Turning Point Brands (TPB) is a textbook low risk, high return investment with immediate catalysts. Based on conservative assumptions I estimate that Turning Point Brand´s equity provides at least 80% upside to today´s valuation. The company is in the business of selling other tobacco products, which among others includes moist snuff, chewing tobacco, cigars, cigarette paper and liquid vaporisers. A 2016 IPO has provided relieve to TPB´s sky-high pre IPO debt load. Further refinancing and deleveraging of the balance sheet, which is supercharged by utilisation of loss carry-forwards, will reveal true earnings power of the business in 2018. Fetching a conservative multiple on 2018e earnings of 15x, implying an earnings yield of 7%, I arrive at a fair value of USD 23 per share.
Operations at TPB are segmented into smokeless, smoking and NewGen products.
Smokeless products (31% of sales) contain moist snuff and chewing tobacco products. Both markets feature different economics.
Moist snuff (MST) is essentially a finely shredded and moisturised form of tobacco that is consumed by pinching it against lip and gums. The product also comes in the form of snus, which are small pouches of tobacco placed behind the upper lip. Over the last 10 years the industry grew volumes by 4% annually driven by cigarette smokers that chose switch to less hazardous smokeless products and first-time consumers. TPB markets its MST products under the stoker brand that currently commands a 2.5% market share. There is a lot of runway for market share gains given that at stores which distribute Stoker´s it has a 6.8% market share. To get a feeling UST´s Copenhagen Brand is distributed to 159.000 stores whereas Stokers is available in only 28.000 outlets. Responsible for Stoker´s underrepresentation in stores compared to other MST brands is the lack of an appropriately sized sales force. IPO proceeds enable TPB to right size sales force and thus increase share. Further, pricing in the category has increased mid-to high single digits annually. MST hence provides the very impressive economics of volume, share and price gains at the same time.
Chewing tobacco products do not feature equally attractive dynamics. Industry volumes decline by approx. 6% annually. This is offset by higher pricing due to addictive nature of product and brand loyalty, margin expansion due to less sold product, and share gains of the Stoker and Beech Nut brands.
Smoking products (41% of sales) consist papers to roll-your-own, cigar tobacco, whole cigars as well as pipe tobacco.
Papers are marketed under the well-known Zig-Zag brand. For cigarette papers Zig-Zag holds the number one market share in the U.S. (32.7%). Zig-Zag is also the leader in make-your-own cigar papers and holds an 80.9% market share in this category. Given the wide recognition of the Zig-Zag brand I believe pricing is quite stable in this segment. Papers might even see some limited growth due to people migrating to roll-your-own cigarettes because of high priced packaged cigarettes and popularity among cannabis users.
Cigars have seen rising volumes in the largest cigar market that is the U.S. But since tobacco companies such as Swedish Match and Imperial entered the cigar market pricing went down significantly, rendering the market less attractive.
NewGen (28% of sales) is the wild card at TPB. NewGen is referred to as smoking products that instead of burning only heat or vaporise liquids and hereby create no carcinogenic tar. TPB has aggressively invested into this new category with the acquisition of Vapor Beast.
Vaporisers and liquids are marketed under the Zig-Zag brand which leverages its wide brand recognition among smokers. Additionally heat sticks are sold under the licenced V2 brand. Zig-Zag and V2 own 4.1% and 5.8% of the market respectively.
VaporBeast is an online store that specialises in selling these NewGen products. The store creates around USD 50 mn in revenues on USD 6.9 mn in EBITDA and is fast-growing.
As of last quarter Zig-Zag and V2 products were slightly loss making, but TPB guided for profitability in 2018. However, I really consider this a wild card and do not factor in any growth from VaporBeast or vaporiser products.
The most interesting part in TPB certainly lies in its smokeless MST segment, where organic growth in excess of 10% p.a. is likely. Despite featuring big players such as Swedish Match and Altria owned UST, smokeless is a fragmented market in which TPB plans to be an active consolidator. Pricing in smokeless will likely remain rational since the larger players want to maintain their profitability. MST is arguably the best niche to currently do business in Tobacco. As a whole the other tobacco products industry grew at 4.9% last year.
Before its IPO TPB was highly levered with over 300 mn in high yield debt on its balance sheet. As a consequence the company was choked by enormous interest payments and posted losses year over year. In the following investments in its operations such as a necessary increase in its sales-force were foregone to be able to service debt. The IPO in the beginning of 2016 provided necessary relieve and by conducting a debt-to-equity swap reduced principle outstanding to little above 200 million. Leverage decreased from 6x EBITDA to around 4x. The company is now profitable and factoring in loss carry-forwards can expect to generate some USD 30 mn of net income over the next year. Additionally releasing the constraints on investment should benefit growth in the years ahead since e.g. a larger salesforce can bring the product to more points of sales.
TPB outsourced almost its entire production to manufacturers like Swedish Match. This creates dependencies but on the upside leads to very little CAPEX requirements. TPB can essentially finance growth with no additional investments into factories etc. CAPEX ran historically at around USD 2 mn. Going forward this might increase somewhat to catch up with past underinvestment. Since TPB does not plan to initate any dividend excess funds will be devoted to debt retirement and M&A.
