Turning Point Brands ($TPB) — Initiation (7/21/2021)

My first "cannabis" stock...

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I don’t typically get involved with growth-y stocks but as I’ve dug into the tobacco/cannabis sector, this name has caught my eye…

Here’s the quick and dirty:

  • TPB sells “accessories” in the tobacco and cannabis industry — rolling papers, chewing tobacco, and some vaping/CBD products
  • Growth — “The alternative smoking accessories market is a dynamic market experiencing robust secular growth driven by cannabinoid legalization in the U.S. and Canada” — revenue and EBITDA are growing 10%+
  • Valuation — Trading at 18.6x trailing free cash flow / 10.8x EBITDA (2021 guidance)
  • Management — CEO Larry Wexler has been at the helm since 2009, growing revenue and earnings, taking the company public, and navigating a massive deleveraging period…

Background…

Turning Point came public via IPO in 2016 — link to IPO prospectus — it was initially controlled by hedge fund Standard General… later, an NOL shell Standard Diversified took a controlling interest which was recently collapsed into a single shareholding structure as of 2020.

Prior to the IPO, it was a highly levered but very stable business earning a consistent ~$45m per year in operating income while carrying 6x leverage.

2011-2015 financials

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TPB call themselves a manufacturer, marketer, and distributor of leading consumer brands. They’ve transitioned from mainly manufacturing products to licensing/sourcing/distributing products. They describe the make-up better than I can…

Industry overview

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There are 3 segments today:

  1. Zig-Zag — 38% of 1Q21 sales / 47% of 1Q21 income — rolling papers
  2. Stoker’s — 27% sales / 30% income — chewing tobacco and moist snuff
  3. NewGen — 35% sales / 23% income — vape distribution and other “ventures”
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Market share changes…

You can see the progression of market share changes from the time of IPO in 2016 to today…

2016 market share data

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Stoker’s chewing tobacco gained plenty of share — from 15.8% to 24.4% — while MYO cigar wraps dropped from 80% to 63%… Zig-Zag rolling papers haven’t always been a growth business… they’ve held share from ~33% to 34%… but are now starting to see growth thanks to cannabis.

2020 market share data

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Zig Zag

They don’t actually own this brand — which is a massive potential risk — but rather they license and distribute the products exclusively in the US and Canada.

Bollore is/was the owner of the Zig-Zag trademark and name and had been licensing distribution to TPB since 1992… In November 2020, Bollore assigned the distribution rights to Republic Technologies (RTI) which has been the contract manufacturer of the rolling papers for a number of years. Today, TPB still licenses the exclusive right to the Zig-Zag name via RTI.

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The rights to the name were originally cut with Bollore in 2012 on a twenty year term.

Stoker’s Products

Moist snuff and chewing tobacco brands mainly under Stoker’s and Beech-Nut brand names. These have good market share positions and are manufactured by publicly traded Swedish Match.

NewGen

This is a hodgepodge of brands and assets. Mainly in the vaping distribution space. They spent some $66m in acquisitions and another $15m in investments mostly in this segment over the past 3 years. Performance has been spotty, racking up cumulative operating losses of $8m over the past 3 years. A potential source of opportunity if this portfolio can be turned around.

Financials…

Like other tobacco-related businesses, TPB generates a good amount of cash. And frankly, I’d rather focus on cash flow given the generous add-backs they take in calculating EBITDA.

Let’s start with the big picture…

TPB Financial Overview

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  • Leverage has come down significantly over the years — partly thanks to a 12% CAGR in EBITDA from 2015-2020
  • Adjusted EBITDA margins have averaged 23% and lately have been in the 26% range
  • Capex averages ~1% of sales — minimal needs here
  • TPB converts EBITDA to FCF at a pretty low rate — roughly 45% — mainly due to some aggressive add-backs (see below)
  • 1Q21 performance was strong — trailing FCF is $47m or ~$2.15 per share
  • Share repurchases have started over the past 5 quarters — $16m in 2020 and 1Q21… just about 2% of the current market cap
  • Acquisitions and investments are the primary focus of capital allocation — $127m in total from 2015 to 1Q21… 70% of operating cash flow went to this bucket
  • Dividends are minimal — very important differentiator to other tobacco competitors

More on the aggressive add-backs to Adjusted EBITDA situation — EBITDA reconciliations from 2015-2020 below…

2020 EBITDA reconciliation

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2015-2019 EBITDA reconciliation

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Add-backs seem egregious — $15m from 2015-2019 for new product launches? $15.3m for transaction expenses? $25m for restructuring…

Some of these might be reasonable but some look recurring. Probably why I’ve always preferred operating cash flow and free cash flow in studying / valuing businesses… and these factors absolutely contribute to the low EBITDA-to-FCF conversion rates at TPB.

Why own it…

1) Organic Growth

This business is firmly in the growth camp… Not counting the strong start to 2021, revenue and EBITDA have both grown at a 12%+ annual rate from 2015-2020.

2021 is off to a strong start as well… Q1 revenue / EBITDA were up 19% and 57% respectively and full year 2021 guidance is looking for ~6.5% revenue growth and 17% EBITDA growth.

2021 outlook

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Zig-Zag in particular has solid exposure to secular growth trends in cannabis legalization across the country. Oddly, this really started kicking in during 2020.

Zig-Zag performance

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2) NewGen segment upside…

NewGen is the largest segment from a revenue perspective but contributes virtually nothing from an earnings standpoint. Zig-Zag has 40%+ operating margins and Stoker’s isn’t far behind at more than 35%.

If NewGen had 20% margins, it could chip in an extra ~$25m in operating income… closer to $40m at 30% margins. Management commented on 4Q20 earnings call that they expect margins to trend higher but this may take some time as they’ll need FDA enforcement help to move more proprietary products.

Charts below highlight the relative strength of Zig-Zag/Stoker’s vs. the NewGen segment…

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3) Acquisitions

Here is management with some background on their approach to the business lately…

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Acquisitions are going to be a big focus for TPB — and part of the reason for the big debt raise recently. Most of the assets acquired have been small tuck-ins as opposed to large deals. I think we’ll continue to see that approach.

Valuation…

There are competitors that make cigarettes and vaping products and then there are a variety of cannabis players. None of these make for perfect comparisons to TPB.

Phillip Morris ($PM) has a high-growth non-cigarette business and trades at 11.6x EBITDA. Slower growth Altria ($MO) which is mostly exposed to domestic cigarettes trades at 9x EBITDA.

Peers - TPB in $m / others in $bn

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TPB doesn’t require much cash to grow its business organically and unlike most competitors with hefty dividend payouts, they are free to spend that cash in other ways — this is one of their “competitive advantages.”

Tobacco isn’t necessarily a fragmented market but the newly minted cannabis / CBD space is less dominated and that seems to be a key focus for the company.

A multiple in-line with faster growing Phillip Morris seems appropriate with upside from faster growth, good acquisitions, etc. This isn’t a quick re-rate for huge upside but I do think TPB is undervalued compared to PM and has double-digit growth prospects — bake that together and it should lead to ~15% returns annually.

What gets me excited about this business compared to other “50 cent dollars” is the stability of earnings and management.

Skim the long-running numbers above and see just how remarkably stable the Zig-Zag and Stoker’s businesses are… Layer in some growth from cannabis and optionality in the NewGen segment and this has a great multi-year makeup to it.