Article tonight on Seeking alpha PRO VPCO
Jan. 29, 2014 7:07 PM ET | About: VPCO, Includes: DG, ECIG, FDO, LO, MO, PM, RAD
Disclosure: I am long VPCO. (More...)
Vapor Corp (OTCQB:VPCO) is one of only two pure-plays available to equity investors interested in participating in the booming e-cigarette marketplace. Vapor Corp. designs, markets and distributes electronic cigarettes (e-cigs) which are alternatives to traditional tobacco cigarettes, as well as vaporizers for dry herbs and oils. E-cigs are battery powered products that offer users a smoking experience without having to inhale smoke, tar, ash or carbon monoxide. Exhaling an e-cig produces only water vapor, not smoke or second-hand smoke.
E-cigs look like traditional cigarettes and are comprised of the following 3 primary components:
· A mouthpiece, which is a small plastic cartridge that contains a liquid nicotine solution.
· A heating element that vaporizes the liquid nicotine so that it can be inhaled; and
· The electronics which include a lithium-ion battery, an airflow sensor, a microchip controller and an LED which illuminates to indicate use.
When a user draws air, that air flow is detected by a sensor, which activates a heating element that vaporizes the solution stored in the mouthpiece/cartridge. The solution is then vaporized and it is this vapor that is inhaled by the user. The cartridge contains either a nicotine solution or a nicotine free solution, either of which may be flavored.
VPCO offers disposable and rechargeable e-cigs in multiple sizes, puff counts, styles, flavors and nicotine strengths. The company's e-cigs are sold under brand names including Krave, Fifty-One, VaporX, Vapur, Hooka Stix, and Alternacig among others.
LARGE, FAST GROWING, INTERNATIONAL MARKETPLACE
The growth in the e-cig industry is extraordinary. The left hand side of the following table shows projections made in Q2, 2013. The right hand columns show projections updated just seven months later, from the same sources as the May estimates. The worldwide market for traditional cigarettes is somewhere between $720 billion and $800 billion, depending on the source. The US market alone is nearly $90 billion annually.
Estimates Made in May, 2013 Estimates Released in January, 2014
Year
Sales (mil.)
YoY Growth
Year
Sales (mil.)
YoY Growth
2012
$500
-
2012
$500
-
2013
$1,000
100%
2013
$1,500
200%
2014
$1,250
25%
2014
$3,000
100%
2015
$1,550
24%
2015
$6,000
100%
2016
$2,000
29%
2016
$12,000
100%
2017
$2,500
25%
2017
$24,000
100%
2018
$48,000
100%
Source: Bloomberg International, Tobacco Merchants Assoc., Mintel.
According to the U.S. Center for Disease Control and Prevention, in 2010 an estimated 45 million Americans, or 19% of the population 18 years old and older, smoked cigarettes. As of 2012, just 3.5m people used e-cigs in the U.S., according to the Tobacco Vapor Electronic Cigarette Association, equivalent to only 8% of the tobacco cigarette smoking population, suggesting that e-cig adoption by smokers (and non-smokers) can indeed drive the growth rates projected above.
COMPARISON OF THE IMPACT OF E-CIGS VS. TOBACCO CIGARETTES
In the U.S. alone, cigarettes kill 450,000 people per year, and another 8 1/2 million people and their families suffer lingering illnesses. Nevertheless, one American in 5 of legal age to buy cigarettes continues to smoke. Quitting cigarettes is very difficult - most smokers want to quit, but of the millions who try each year, less than one in ten succeed for long.
