EP85: Puff Piece
Stock Ideas From Investment Professionals
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We dove into another batch of second quarter investor letters this week, and we’re excited to share our findings.
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This week, we highlight 7 new ideas, including:
A microcap nicotine product company with significant exposure to a rapidly growing form factor.
A small cap picks-and-shovels play on streaming television.
A midcap analog semiconductor company with a primary focus on radio frequency (RF) solutions.
Keep reading to learn more.
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Let’s get to it.
Maran Capital repurchased shares in a company they owned in the past, Turning Point Brands (TPB). TPB owns a variety of nicotine-adjacent products and brands. In particular, Maran believes the company’s Zyn alternative, FRE, adds meaningful upside potential. They see fair value in a range of $75-$90, nearly 150% above TPB’s current price.
Returning to Turning Point Brands (TPB)
In my first quarter 2024 letter, I indicated that we had purchased shares of a company, making it our sixth largest position. This company is now firmly in our top five. It will be familiar to long-time partners and readers of these letters: Turning Point Brands (“TPB”).
Turning Point Brands is comprised of Zig Zag rolling papers and a portfolio of non-combustible nicotine products, including Stoker’s (oral tobacco) and—spoiler alert—a non-tobacco nicotine pouch product called FRE. Zig Zag benefits from the tailwind of cannabis legalization currently underway in the U.S., and Stokers continues to take share and benefit from an industry pricing umbrella.
There are times when stocks get ahead of themselves; when a thesis breaks; when fundamentals weaken; or management makes mistakes. We must always attempt to be rational in the face of change, and when faced with certain situations, to sell and move on. Just as importantly, when we know a name well, it makes sense to continue to track it as the set-up may improve and create opportunities down the line. I have followed TPB since its IPO in 2016. We owned it as a core position from the first quarter of 2017 through the third quarter of 2018, and then again from the second quarter of 2020 (following its merger with its parent holding company, Standard Diversified) through the third quarter of 2021.
Despite its solid core in Zig Zag and Stoker’s, Turning Point had a tumultuous 2022 and 2023 as investments it made in vaping faltered, among other challenges. I continued to monitor the company during this period, though, doing checks on the brands, business, and team.
While investors fled the stock, the company was making numerous beneficial changes: it transitioned its senior management team (new CEO, CFO, and Chief Revenue Officer), de-emphasized the vaping segment, optimized inventory, generated cash (as always), paid down debt (including buying some of its converts at a discount), and incubated FRE. As a result, I think the TPB story is as exciting as ever, but it is only just starting to get back on investor radars.
TPB has a ~$650 million market cap and $225 million of net debt, bringing its enterprise value to approximately $875 million. It should generate approximately $100 million of EBITDA and $50-$60 million of free cash flow this year.
TPB is trading at a high single-digit free cash flow yield (low teens on our cost basis). Its core brands (Zig Zag and Stokers) should drive mid-single-digit growth in EBITDA. If the stock re-rates from just over 10 times free cash flow to the mid-teens over the next three years, that would add over 10 percentage points per year to the expected return. These components (high single-digit starting yield, mid-single-digit growth, 10%+ from multiple expansion) should therefore drive an expected mid-20% return profile (the “three-year double” for which I like to underwrite).
If this were the whole thesis, it would be sufficient. But there is an additional source of meaningful upside that I believe the market does not yet appreciate. This is the company’s nicotine pouch product called FRE.
Nicotine pouches deliver nicotine without tobacco. ZYN, owned by Philip Morris International (PM), is the market leader in this category, and will almost certainly remain in that position. That said, Turning Point has an excellent playbook for capturing market share and growing brands under the umbrella of larger competitors. It has grown Stokers to a high single-digit market share against entrenched competitors, for example.
Nicotine pouches are riding a huge wave of global growth—one which could continue to build for decades. The U.S. nicotine pouch market is $2.5-$3 billion and will likely double in the next few years. To give a sense of the growth rates, PM’s ZYN has grown from 13 million cans sold in the U.S. in 2018 to 174 million in 2021 to 385 million in 2023. It will likely top 550 million cans this year if production can keep up (there have been numerous recent reports of ZYN out-of-stock issues).
Despite FRE’s small market share, it has a number of competitive advantages and moats. First of all, it has PMTAs (premarket tobacco product applications) for each of 3, 6, 9, 12, and 15mg pouches, and is already in market with the latter four dosages. Most of its competitors are only in market with 3mg and 6mg versions, and don’t even have PMTAs for higher dosages (which means it could take them several years to launch them, if they chose to try).
While FRE capacity is a fraction of ZYN’s, FRE has established a robust supply chain. It has expanded capacity and is positioned to continue to do so. This should drive trials and conversion while ZYN faces capacity limitations.
FRE has been a fun one to research. I still think it is very early days and that not many investors are paying attention to it. The company has kept disclosure regarding FRE close to the vest, so independent research has been rewarding.
Based on both top-down and bottom-up assumptions, I believe FRE has a chance of growing to a $100 million revenue brand in the next few years. If things go very well, it could even take 5% share of a $5 billion (and still growing) market over time (i.e., $250+ million of revenue).
What is a high-growth, high-margin consumer brand in an emerging category worth? PM paid over seven times revenue for Swedish Match (the prior owner of ZYN). Even four times revenue (which implies a low double-digit multiple of EBITDA) would mean that FRE could attain a value of $400+ million in the next few years (and the blue-sky scenario is that FRE could eventually be worth $1 billion or more). These are very meaningful numbers relative to TPB’s current market cap of ~$650 million.
In my interactions with the TPB board and management team, there seems to be a renewed energy and determination, kindled in part by FRE. They appreciate the magnitude of the current opportunity and want to take advantage of it. These insiders are putting their money where their mouths are. Several executives, including the Chief Revenue Officer and Chief Strategy Officer, have recently purchased TPB shares in the open market. Additionally, TPB’s newest board member purchased over 2% of the company, a position worth over $15 million.
Capital allocation remains a further lever for value creation. After paying off its convert with cash on hand this summer, TPB restarted its buyback. TPB could comfortably repurchase up to one million shares per year (on a base of 17.6 million), even while continuing to invest in FRE. Compared to legacy tobacco companies, which generally have no—or negative—growth and pay high dividends, TPB is unique: a growth nicotine and cannabis-adjacent company that can be a share buyback machine. We already own the “NVR of the U.K.” in Vistry; I’m hoping TPB, this time around, can become the “Autozone of nicotine and rolling papers.”
TPB should generate $3.50-4.00 of normalized free cash flow per share next year, and over $5.00 by 2027. If it trades at a 15-18x multiple, that would put its value at $75-90 per share in a few years, and there is no reason to think that TPB can’t continue to compound from there (that is, if it isn’t bought out by one of the tobacco majors first). It just needs to avoid distracting M&A, execute on the brands it owns, and shrink the share count while maintaining appropriate leverage—and I believe, under the current management team, that it will.
The profile of our investment in TPB is similar to many of my prior favorites. I believe that we have limited risk of permanent capital loss; a core business that can drive excellent performance on its own; and an additional asymmetric source of potentially meaningful upside. If FRE disappoints, our investment in TPB should still be solid. If FRE is a real winner, though, then watch out.
We have 6 more ideas for our paid subscribers below.