Turning Point Brands: Zig When Others Zag

Summary

• A bet on cannabis legalization through an asset-light business trading at a cheap valuation.
• Broad portfolio of brands capturing the shift in consumer preferences.
• Small-ticket, repeat purchases make the company resilient in market cycles.
• An experienced management team that has shown skill in deploying capital in high-value add acquisitions and investments.
• Legacy products continue to grow and generate significant cash flow to develop the NewGen business.

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Turning Point Brands (NYSE:TPB) offers a recession-proof, asymmetric bet that is worthy of adding to your portfolio especially as the company currently trades at an attractive valuation relative to the growth prospects ahead. At a high level, the company operates in the cannabis and tobacco markets through three segments: Zig-Zag, Stoker's, and NewGen. These segments are fairly evenly distributed in terms of revenue generation bringing in $133 million, $116 million, and $156 million, respectively in 2020. With a highly experienced and capable management team and a diversified portfolio of brands, TPB is well-positioned to tap into the secular growth opportunity driven by the legalization of cannabis in the United States as well as the shift in user preferences regarding tobacco and nicotine consumption.

Three Product Channels

TPB is a leading independent provider of Other Tobacco Products, OTP, which have exhibited years of continuous low single-digit growth in contrast to the decades of declining sales associated with cigarettes. The company describes the OTP industry as "characterized by non-cyclical demand, relative brand loyalty, consistent profit margins, relatively low price elasticity, and the ability to generate consistent cash flows." In addition, regulation has created significant barriers to entry for smokeless and smoking products. Over time, the company has transitioned to an asset-light sourcing and marketing model that leverages a network of long-standing, trusted producers. TPB holds a broad portfolio of consumer products that can largely be divided into three segments: Zig-Zag, Stoker's, and NewGen.

Source: (Turning Point Brands)

Zig-Zag

Zig-Zag is the #1 rolling paper brand with 35.1% of the rolling papers market and is TPB's most iconic product. It has been a mainstay in Pop Culture with recognition that is unparalleled in the industry. Other products included under Zig-Zag are MYO cigar wraps introduced in 2009, owning a majority of the cigar wraps market, and cones with a 33.3% share of the market. Zig-Zag is currently the most profitable segment as well as the fastest growing with over 40% growth for the second consecutive quarter in Q1 2021. TPB has had a perpetual license in the US and Canada since 1992 for Zig-Zag that renews every 20 years and will renew again in 2032. Through rolling papers and make your own cigar wraps, TPB is a dominant presence in the cannabis accessories market. From 2016 to 2019, Zig-Zag did not show much growth, however, the recent uptick in growth during the most recent quarters as well as 22% growth in 2020 clearly highlights the capability and alignment of management. One clear example of management's growth initiatives is TPB's cones business. Cones have quickly become a favored and convenient option among many customers purchasing rolling papers. In 2018, TPB did not offer cones at all and was quickly losing out to competitors like RAW. Within two years, TPB's cones business grew from 0% of sales to now 19% of TPB's entire papers business and holds a 33.3% share of the cones market. This has been an exceptional driver to the company's top line as one cone effectively sells for 4x to 10x the price of an individual sheet of rolling paper. Another aspect to this that especially gives me confidence in TPB moving forward is that management knows how to use its best brand. Most recently, TPB made a $9.6 million investment to acquire a portfolio of Unitabac cigar assets to enter the large and growing cigar/cigarillo market (8% CAGR from 2017 to 2020 according to TPB). Using this report from 2019, I have estimated the global market size for the tobacco/no flavor segment of the cigars/cigarillo market to be around $13.2 billion in 2021 given a growth rate of 3%. Since TPB sells almost all of its products in the United States, I have used the 57% total revenue share the United States had in 2018 to get to a value of $7.5 billion in 2021. Given that this also includes premium cigars which skew the total sales higher, I will halve this value again to get to $3.7 billion. This is roughly in line with CEO Larry Wexler speaking of the "multibillion-dollar cigarillo market." With a modest 2.7% market penetration, similar to Stoker's MST early market share, TPB would add a line of business doing roughly $100 million in revenue with a greater than 50% margin profile similar to that of Zig-Zag papers. All for $9.6 million. With the company's large retail footprint of over 210,000 stores, the addition of the Unitabac assets will allow TPB to expand its reach and capture customers who prefer to use cigars/cigarillos as wrappers. As consumer preferences will most likely change once again in the future, management can use the trusted Zig-Zag brand to introduce new products and achieve almost instant success. As cannabis legalization spreads across the United States, TPB's dominance in the rolling papers market will continue to drive impressive yearly growth.

