TURNING POINT BRANDS, INC.
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| | ITEM 1A. | | 17 |
| | ITEM 1B. | | 37 |
| | ITEM 2. | | 37 |
| | ITEM 3. | | 37 |
| | ITEM 4. | | 37 |
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| PART II | | |
| | ITEM 5. | | 39
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| | ITEM 6. | | 40 |
| | ITEM 7. | | 41
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| | ITEM 7A. | | 56 |
| | ITEM 8. | | 57 |
| | ITEM 9. | | 100
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| | ITEM 9A. | | 100
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| | ITEM 9B. | | 101
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| | PART III | | |
| | ITEM 10. | | 102
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| | ITEM 11. | | 102
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| | ITEM 12. | | 102
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| | ITEM 13. | | 102
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| | ITEM 14. | | 102 |
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| PART IV | | |
| | ITEM 15. | | 103 |
| | ITEM 16. | | 107 |
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Cautionary Note Regarding Forward-Looking Statements
This annual report on Form 10-K contains forward-looking statements within the meaning of the federal securities laws. Forward-looking statements may generally be identified using words such as “anticipate,” “believe,” “expect,” “intend,” “plan” and “will” or, in each case, their negative, or other variations or comparable terminology. These forward-looking statements include all matters that are not historical facts. By their nature, forward-looking statements involve risks and uncertainties because they relate to events and depend on circumstances that may or may not occur in the future. Some, but not all, of these risks are described under Item 1A “Risk Factors” and elsewhere throughout this Annual Report. As a result, actual events may differ materially from those expressed in or suggested by the forward-looking statements. Any forward-looking statement made by us in this annual report on Form 10-K speaks only as of the date hereof. New risks and uncertainties come up from time to time, and it is impossible for us to predict these events or how they may affect it. We have no obligation, and does not intend, to update any forward-looking statements after the date hereof, except as required by federal securities laws.
PART I
Turning Point Brands, Inc., Overview
Turning Point Brands, Inc. (the “Company,” “we,” “our,” or “us”) is a leading manufacturer, marketer and distributor of branded consumer products. We sell a wide range of products to adult consumers consisting of staple products with our iconic brands Zig-Zag® and Stoker’s® to our next generation products to fulfill evolving consumer preferences. Among other markets, we compete in the alternative smoking accessories and Other Tobacco Products (“OTP”) industries. The alternative smoking accessories market is a dynamic market experiencing robust secular growth driven by cannabinoid legalization in the U.S. and Canada, and positively evolving consumer perception and acceptance in North America. The OTP industry, which consists of non-cigarette tobacco products, exhibited mid-single-digit consumer unit annualized growth over the three-year period ending 2021 as reported by Management Science Associates, Inc. (“MSAi”), a third-party analytics and information company. Our three focus segments are led by our proprietary brands: Zig-Zag® in the Zig-Zag Products segment; Stoker’s® along with Beech-Nut® and Trophy® in the Stoker’s Products segment; and our distribution platforms (Vapor Beast®, VaporFi® and Direct Vapor®) along with Solace® in the NewGen Products segment. Our businesses generate solid cash flow which we use to invest in our business, finance acquisitions, increase brand support, expand our distribution infrastructure, and strengthen our capital position. We currently ship to approximately 800 distributors with an additional 200 secondary, indirect wholesalers in the U.S. that carry and sell our products. Under the leadership of a senior management team with extensive experience in the consumer products, alternative smoking accessories and tobacco industries, we have grown and diversified our business through new product launches, category expansions, and acquisitions while concurrently improving operational efficiency.
We believe there are meaningful opportunities to grow through investing in organic growth, acquisitions and joint ventures across all product categories. As of December 31, 2021, our products are available in approximately 195,000 U.S. retail locations which, with the addition of retail stores in Canada, brings our total North American retail presence to an estimated 215,000 points of distribution. Our sales team targets widespread distribution to all traditional retail channels, including convenience stores, and we have a growing e-commerce business.