As mentioned the other tobacco product marked is highly fragmented with many regional players. A lot of them too small (sales up to 100 mn) to meaningfully move the needle for giants such as Altria and Swedish Match. TPB has already identified possible targets with combined net sales in excess of 250 mn. Management said these companies can be acquired at 4x EBITDA before synergies. Acquisitions in this space are therefore highly value accretive. Small companies might willingly be acquired by TPB since it provides them with necessary experience to comply with FDA laws and deep pockets in case of law suits.
I cannot say a lot about Management other than that all of them have long standing tobacco experience at major players such as UST, Altria and Ligett. Management should therefore be equipped with appropriate skill to grow operations organically and expand via intelligent acquisitions.
TPB is undervalued because of several factors:
1. With a market cap of about USD 250 mn at USD 13 per share it is a small cap under the radar stock with little analyst coverage
2. Profitability is masked by high interest expenses
3. Sales growth appears flattish because of pre IPO underinvestment in the business
Still the business is very sound and TPB consistently earned EBITDA of around USD 45 million. However, in the past interest expenses ate up most of that. Therefore the company has posted a tiny profit only once in the last years.
The beauty of this investment is that for the case to play out the only thing to do for TPB is reduce and refinance debt. TPB has already guided to reduce leverage to 2.5x to 3.5x EBITDA. At 2018 pro-forma EBITDA of USD 61 mn this would translate into USD 184 mn in principal ouststanding given they reach their 3x EBITDA in 2018. Currently TPB´s pays interest rates north of 9%. I believe the company has the ability to refinance the reduced outstanding debt at rates of 5% to 6%. Refinancing at 6% would amount to USD 9.2 mn of annual interest expense and thus reduce payments to bondholders by USD 22 mn annually. This kicks net income to an above USD 30 mn 2018 run rate, up from USD 10 mn in 2015. A 300% increase solely due to debt reduction.
Can TPB retire enough debt by 2018 to arrive at 9 mn in interest payments?
For the investment in TPB to play out debt reduction is essential. I fell that therefore a quick examination of the company´s ability to reduce leverage to stated targets is necessary.
At the midpoint of guidance at 3x 2018 EBITDA the company needs to target a 184 mn debt level. Adjusting for the VaporBeast acquisition in Q4 (23 mn in additional credit financing) TPB has USD 221 mn in long-term debt outstanding as of today. Hence it would have to reduce leverage by USD 37 mn to hit 3x EBITDA. This is where net operating loss carryforwards (NOL) come into play. As of end 2015 TPB had unused deferred tax assets (DTA) from NOLs of USD 17 mn on the balance sheet. Some further USD 18 mn were written down because they seemed unlikely to be used prior to the IPO. Increased profitabilty however makes these 18 mn just as usable and viable for TPB as DTAs on the balance sheet. Essentially this means all profits are tax-free until 2018. Beginning Q4 2016 until end of FY 2018 TPB will therefore create about 75 million in FCF that is available for debt reduction. If during that time only half of all available CF is dedicated to debt retirement the target of 184 mn will be comfortably reached.
Starting from here the valuation is fairly straightforward. At current prices of USD 13 per share earnings of USD 30 mn translate into a very low 2018e P/E of 8.3 or a 12% earnings yield. Comparables such as Altria, PhilipMorris and Swedish Match all trade at forward P/Es well in excess of 17x. Even though TPB is an illiquid small cap a 50% discount to peers is certainly not warranted. Fetching a conservative 15x multiple on 2018 pro forma net income yields a price target of USD 23 per share implying 80% upside.
Beyond interest expense reduction and multiple expansion I model 4% sales growth for 2017 and 2018 for the core business and no growth for the recently acquired VaporBeast online store. I believe this to be conservative enough since these numbers do not factor in bolt on smokeless acquisitions and a nicely growing NewGen business. Including those growth of 6% to 7% p.a. seems possible. Further the PT doesn’t account for unused DTAs related to NOLs in excess of those required for debt reduction.
A DCF calculation that factors in all available NOL DTAs and decreasing WACC in 2018 to 8% due to debt refinancing yields a PT of 24 USD per share or upside of around 85%. I arrive at this PT assuming no growth beyond 2018. Stress-testing the DCF shows that to permanently lose capital the company´s earnings would have to shrink in excess of 10% a year after 2018. I call this as risk-less as it gets.
*2016 estimate of USD 0.79 EPS differ from the median analyst target of 1.01. This is because my model calculates with fully diluted shares of 19.7 mn instead of weighted average shares outstanding for the year. Further it ignores one quarter of Vapor Beast earnings, which should be worth around 9 cents per share.
1. inability to refinance and retire debt
2. Engaging in value desctructing M&A instead of focusing on optimisation of capital structure
3. class actions in NewGen where regulatory environment remains uncertain.
I am currently long Turning Point Brands Inc. (TPB)