Stoker's

Under the Stoker's product segment, TPB sells the #2 loose leaf chewing tobacco brand and the leading moist snuff tobacco value brand. Stoker's created the moist snuff tobacco (MST) tubs category and has a 60% share of that market. In stores, TPB often puts tubs next to cans to display the value proposition to consumers and ultimately drives them from cans to tubs. At the time of the company's IPO, the Stoker's product mix was 60% tobacco chew and 40% MST. Today, that mix is reversed as consumer preferences have shifted to favor MST. The distribution of Stoker's has also been improved with the number of stores selling the brand growing 87% since 2015. Louie Reformina, the CFO of TPB, refers to tobacco chew as basically an annuity with moderate yearly price increases while MST serves as the real growth driver for this segment. Stoker's has grown from a 2.7% share in MST to 5.5% by the end of 2020. Stoker's MST is priced 40% below competitors but offers a premium product that will continue to drive customer adoption. The global smokeless tobacco market is expected to grow at a 4.7% CAGR through 2027 and presents ample room for growth for TPB's products both in the US and abroad.

NewGen and Nu-X Ventures

TPB's NewGen product segment consists of next-generation innovative alternatives and vapor products. Primarily built through a series of acquisitions, NewGen is a well-diversified product mix ranging from tobacco alternatives to various CBD and cannabis products that gives TPB significant optionality and potential upside. Although the segment is currently not contributing much to the company's overall profitability, vapor products, in particular, are potentially poised to be a key revenue driver as the PMTA process and the PACT act come into play. I will touch on both PMTA and PACT below and how TPB can actually benefit from these regulatory hurdles. Management has proven that it is willing to invest heavily to broaden its portfolio of brands and NewGen has been the main beneficiary of that as management targets rapid growth. The company continues to make a series of strong acquisitions and investments and still has plenty of liquidity left with $157 million in cash in Q2 2021 and further credit available on a revolver. TPB often completes a number of acquisitions and investments during the year with the several taking place in July 2021 alone. For the NewGen segment, TPB completed an $8 million investment in Old Pal to aid the company's growth as well as to increase TPB's product sales presence in dispensaries. This, along with the company's previous investment in Marley, bolsters TPB's position in the cannabis space by bringing another recognizable and scalable brand into the product portfolio. TPB has a successful track record of rapidly commercializing new products and leveraging the value of existing brands into new categories. The goal for this segment is to create proprietary products to grow current margins from 20% to over 50%. With this in mind, management restructured the NewGen category through a workforce reduction, consolidation of warehouses, store closures, and the elimination of unprofitable platforms. NewGen has pivoted away from third-party vaping businesses to focus on proprietary brands with all fulfillment operations now consolidated in Louisville, Kentucky. The company has overhauled distribution to include e-commerce and direct to consumer. This has been achieved over time with the acquisition of Vapor Beast in 2016 and International Vapor Group in 2018 which brought in the VaporFi and Direct Vapor distribution platforms.

Source: (Turning Point Brands)

Nu-X Ventures, launched in 2019, is a wholly-owned subsidiary dedicated to the development, production, and sale of alternative products. Solace Technologies was acquired in 2019 to expand the Nu-X team and bring in digital marketing expertise as well as serve as the hub of marketing and eCommerce. With this acquisition, Nu-X was provided with a leading line of liquids and a powerful new product development platform. Under the Nu-X brand, CBD and nutraceutical products are brought to market while nicotine e-liquid products and nicotine chew are launched under the Solace brand. These products give TPB a significant amount of diversity as it continually expands into new markets to meet a changing landscape. The NewGen segment is one of the reasons I am extremely confident in the future growth prospects of the company. Management has continued to analyze cannabis and nicotine/tobacco markets to develop new products to meet where customers are trending. As TPB continues to expand into new markets, develop its portfolio of consumer products, and leverage its strong brand recognition, it becomes more resilient to regulation and more capitalized to launch new ventures and knock out one-off competitors.

