Monday, November 8, 2021

Tobacco Industry Thoughts - Q3 2021

This is from the FDA's "deeming" rule that was published in 2016:

In the case of ENDS hardware/apparatus components, FDA expects that it may be difficult for manufacturers to make the showing necessary to meet the statutory standard, given the great extent of possible variations in combinations of hardware components, if all are considered and sold separately. Thus, with respect to apparatus, FDA expects that manufacturers will be most successful where authorization is sought for entire delivery systems, rather than individual components. In the case of these complete delivery systems—systems for which the application covers all potential parts, including customizable options as applicable, and where labeling, instructions for use and/or other measures are used to help ensure use as intended—FDA expects that the range of possible outcomes may be narrow enough for the manufacturer to demonstrate, and for FDA to assess, public health impact.
In other words, everybody will need to buy a closed tank (or "pod") format vape device from Big Tobacco. This is in keeping with Big Tobacco's plan for the industry that we first realized two years ago:
Build a regulatory moat around [Electronic Nicotine Delivery Systems]: Push legislation which will require FDA submission and ingredient disclosure for e-liquid based [Electronic Nicotine Delivery Systems](consumer safety regulations, labeling, etc.). Regulate nicotine levels. Keep chasing MRTP for IQOS. The U.S. regulatory environment would then be the model for the rest of the world. This would effectively cede the ENTIRE electronic cigarette space to the big players. Only the big players can afford to comply with a complex approvals/disclosure process--it would put all the small importers of various Chinese-made products out of business in the U.S. because they will not be able to afford this kind of testing/QC. The more burdensome/labyrinthine the regulatory process becomes, the better it is for PM/MO with their armies of lawyers and quality engineers.
We recently finished reading two books about Juul (which will be in Q4 book reviews): Big Vape and The Devil's Playbook. Some themes:
  • Juul was a Stanford startup, so it exhibits some of the dark traits that we associate with the lawless "disrupter" companies from California. For example, very poor quality control in the vape pods. Rolling out new flavors and scaling production so quickly that there were impurities in the juice. Pretty gross.
  • "Disruption" in the sense of typical regulatory arbitrage or lawbreaking. Even if Altria had been clever enough to come up with the Juul product (which they weren't), they would not have been willing to market it to young people, sell it indiscriminately over the internet to underage people, roll out flavors with ingredients that weren't tested.
  • Juul cleverly exploited the research documents disclosed by Big Tobacco in the master settlement to find a great chemistry for their vape juice: instead of freebase nicotine, a salt with benzoic acid. Vaping is endless unlike cigarettes, which are discrete. Vape users develop a tolerance for nicotine.
  • When Altria negotiated the Juul purchase, it had missed its opportunity to create a knockoff. Only products that had been on the market as of a certain date are allowed to be sold (temporarily) while waiting for an FDA decision on their PMTAs.

Looking at Q3 2021 results for tobacco companies. In the U.S., Zyn sales were up 43% vs Q3 2020 (prior year) and up 9% over Q2 2021 (sequential). The market capitalization of Swedish Match is $13 billion US. Last year they earned $587 million, this year they are on track to earn about $750 million. So about an 17x P/E but with massive growth in a hot product.

I have surveyed nicotine users and Zyn is considered by far the best oral pouch product. As with Juul vs other vape devices, little differences in chemistry (and other design aspects) matter a lot. 

Swedish Match announced that they are going to spin off their cigar business (Garcia y Vega, Game by Garcia y Vega, 1882, White Owl, Jackpot) which contributes 28% of revenue and 25% of operating profit. Also interesting was this comment in the announcement:

"[T]he new stand-alone cigar business, with its strong cash flow profile, could be capitalized at a higher level of leverage than has been the case for Swedish Match historically, which would create the opportunity for Swedish Match to use financing proceeds upon separation to further enhance shareholder returns."

We take that to mean that the cigar business will be put into a new entity ("in the second half of 2022"), that entity will borrow money, dividend it to the parent (Swedish Match), the entity will be spunoff to shareholders, and Swedish Match will use the money received pre-separation for buybacks.

The smallest tobacco company that we follow is Turning Point Brands (TPB), with a market capitalization of $771 million. For Q3 2021, TPB sales increased 5.5 percent to $109.9 million and net income increased 49.3 percent to $13.4 million. (Trading for about 14x Q3 annualized earnings.) TPB gets 38% of revenue from Zig-Zag Products (rolling papers), 28% from Stoker's Products (loose leaf chewing tobacco), and 34% from NewGen Products. Zig-Zag and Stoker's are the moneymakers, earning $40 million of gross profit in the 3rd quarter (vs $54 million for the company as a whole) on $72 million of sales.

In the NewGen segment, TPB has essentially been acquiring (rolling up) open-tank vaping companies at low multiples. This is a risky strategy. On September 14th, the FDA issued a Marketing Denial Order in response to TPB's PMTA covering "certain of" its vapor products. (Neither FDA nor TPB said which products.) TPB sued the government and the FDA actually rescinded the MDO and is reviewing further. 

The good news for TPB shareholders is that the NextGen vaping segment isn't contributing any income; it is actually making losses because the PMTA process is so expensive. If TPB manages to get their open tank vape products approved (against all odds), it may be one of the only players to do so, and earnings should grow significantly. If not, the PMTA expenses should stop and shareholders will be left with the legacy tobacco and rolling paper businesses at a reasonable multiple.

Here is our guess (or hope) for how the next several years in the tobacco business will play out. The FDA will deny the PMTAs filed by small tobacco, leaving big tobacco (PM, MO, BTI, and Swedish) as the only players granted PMTAs in the reduced risk product game. There will be a handful of legal lozenges and pouches, there will be a handful of legal closed tank ("pod") vape products.

At that point, it will be time for some M&A activity and consolidation. If Juul's PMTA is approved, it makes sense for Altria to take-under the remaining Juul stake that it doesn't own, possibly structuring the transaction in a way that sheds the startup-era liabilities. (Maybe a bankruptcy or purchase an exclusive license of Juul combined with a sale of their minority stake back to the company for $1 to realize the tax loss.)

Altria should reunite with Philip Morris, and together they should buy Swedish Match. Together they would have the #1 cigarette (Marlboro), #1 closed tank vape (Juul), #1 oral nicotine lozenge (Zyn), #1 snus (General), #1 heat not burn tobacco product (IQOS), and the #1 and #2 dipping ("moist snuff") tobaccos (Copenhagen / Skoal). 

And then... no more acquisitions! All that cash flow could roll on home to shareholders.

1 comment:

CP said...

The chief executive of Philip Morris International has said the two houses of Marlboro will not be reunited, telling the Financial Times that PMI will no longer pursue a combination with fellow tobacco group Altria.

Jacek Olczak said at the Financial Times Global Dealmaking Summit on Tuesday that the “chapter with Altria is closed”, when asked about reviving merger talks between the two tobacco giants, which last took place in 2019.

Instead, Olczak said he was focused on expanding PMI’s “pharmaceutical and therapeutic” knowledge and suggested the group may move into the cannabidiol (CBD) market.