (L+3.25%) for the 2.25% convert and netted $110m of cash to the balance sheet.  Pro forma for the Durfort acquisition, the company has $63m of cash (plus $50m available on its revolver) and $317m of debt, for net debt of 3.5x 2020 Adj. EBITDA.

The stock is under-covered and consensus estimates are too low:  Turning Point is covered by three sell-side analysts, one of whom launched just last week.  By comparison, Altria and Philip Morris International are both covered by at least 10.  TPB is obviously a much smaller stock, but over time, as it continues to grow, I think we’ll see additional analysts launch on the name.  If someone is a tobacco analyst, or even a consumer staples analyst, there are simply too few growth stocks to ignore any name of size in the space.  As recently as a few weeks ago, Morgan Stanley hosted a virtual NDR with Turning Point management, a strange step to take if they are not considering launching on the stock.  Regardless, the lack of coverage today means the stock is largely off investors’ radar.  It also means that consensus estimates don’t capture a diversity of opinion.  In the case of TPB, both analysts take exceptionally conservative stances on the company’s growth opportunity, particularly in the Smokeless business, and neither has updated their models to include the accretive Durfort acquisition (announced June 10th).  As a result, consensus 2021 EBITDA figures are likely too low by at least 15%, and EPS by 23%.

Risks

TPB fails to secure FDA approval for any of its products:  As discussed above, if TPB fails to get any of its vaping products approved, it will have wasted $15m to $18m on application expenses and we can assume the $120m of current vaping revenue and ~$8m of operating income it will generate this year goes away.  It’s possible there are some incremental wind-down costs, but they should be manageable and most investors will see them as the non-recurring expenses they are.  Given where the stock is, the scenario seems to be fully discounted.

MST volume growth slows:  MST revenue growth has accelerated in each of the last three years and hit 33.3% year-over-year in 1Q20.  As TPB continues to take share, it will become difficult maintaining this pace of growth.  I model growth slowing to 18% in the remainder of 2020 and 15% for 2021 and 2022.  Should these estimates prove overly optimistic, earnings growth would be more modest than I expect.  However, even in a downside case, I think it is highly unlikely we see the business shrink from current levels.

Value-destructive M&A:  As discussed above, management has historically been prudent in the deals they have pursued, so this isn’t a great concern for me.  And, in light of the current economic environment, I would imagine they are finding more attractive opportunities today, not fewer.

Catalyst

• Collapsing of the capital structure
• PMTA approval process