Source: (Author)

Changing Consumer Landscape

The legalization of cannabis in the United States is a matter of when not if. Currently, there are 19 states plus D.C. where usage is legal and federal legalization is surely on the horizon as a majority of Americans are in favor of legalization. During the pandemic, the health and wellness benefits of cannabis became more apparent as products were used in place of their pharmaceutical counterparts. Cannabis products regularly replaced sleeping pills and harsh opioids used for pain relief. Average annual consumer spend in Colorado stands at $2683 for cannabis versus $1378 for alcohol. States have an eye on this shift and the potential tax revenue is becoming too large to ignore with Colorado collecting $1.6 billion in marijuana tax revenues over the last 6 years. Louie Reformina highlights this point stating that the potential tax revenues will create a domino effect from state to state. With these secular tailwinds, TPB cites an estimated 16% CAGR for the US cannabis industry over the next 5 years and 11% for the CBD industry.

In terms of tobacco, sales of cigarettes have been declining for decades as preferences move to embrace other tobacco products and regulations continue to crack down on the cigarette market. Given that TPB has never focused on cigarettes, the company has been well-positioned to capture this secular trend. In mid-2019, management repositioned the business with growth initiatives to focus on new product introductions and channel expansions to align with these growing market shifts. The benefits of this realignment are already beginning to be seen with great top-line growth (especially in Zig-Zag) and I believe they will continue to be seen for years to come. According to British American Tobacco's analysis of cigarette alternatives, global vapor sales were worth $20.2 billion in 2019 while global tobacco heating products (THP) revenues were $15.2 billion representing a yearly increase of $4.5 billion and $3.3 billion, respectively. Traditional oral products have shown steady growth and modern oral products have exhibited an acceleration in growth in both Europe and the US. TPB is well-positioned to capture this growing demand.

Regulatory Hurdles Present Opportunity

Cigarettes in particular have drawn the most attention from the government. TPB does not sell cigarettes and is therefore already in a better starting position than many other companies. However, the recent implementation of the PMTA and PACT act now broadens the spotlight to include vaping products. The PMTA, or Pre Market Tobacco Authorization, required that all vape products introduced since 2007 have an application submitted to the FDA by September 2020. Below is an overview of what the FDA considers in each application. The process is extensive and very expensive, costing TPB over $17 million to file for all of its products. The vaping industry is highly fragmented with hundreds of companies and many of TPB's competitors in the market do not have sufficient resources to successfully complete the process. In contrast, TPB submitted 250 applications comprising one of the broadest portfolios of products in the industry and the company. As of Q2 2021, all of TPB's applications for products deemed new tobacco products by the FDA had received acceptance letters. As the market consolidates, TPB's extensive product offerings will allow it to reap benefits as competitors struggle to navigate the process. Just as it served as a form of market consolidation for existing companies, PMTA also creates significant barriers to entry for new upstarts who will not only be forced to submit expensive applications but also to compete with well-capitalized incumbents who have survived consolidation. Likewise, the PACT Act, Prevent All Cigarette Trafficking Act, was amended by Congress in 2021 to include vaping products as well and bans the US Postal Service from mailing vapes and other smokeless tobacco products. Management responded quickly and rebuilt the company's transportation infrastructure within a few weeks. While this increased SG&A by over 3% as a percentage of sales, the consolidation of the industry being driven by the increased cost and complexities around logistics is already being seen. TPB is now being approached by companies who are not confident in their ability to meet the new requirements. This presents a significant opportunity as well for TPB to form new partnerships and take market share.

Source: (FDA)

Management

I have briefly touched on the capability of management above through their growth initiatives and product alignment but will further highlight their strengths here. The team at TPB is top-notch with previous experience at leading tobacco companies such as Altria, Swedish Match, and American Brands. Management has clear goals to grow TPB further and pivoted the company successfully from survival to growth. Historically overlevered, TPB operated at 6x leverage for quite a bit of its history and at one point had $40 million in EBITDA and $40 million in interest payments. Management has effectively navigated this and net debt to EBITDA has moved from 5.7x in 2015 to 3.1x in 2020. Now, as a result of the initiatives set in place, the company is an asset-light business with Capex around 1% of sales and an average EBITDA cash conversion of 94%. The NewGen business relies on acquisitions and management is constantly looking for ways to deploy capital. In particular, management has highlighted cannabis related plays to embrace the legalization trend as well as acquisitions to expand distribution. TPB's products currently reach over 210,000 retail outlets in North America and were traditionally sold in convenience stores and smoke shops. In 2019, management identified distribution channels where products had been historically under-represented and expanded these into end markets through product repositioning and several acquisitions. Namely, the VaporBeast and IVG acquisitions expanded the business to business and business to consumer channels while the Solace acquisition bolstered TPB's e-commerce capabilities. As a result, TPB products are now sold in headshops, dispensaries, and online in addition to the traditional distribution channels. Lastly, management has shown a willingness to deploy capital to repurchase shares and add further value to shareholders.