E-cigs do not contain tobacco, and are a less harmful, logical option for people who wish to ingest nicotine rather than smoke traditional tobacco cigarettes. Tobacco-specific nitrosamines (TSNA) comprise one of the most important groups of carcinogens in tobacco product and are a causative factor for cancers of the lung, pancreas, esophagus, and oral cavity in tobacco users. A single e-cig cartridge (about 240 puffs) contains about 9 TSNAs, whereas a single full-flavored tobacco cigarette contains about 1,100 TSNAs, or about 120 times more. Carrying this analogy one step further, a full pack of tobacco cigarettes contains 20 cigarettes with approximately 22,000 TSNAs. If we assume 12 puffs per tobacco cigarette, or 240 puffs/pack, than the puff count of the pack of tobacco cigarettes approximates that of a 240 puff e-cig, and delivers the smoker about 2,400 times the TSNAs of an e-cig.
In addition to the TSNAs, cigarette smoke contains more than 7,000 identified chemicals including
· Arsenic (used in rat poison)
· Ammonia (found in window cleaner)
· Acetone (nail polish remover)
· Hydrogen Cyanide (gas chamber poison)
· Naphthalene (found in mothballs)
· Carbon Monoxide (car exhaust)
· Formaldehyde (embalming fluid)
E-cigs generally have just 5 ingredients/chemicals including propylene glycol, glycerin and water to create the vapor, nicotine and flavorings (which may have additional chemicals). The FDA has classified propylene glycol as safe for human consumption and it is widely used as a solvent and preservative in food. Glycerin is a synthetic sugar classified as a carbohydrate by the FDA and is used in a myriad of food products, pharmaceuticals, etc.
For those who desire nicotine, the delivery system can be through a conventional cigarette with an additional 7,000+ chemicals and 1,100 TSNAs, or through an e-cig with an additional 4 benign chemicals and 9 TSNAs.
VALUATION
VPCO trades for approximately 2.5x 2014 EV/Revenue and 1.55x 2015 EV/Revenue. By way of comparison, Lorillard (LO) acquired Blu e-cigs in 2013 for 4.5x trailing twelve months revenue.
Financial Summary
Year End December
Revs (M)
Gross Profit
Operating Income
2012A
$21
$8.1
($8.7)
2013E
$26
$10
$1
2014E
$50
$19
$4
2015E
$80
$30
$10
Key Metrics
2012A
2013E
2014E
2015E
Gross Margin
38%
38%
38%
38%
Working Capital
$0.4m
$10m
$10m
$10m
Primary Shares
12.0m
16.2m
16.2m
16.2m
Diluted Shares
12.0
17.5m
17.5m
17.5m
Sources: Company SEC filings, Bloomberg, press releases, EPS conf. calls, and industry growth rates.
GROWTH STRATEGY
Through a combination of product price and quality, supply chain management, branding, new product launches, and substantial increases in the number of retail outlets selling its e-cigs, VPCO appears poised to drive substantial revenue and income growth.
The company's products are available for purchase in more than 60,000 stores in the U.S. and Canada, an approximate 100% increase since 2012. By way of comparison, tobacco cigarettes are sold in 400,000 locations in the U.S. VPCO's customers include Rite Aid (RAD) (the largest drug store chain on the East Coast with 6,400 stores), Family Dollar (FDO) (VPCO's Krave e-cig is the first e-cig available in the chain's 6,600 stores nationwide as of 12/20/13) and Dollar General (DG) (VPCO is the exclusive e-cig provider to the chain's 10,000 stores), and also to 10 of the top 20 convenience store chains in U.S. In addition to chain stores, the company sells thru approximately 30 distributors, several of which have said they can sell all of the product they can obtain from VPCO. Each distributor has between 20-100 salespeople, and VPCO's e-cig business does not exceed 10% of the sales volume of any its distributors.
The company's largest customer is its Canadian distributor (which has never been disclosed) at 8% of 2013 sales thru the September quarter, and its Vapur brand is the most popular e-cig sold in Canada with an estimated 70% market share. Furthermore, the Canadian distributor (which is also Canada's largest importer of Cuban cigars and coffee) is exploring opening up European accounts which, if successful, would be VPCO's first business outside of North America. Interestingly, Canada doesn't currently allow nicotine in e-cig juice, but that is likely to change in 2014.
