Turning Point Brands (NYSE:TPB)

Some Wonderful Parts in a Not-So-Wonderful Business

NOTE: I will not buy TPB. This write-up is just for house-keeping so I can reflect on it later. I still think it’s worth a read (it’s short) — but you won’t find a detailed analysis or a buy recommendation.

Turning Point Brands

TPB is a decent business. In the Stoker’s and Zig-Zag segment, it may even be a wonderful one. The OTP (Other Tobacco Products) industry is generally characterized by strong brand loyalty and consumer captivity, low threat of innovation, and few dominant market players. Although entrants don’t need a large market share to be economically viable, it is very hard for new players to compete with the brand and the economies of scale of the incumbents. Rolling papers, MYO cigar wraps, moist snuff tobacco, and loose-leaf chewing tobacco products are a niche category that has, in the past, benefited from the increased regulation and taxation of traditional cigarettes. That advantage is no longer as significant given the increasing regulation of the products — both today and in the future.

Tobacco products are, as we all know, incredibly addictive and generally anti-cyclical. For a person addicted to smoking, cigarettes are one of the last things they are willing to give up spending money on. The same goes for OTP products. Hence, companies like TPB have pricing power and can increase prices along with inflation.

Zig-Zag and Stoker’s are both market leaders in their respective categories (with the exception of moist snuff) and enjoy strong customer loyalty. With the increasing legalization of cannabis, products like Zig-Zag’s MYO wraps are expected to enjoy strong demand going forward. The company has also worked on better capturing this traffic with products like hemp wraps. Although historic growth isn’t anything astounding (not including the last couple years of very strong market conditions), the two segments can comfortably grow at over 5-6% a year IMO. Historic 5-year growth for the overall company was around 15-16%, but in no way is this sustainable.

Combined operating income for ZZ and Stoker’s was $88mm (less corporate unallocated costs which I just see as an accounting gimmick). The two segments enjoy decent margins and have a genuine competitive advantage in 1) brand, 2) scale, 3) distribution network, and 4) customer captivity. On paper, TPB is a great business. I can pretty clearly picture the results of these two businesses over the next five years. Even behemoths like Altria and Swisher have a hard time displacing ZZ and Stoker’s from their market positions. What’s more, ZZ products are generally sold through convenience stores and similar retail outlets. These retailers just want their product to sell, and will hence go with the product that has consistently delivered profitability and volume – which usually happens to be Stoker’s and (especially) ZZ. Retailers don’t want to risk giving up their shelf space to an unknown brand. So, not only do entrants have to undercut TPB’s products or, even worse, compete with them based on brand, but they also have to break in and steal shelf space from TPB’s products where it is, for the most part, the dominant player. 

Moreover, the company outsources around 80% of its manufacturing, so it's an asset-light business model with very low capital requirements. Fixed Assets to Sales ratio has averaged around 3% and Working Capital to Sales around 20%. The company can fairly easily pivot and aggressively introduce new products into the market within a short period of time.

So far, TPB seems like a decent business. Why don’t I like it?

1. NewGen Segment

While NewGen is depicted as a point of growth for the company – driving sales through its e-commerce platforms and vape/ e-liquid brands – the segment has been lackluster at best and, in light of recent developments, is essentially worthless. Unlike ZZ and Stoker’s, NewGen is competing in a fragmented, nascent market with no barriers to entry. It is virtually impossible (at least for now) to establish sustainable economies of scale or brand recognition. Vapes and e-liquids are, essentially, a commodity product. What’s more, NewGen is competing against “Big Tobacco” who have a much deeper pocket for consolidation and investment that TPB does. 

Here are the segment’s acquisitions:

1. IVG for $23.8mm

2. Vapor Supply for $4.8mm

3. Assets of Vapor Shark for ~ $4mm

4. dosist™  for $15mm

5. BOMANI Cold Buzz for $1.8mm

6. Old Pal for $8mm

7. Docklight for $8.7mm

8. Minor Investments (let’s assume these are worth 0)

So, for a combined investment of ~ $66mm, we get a semi-profitable segment that has (at its best) produced operating income of around $6.7mm or about $4.4mm after-tax. This represents a return of just 6.7%  on an investment where, given the risks mentioned above, we’d want a return of at least ~ 12%. What’s more, many of the company’s products have been rejected by the FDA (mainly e-liquids) making any notion of success farfetched at best. I’m not even considering the costs of applying here (which are in the > $15mm range for around 250 products).

I’ll give credit to management that the application failure was a surprise and (according to them) shouldn’t have happened – but the point remains the same. Over $80mm has been burned through (over 16% of today’s market cap). Even if the company does manage to succeed in developing its vape segment, the returns on that would be decent at best. There’s no way TPB could dominated a field that, from the very start, is overcrowded with both smaller and much larger players selling commodity-like products. If they focused on their core business instead and leveraged their distribution network (their agreement with Swedish Match is a great example), I would’ve liked the company a lot more.

2) Change in Management

Mr. Wexler was replaced with Mr. Yefremov last year and, so far, I’m not too convinced with the new CEO. Wexler has actually performed fairly well and has been with the company since before 2003 (we don’t know exactly why he left). Yes, NewGen was a bit of a failure, but results overall weren’t too bad. 

Mr. Efremov, on the other hand, has essentially zero experience in the OTP market. He was the CEO of Motosport for just 8 months (this was his only role as CEO) and has a history in M&A and investment banking. Of course, Mr. Efremov can turn out to be a fantastic CEO (and he is likely in charge for only a temporary period), but our odds with such management aren’t too great.

3) License Risk

Zig-Zag, TPB’s biggest brand, is owned by RTI (Republic Technology) who bought the brand from Bolloré. Although the TPB has decades of proven ability to renew and maintain the license, there is no guarantee that the agreement can exist on favorable terms (if it’ll even exist at all). Losing ZZ rights would lead to permanent, heavy losses. 

Even if the agreement does continue, RTI can go around and find ways to increase what TPB pays for the ZZ products. After all, why would RTI buy the brand if they just intend to license it out? The brand isn’t growing as much and the large fixed costs in manufacturing aren’t really worth it.

I’m pretty risk-averse, and I’m not comfortable investing when intrinsic value can be cut by as much as ½ within a matter of months or even weeks. Even if it’s a 1% probability – I’d rather invest in something like Couche-Tard instead.  

So yes, parts of TPB are wonderful, but the overall business is OK, capital allocation is fine, and management is inexperienced and hence future results (and allocation strategy) are highly uncertain.

Assuming NewGen is worth zero, ZZ and Stoker’s produce around $88mm in OPIN. Assuming a tax rate of 35% (it’ll likely be even higher in the future with increased regulation) we get an after-tax OPIN of ~ $57mm. At a current market cap of around $500mm, I think we’re getting too small of a margin of safety to comfortably invest in light of the mentioned issues. 

For some, TPB will be a wonderful business and the price, then, will appear mouth-watering. With an aging customer base, shrinking industry, and increasing competition, I think TPB’s moat is really going to be under a lot of pressure over the next decade. Younger generations generally don’t use moist snuff or chewing tobacco (and NewGen failed) so the only possible segments with sustainable long term growth are Zig-Zag’s wraps and papers. If I could just buy a company that owned just ZZ and Stoker’s that:

1. Invested primarily in these two segments through product development and operating efficiency

1. Distributed excess cash to SH

1. Continued making intelligent partnership’s like “Clippers” with SWMA

I’d be very happy at the right price. New management and the failure of NewGen is really the main issue here – and I’m not comfortable betting that either one will be resolved soon enough.

TPB is a good business – it’s just not right for me.