FA Alpha Daily

A defensive play beyond big tobacco

Despite recent economic optimism, recession risks persist, driving investors towards defensive sectors like tobacco, renowned for inelastic demand amid market volatility. Among these, Turning Point Brands (TPB) stands out for its resilience, buoyed by its diverse tobacco portfolio and proven profitability during downturns. However, regulatory risks and broader market trends continue to cast a shadow of doubt. In today’s FA Alpha Daily, let’s watch closely to see if TPB smokes away the risk or fades amidst the economic haze.

FA Alpha Daily:
Thursday Uniform Accounting Analysis
Powered by Valens Research

The markets have become more optimistic about the economy and inflation in the last months of 2023.

This was influenced by better-than-expected inflation and the increasing likelihood of interest rate cuts.

However, there is still a significant risk of recession. While the Fed is focused on curbing high inflation, a soft landing may be difficult to achieve.

The recent release of the Consumer Price Index (CPI) report has brought an overly positive outlook to reality.

The CPI numbers came in higher than expected, signaling persistent inflationary pressures that could challenge the optimism surrounding the economy and inflation.

This unexpected uptick suggests that the Federal Reserve may need to maintain or even increase interest rates for a longer period than previously anticipated.

Such a scenario complicates the path to achieving a soft landing, as higher rates could dampen economic activity and heighten the risk of a recession.

With the labor market staying robust, the Fed seems committed to doing whatever is necessary to prevent another round of high inflation through the end of the year.

This raises the risk of an economic slowdown being more severe than expected. As a result, it makes sense for investors to consider hedging their portfolios against potential recession impacts.

One approach is to invest in defensive stocks from industries that tend to hold up well even in a downturn.

The tobacco industry is an incredible one for recession protection, particularly because of the inelastic nature of its demand. Thanks to its addictive nature, consumers keep buying even when prices are increasing.

Among the giants of the tobacco industry, there exists a less prominent yet potentially lucrative player: Turning Point Brands (TPB).

This company might not grab headlines as often as its larger counterparts, but it offers a unique value proposition that could serve as an effective hedge against recession risks.

Turning Point Brands specializes in the production and marketing of a variety of tobacco-related products, including rolling papers, tubes, finished cigars, and make-your-own cigar wraps. These products cater to a niche yet stable market segment, leveraging the overall inelastic demand characteristic of the tobacco sector.

We already witnessed the company’s resilience in the last few years…

The company managed to keep its profitability during the pandemic, even reaching an all-time high Uniform return of assets (ROA) in 2021 with 41%.

Turning Point Brands’ focus on tobacco products places it in a unique position to weather economic downturns better than companies in more cyclical industries. The reason is simple: consumers of tobacco products tend to maintain their consumption habits despite economic headwinds.

This consistency in demand can provide a stable revenue stream for the company, even when other sectors are floundering. Moreover, the growing interest in make-your-own tobacco products could open new avenues for growth, particularly among cost-conscious consumers.

Despite the solid fundamentals underpinning Turning Point Brands’ business model, there seems to be a cloud of pessimism hanging over the company in the market.

We can see what the market thinks through our Embedded Expectations Analysis (“EEA”) framework.

The EEA starts by looking at a company’s current stock price. From there, we can calculate what the market expects from the company’s future cash flows. We then compare that with our own cash-flow projections.

In short, it tells us how well a company has to perform in the future to be worth what the market is paying for it today.

At the current stock price, the market expects the company’s ROA to fall to 12%.

The market’s pessimistic view is caused by regulatory risks and broader market trends impacting the tobacco industry…

Turning Point Brands, with its focus on a niche within the inelastic tobacco market, presents an intriguing option for investors seeking recession protection.

While the market’s skepticism has kept Turning Point Brands under the radar, this could very well be the opportune moment to consider it more closely.

SUMMARY and Turning Point Brands, Inc. Tearsheet

As the Uniform Accounting tearsheet for Turning Point Brands (TPB:USA) highlights, the Uniform P/E trades at 11.5x, which is below its global corporate average of 22.4x and its historical P/E of 13.1x.

Low P/Es require low EPS growth to sustain them. In the case of Turning Point Brands, the company has recently shown a 13% shrinkage in Uniform EPS.

Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Turning Point Brands’ Wall Street analyst-driven forecast is a 17% EPS shrinkage in 2023 and a 33% EPS growth in 2024.

Based on the current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Turning Point Brands’ $22.94 stock price. These are often referred to as market embedded expectations.

The company is currently being valued as if Uniform earnings were to shrink 7% annually over the next three years. What Wall Street analysts expect for Turning Point Brands’ earnings growth is below what the current stock market valuation requires in 2023 but above its 2024 requirement.

Furthermore, the company’s earning power is 5x its long-run corporate average. Moreover, cash flows and cash on hand are 5x its total obligations—including debt maturities, capex maintenance, and dividends. Also, the company’s intrinsic credit risk is 540bps above the risk-free rate.

All in all, this signals a high credit risk and a low dividend risk.

Lastly, Turning Point Brands’ Uniform earnings growth is below its peer averages but in line with its average peer valuations.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

The Uniform Accounting insights in today’s issue are the same ones that power some of our best stock picks and macro research, which can be found in our FA Alpha Daily newsletters.

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