DISCUSSIONS WITH CUSTOMERS
VPCO customers have said that the company is very easy to work with, quick to fill orders, and able to prioritize the needs of the customer. For example, the buyers at one chain store customer said that they had evaluated more than 100 e-cig companies before ultimately choosing to purchase from just four including VPCO. The buyers are smokers and liked Vapor's taste and soft-tip. This particular account has been experiencing 80-90% growth in the e-cig category and intends to add additional SKU's of VPCO. The major tobacco companies tend to want to dictate pricing, margins and inventory levels, whereas VPCO treats the customer as a true partner. Furthermore, e-cigs have much better gross profit margins for retailers (30-50%) and distributors than tobacco cigarettes (5-10%). Other customers have said they can sell all of the inventory they can obtain from VPCO.
Q4 1013 FINANCING
The company's revenue was relatively flat sequentially for each of the 3 reported quarters in 2013 primarily because it didn't have working capital to grow the business. VPCO was so capital constrained that in Q3, 2013, the CEO and CFO each had to each provide a personal guarantee in order for the company to obtain a new $750k Term Loan and Factoring Facility.
The company's products are made in Shenzhen, China, by contract manufacturers with virtually unlimited manufacturing capacity. Therefore, VPCO's business can scale as rapidly as it can obtain orders and finance working capital, without the need for capital investment. Working capital cycle is about 90 days. In October, 2013, VPCO raised $10m gross by selling unregistered shares to institutional investors in a PIPE transaction. Insiders purchased about 7% of the deal. We believe the company netted about $9m of capital in the raise, paid off $1.5m in Accounts Payable, leaving about $7.8m in total cash on the balance sheet. If the company allocated $6m of that cash to purchasing inventory at an average gross margin of 40%, and working capital turns every 90 days, VPCO now has sufficient capital to grow sales by about $10 million per quarter, or $40m per year, on top of the roughly $25m/year that they have been selling.
Q3 RESULTS
VPCO's break-even revenue is about $25m per year. In November, the company reported Q3 results of $6.4m of revenue, up 64% YoY and 4% sequentially. Gross margin was 39% vs. 35% YoY, a 4% improvement due to reduced cost of product as a result of increasing the number of units purchased from the Chinese manufacturers. Operating margin was 6% vs. (30%) YoY, and the company generated $280k in GAAP profitability. The company is exploring shifting a portion of shipping from air to sea, which costs less and would benefit margins to the extent this change is adopted.
MANAGEMENT
· Kevin Frija is CEO and co-founder, and is on the Board. Kevin's background is in sourcing, supply chain management, marketing, and licensing in the apparel industry.
· Jeff Holman, President and Director, is an attorney who has been on the Board of VPCO's predecessor e-cig company Smoke Anywhere USA since its inception in March, 2008.
· Harlan Press, CFO, is a CPA who has been CFO of a number of private and public companies
RISKS
The key risks include anticipated FDA regulation that will prevent sale of e-cigs to minors, the elimination of sales over the internet (approx. 10% of VPCO sales), and limitations on how e-cigs can be marketed. Big Tobacco has begun to enter the e-cig space and could crowd out smaller companies such as VPCO. Only recently has e-cigarette technology become affordable enough to compete with traditional tobacco cigarettes. If e-cigarettes become taxed similarly to tobacco products, the cost of e-cigarettes may no longer be competitive enough with traditional cigarettes and purchases may decline. Finally, the FDA dos not currently regulate or approve e-cigs. However, in anticipation of future regulation, the company has already taken the following steps:
o Provides FDA approved warning labels that comply with California's Proposition 65 requiring companies to disclose chemicals contained in their products.
o Maintains product recall and liability insurance (which it has never had to use).
o Uses certified labs to verify the quality of its e-cigs, with certificates of origin connecting those cigarettes to specific factories and batches.