Source: (Turning Point Brands)

Valuation

Using a required rate of return of 8.5%, I value TPB as currently ~19% undervalued. I have used analyst consensus revenue estimates for 2021 and 2022. 2023 onwards, I have modeled a relative step up in revenue driven by further cannabis legalization at the state level and eventual federal legalization as well NewGen products coming to market. A modest decline in revenue growth is shown following 2023 as well as a slight increase in operating income as a percentage of revenue as NewGen products reach maturation and margins for that segment increase. CapEx, D&A, tax rate, interest expense, and change in NWC are in line with historical values.

Source: (Author's Model)

To err on the side of caution, estimates used in this model are conservative by nature given the uncertainty of the regulatory environment in the cannabis and OTP industries. I believe that I have essentially modeled a very base case, if not a slightly bearish one, and am not accounting for significant acquisitions, international expansion, dividend increases, debt reduction, or share buybacks. Analyzing Q1 2021 and Q2 2021, TPB is already on track to outpace current analyst estimates. The green highlighted values below show estimated values greater than the share price as of August 4, 2021.

Source: (Author's Model)

Risks

Regulation, regulation, and regulation. While TPB does not sell cigarettes, 61% of sales in 2020 were tobacco products. However, many of these products present a much lower risk profile than cigarettes. Studies have shown that health risks associated with the usage of nicotine pouches, MST, and vapes are lower than those associated with smoking cigarettes. Whether the FDA and other regulatory bodies are inclined to believe that is another matter. OTP can often either be considered a path to smoking cessation or, more negatively, a gateway to further tobacco usage. The likelihood of which regulatory stance will be taken in the future is unknown and should be considered when adding TPB or any OTP/tobacco company to your portfolio.

Continued cannabis legalization at the state level and the large increase in TAM brought about by it should outweigh any regulatory concerns at least for the immediate future. There is still the glaring fact that cannabis is illegal at the federal level, but the domino effect has begun and a policy reversal looks highly unlikely at this point. Long term, there will no doubt be further regulation around cannabis, however at this point, the market is far too nascent.

Being an asset-light business has significant advantages and has been an incredible growth driver for TPB, however, it does bring about several potentially serious risks. TPB relies on three suppliers for its Zig-Zag and Stoker's products. Republic Technologies, a UK-based company, provides TPB with exclusive access to the Zig-Zag cigarette paper and accessories. Bolloré had historically owned the rights to trademarks for Zig-Zag in the US and Canada, but sold them to RTI in November 2020 and assigned Distribution and License agreements. Pricing terms are renegotiated every five years and the most recent Distribution agreement was in 2012. RTI offers an extensive range of smoking accessories and is an affiliate of one of TPB's competitors. Swedish Match manufactures all of TPB's loose-leaf tobacco products in the US through a deal entered into in 2008. The deal will automatically be renewed for five successive ten-year periods, unless either Swedish Match or TPB provides at least a 180-day notice prior to a renewal period. Both Swedish Match and TPB share responsibilities related to process control, manufacturing activities, quality control, and inventory management. While the terms of these deals are favorable and allow TPB to maintain a CapEx light, cash-flowing business, the company is still at the mercy of the performance of RTI and Swedish Match. To mitigate risk, TPB has negotiated agreements with suppliers to purchase and maintain a 12-to-24-month supply of tobacco products at their facilities. The third supplier, Durfort, manufactures MYO cigar wraps and cones. TPB acquired certain assets from Durfort in June 2020 to secure the long-term control of the MYO cigar wraps products.

Conclusion

In closing, I believe that Turning Point Brands is a secular growth bet at a cheap valuation. The recession-proof, asset-light business presents an asymmetric opportunity to embrace the cannabis adoption trend as well as the change in tobacco and nicotine consumption currently taking place. In almost all areas of operation, TPB is the leader in market share and, with a capable management team, has put in the pieces to continue to dominate for years to come. Characterized by a loyal customer base making regular small-ticket purchases, TPB is resilient and stands a strong chance of delivering great returns even in the uncertain economic climate we have today.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of TPB either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.