Turning Point Brands, Inc. — Q3 2019 Form 10-Q
Reporting period: Three and nine months ended September 30, 2019; filed November 4, 2019. Unaudited consolidated results. Unless noted, amounts are in millions of dollars.
Business context and reporting period
Turning Point Brands sells smokeless tobacco, smoking products and NewGen products, including vapor and alternative products. Its three reportable segments are Smokeless, Smoking and NewGen. The NewGen business includes wholesale distribution, online sales and company-operated stores; the company also launched Nu-X to develop and sell alternative products.
Financial performance and liquidity
| Metric | Q3 2019 | Q3 2018 | Nine months 2019 | Nine months 2018 |
|---|---|---|---|---|
| Net sales | $96.8 | $83.3 | $281.8 | $238.4 |
| Gross profit | $42.8 | $36.2 | $124.5 | $103.8 |
| Gross margin | 44.2% | 43.4% | 44.2% | 43.5% |
| Operating income | $13.0 | $13.0 | $45.0 | $37.5 |
| Net income | $6.3 | $8.0 | $26.0 | $20.3 |
| Diluted EPS | $0.31 | $0.40 | $1.32 | $1.03 |
| Operating cash flow | Not provided for the quarter | Not provided for the quarter | $20.0 | $1.0 |
- Q3 sales increased 16.1% year over year, while net income declined 21.1%. SG&A rose 28.1% to $29.8 million, outpacing sales growth; operating income was nearly flat.
- For the nine-month period, sales rose 18.2%, operating income 20.0% and net income 28.2%. Calculated net margin was approximately 9.2%, versus 8.5% in the prior-year period.
- Q3 segment sales were $26.2 million Smokeless, $30.2 million Smoking and $40.4 million NewGen. NewGen reported a $1.2 million operating loss in Q3, compared with $2.5 million operating income a year earlier. Nine-month NewGen operating income was $9.1 million, up from $5.5 million.
- Nine-month investing cash flow was positive $16.6 million, compared with negative $21.9 million in 2018; the filing attributes the change primarily to MSA escrow deposits moving from investments to cash and lower acquisition spending. Financing cash flow was positive $70.9 million, principally reflecting convertible-note proceeds, offset in part by debt repayments and capped-call costs.
- At September 30, unrestricted cash was $81.1 million; the separate MSA escrow balance was $32.1 million and is restricted. Working capital was $159.3 million, versus $48.1 million at December 31, 2018.
- Gross debt principal was $324.7 million, including $172.5 million of convertible notes, a $148.0 million first-lien term loan and a $4.2 million IVG note. The second-lien loan and revolving-credit borrowings were repaid. The company reported $47.3 million of revolver availability and compliance with credit-facility covenants. Long-term debt carrying value, after discounts and current maturities, was $299.5 million.
Material changes versus the prior comparable period
- Growth was led by NewGen: nine-month sales increased 44.4%, including $11.4 million of Nu-X alternative-product sales and additional IVG results following its 2018 acquisition. Smokeless sales rose 12.0%, driven mainly by Stoker’s moist snuff. Smoking sales fell 3.9%, reflecting delayed Canadian paper orders and lower cigar sales.
- Q3 NewGen sales increased 20.5%, aided by $6.3 million in Nu-X alternative-product sales and additional IVG activity. Management also cited declines in existing vapor businesses in September.
- In July, the company issued $172.5 million of 2.50% convertible senior notes due 2024. Proceeds were used in part to repay the second-lien facility; the company also spent $20.5 million on capped-call transactions. The notes are convertible at approximately $53.86 per share under specified conditions.
- In July, the company acquired Solace for approximately $8.0 million in cash and holdback consideration, subject to potential milestone consideration. It also acquired a 30% interest in Canadian distributor ReCreation for $1.0 million.
- Nine-month results included a $5.5 million net gain from settling the VMR distribution agreement, recorded as a reduction of SG&A. Q3 included a $1.2 million debt-extinguishment loss related to repayment of the second-lien loan.
- Adoption of lease accounting in 2019 resulted in recognition of $11.3 million in right-of-use assets and $11.7 million in lease liabilities at September 30.
Outlook, commentary, risks and contingencies
- The filing provides no specific revenue or earnings guidance. Management said operating cash flow and available revolver capacity should meet operating cash needs for the foreseeable future.
- In October 2019, the board began reviewing strategic alternatives for the third-party vaping distribution business, saying expected returns may not justify the required investment. No transaction or outcome is assured. The company also determined that an interim impairment analysis of NewGen goodwill and intangibles was required; any impairment was to be recorded in Q4 if applicable.
- FDA premarket-application requirements were a material uncertainty. Under the court remedy described in the filing, the then-current deadline for applications for affected deemed new products was May 12, 2020; products without timely applications could be barred from continued marketing. FDA’s appeal and evolving guidance could change requirements. The company expected to file applications but gave no assurance of approval.
- Federal and state consideration of vapor flavor restrictions, unpredictable rules for hemp- and CBD-related products, tobacco regulation and taxes, and dependence on third-party suppliers and retailers could affect results. NewGen also faces product-liability claims involving allegedly malfunctioning vaporizer devices.
- After quarter-end, New York City filed a complaint naming IVG and VaporFi among other companies, alleging, among other things, sales to consumers under 21. The subsidiaries ceased sales into New York City, described as an immaterial market; the complaint had not been served as of the filing.
- The company cited industry decline in some tobacco categories, competition, leverage and restrictive credit covenants, and the risk that acquisitions or new products may not deliver expected benefits.
Important facts for investors to verify
- Whether NewGen’s underlying sales and profitability stabilize, particularly in third-party vapor distribution, and the outcome of the strategic review and impairment analysis.
- Progress, cost and likelihood of success of required FDA applications, including any changes to deadlines or flavor restrictions.
- Debt service capacity, covenant headroom, variable-rate exposure and potential dilution or settlement obligations from the convertible notes.
- Whether reported earnings growth is sustainable apart from acquisition contributions, the VMR settlement gain and other adjusted-EBITDA exclusions.
- Developments in vapor-product litigation and regulation, including the New York City complaint and potential exposure from distributor-supplied products.