COMPETITION
Big Tobacco is beginning to enter the industry, but data is hard to come by. Lorillard acquired the assets of Blu e-cigs in April, 2012 for $135 million, or approximately 4.5x TTM revenue, and is the only Big Tobacco company to breakout e-cg results. Blu is sold in 127,000 retail outlets, and is the market share leader with about 50% share in Q3, 2013. During the 1st 9 months of 2013, revenue grew 8x from $22m in 2012 to $177m in 2013.
Privately held NJOY raised $20m in April, 2012 from private equity firm Catterton Partners, and an additional $75m in June, 2013, but the valuations for the transactions have not been disclosed. On 12/20/13, Philip Morris (PM) announced it will begin to sell e-cigs in the U.S. in the second half of 2014, but no further details were provided in the announcement. Altria (MO) began selling e-cigs in Arizona and Indiana last year, but hasn't provided investors with data on the results. The primary method of distribution for the vast majority of e-cig companies is over the internet (VPCO only sells approximately 10% of its products via the internet). The Federal Government is widely expected to ban direct to consumer internet sales in 2014, suggesting internet sales-focused companies will have to change their model or be forced out of business.
ADDITIONAL INFORMATION
· Smoking, and presumably vaping, is neither seasonal, nor cyclical.
· E-cigs tend to sell for 20%-50% less than a pack of tobacco cigarettes, on a per puff basis.
· The company stocks it's most popular 200 SKUs (stock keeping units) for immediate shipment, and can quickly make custom designs for customers.
· NASDAQ uplisting. On 12/27/13, the company effected a 1-for-5 reverse stock split sized to yield a post-split stock price of at least 150% of the minimum bid price required to uplist to the NASDAQ Capital Market, or about $4.00 per share. The company has committed to achieve the uplisting by July 29th, 2014.
· On 12/31/13, the company reincorporated from Nevada to Delaware
· No later than 4/27/14, the company is required to reconstitute its Board from the current 3 inside directors to a Board of at least 5 members, 3 of whom are independent.
· The company expects the shares issued in the October, 2013 financing to be registered in Q1, 2014.
· VPCO's executive officers and directors collectively bought 585k shares in the October financing, and own about 25% of the company.
· The company has filed U.S. patent applications for a soft-tip filter which more closely resembles the tip of a tobacco cigarette versus the hard tip on most e-cigs today, and for the 1st e-cig with a battery that can be recharged by shaking instead of plugging the e-cig into an outlet, among others applications.
· Concurrent with the financing, the holders of the company's $1.7m in convertible notes converted their notes into common stock.
· Quality control is performed by testing puff counts and battery life. The company maintains product recall insurance, but has never had to use it.
· VPCO acquired Smoke Anywhere USA, a distributor of electronic cigarettes, in November 2009.
CONCLUSION
VPCO is one of just two public pure play opportunities for investors to participate in the e-cig industry (the other company is Victory Electronic Cigarettes Corp (OTCQB:ECIG)). E-cigarette industry sales are forecast to double in the U.S. each year for at least the next 5 years, reaching $48 billion in 2018. In contrast, sales in the $90 billion domestic tobacco cigarette market (nearly $800 billion worldwide and $90 billion in the US) have been stagnant in recent years and are projected to decline as e-cigs take market share. VPCO is an early mover in the e-cig industry, and with approximately $10 million in working capital and a short, 90 day working capital cycle, appears adequately capitalized to support anticipated growth. In just one year, the company has doubled the number of retail doors carrying its products from 30,000 to 60,000, and we expect that the company will continue to rapidly add retail doors as its products are introduced into new states, countries, and existing accounts increase their SKUs. The use of outsourced, low-cost manufacturing in China allows the company to rapidly scale manufacturing capacity without the need for capital investment, allowing the company to maintain gross margins of approximately 40%. As the company continues to execute its business plan, professional investors and money managers may take an increasing interest.
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