Zig-Zag Products
Our Zig-Zag Products (“Zig-Zag”) segment principally includes rolling papers and MYO cigar wraps used as smoking accessories. The strength of the Zig-Zag® brand drives our leadership position in both the rolling papers and MYO cigar wrap markets. Zig-Zag® is the #1 premium and overall rolling paper in the U.S. with approximately 34% total market share. Management estimates also indicate that Zig-Zag® is the #1 brand in the promising Canadian market. Rolling paper operations are aided by our sourcing relationship with Republic Technology International SAS (“RTI”). See “Distribution and Supply Agreements” for our discussion of the Zig-Zag® distribution agreement.1
In MYO cigar wraps, the Zig-Zag® brand commands a majority of the market and continues to innovate in novel ways through further product introductions including our introduction of Zig-Zag® ‘Rillo sized wraps, which are similar in size to cigarillos, the most popular and fastest growing type of machine-made cigars. In June 2020, we purchased certain assets from our long-term commercial partner Durfort Holdings S.R.L (‘‘Durfort’’) which included the co-ownership in the intellectual property rights for all of our MYO Homogenized Tobacco Leaf (“HTL”) cigar wraps products. Along with the transaction, we entered into an exclusive Master Distribution Agreement to market and sell the original Blunt Wrap® cigar wraps within the USA which was effective October 9, 2020. In late 2021, we extended our MYO cigar wraps offering with entries into the growing hemp wraps and natural leaf wraps markets.
In July 2019, to extend our reach in Canada, we made a minority investment in Turning Point Brands Canada (formerly ReCreation Marketing) that was built up to a 65% ownership stake by July 2021. Turning Point Brands Canada is a specialty marketing and distribution firm focused on building brands in the Canadian cannabis accessories, tobacco and alternative products categories. Our majority ownership stake leverages Turning Point Brands Canada’s significant expertise in marketing and distributing cannabis accessories and tobacco products throughout Canada. The remainder of Turning Point Brands Canada is owned by its management.
In July 2021, we acquired certain assets of Unitabac, a marketer of mass-market cigars. In the acquisition, we acquired a robust portfolio of cigarillo products and all related intellectual property, including Cigarillo Non-Tip (NT) HTL products and Rolled Leaf and Natural Leaf Cigarillo Products that we can leverage to re-introduce the Zig-Zag® brand into a large and growing cigarillo market.
In February 2022, we announced an agreement with Flamagas, a renowned lighter manufacturer, for
exclusive distribution of CLIPPER® lighters in the United States and Canada. CLIPPER is the number one reusable lighter in the world and the number two overall world lighter brand. We aim to use our existing distribution infrastructure to expand access of CLIPPER lighters to more retailers and consumers.
1 Brand ranking and market share percentages obtained from MSAi for the 52-week period ended December 25, 2021.
Since mid-2019, we have been repositioning the business with growth initiatives focused on new product introductions and new channel expansions that are better aligned with the growing market trends. As a result of those initiatives, we have been successful in changing the growth profile of our Zig-Zag Products segment. The Zig-Zag Products segment accounts for the majority of our operating profit and is now our fastest growing segment.
Stoker’s Products
Our Stoker’s Products (“Stoker’s”) segment includes both moist snuff tobacco (“MST”) and loose leaf chewing tobacco. Stoker’s® is our focus brand in both MST and chewing tobacco. In MST, Stoker’s® remains among the fastest growing brands and holds an 8.4% share in the stores with distribution and a 5.6% share of the total U.S. MST non-pouch market. Stoker’s® pioneered the large 12 oz. tub packaging format and is manufactured using a proprietary process that we believe results in a superior product. Starting in 2015, we extended the Stoker’s® MST franchise to include traditional 1.2 oz. cans to broaden retail availability. Our proprietary manufacturing process is conducted at our Dresden, Tennessee, plant and packaged in both our Dresden, Tennessee, and Louisville, Kentucky, facilities.1
Stoker’s® chewing tobacco has grown its market share considerably over the last several years and is presently the #1 discount and overall brand in the industry, with approximately a 26% market share. Our status in the chew market is further strengthened by Beech-Nut®, the #3 premium brand and #7 overall, as well as Trophy®, Durango®, and the five Wind River Brands. Collectively, the Company is the #2 marketer of chewing tobacco with approximately 33% market share. Our chewing tobacco operations are facilitated through our long-standing relationship with Swedish Match, the manufacturer of our loose-leaf chewing tobaccos.1
NewGen Products
Our NewGen Products (“NewGen”) segment includes our vape distribution business that was built through acquisitions as well as a new product development arm dedicated to the development, production and sale of alternative products.
Within our vape distribution business, Vapor Beast® is a leading distributor of vapor products servicing the non-traditional retail channel. International Vapor Group (“IVG”) operates a B2C e-commerce business with direct sales to consumers nationwide and abroad through the Direct Vapor® and VaporFi® brands. We are leveraging our vape distribution business to increase sales of our proprietary brands. As part of this strategy to leverage our distribution infrastructure, we acquired Solace in July 2019. Solace is an innovative product development company which built one of the top e-liquid brands into a leader in alternative products.
We have also made minority investments to gain exposure to the large and growing cannabinoid market including in Wild Hempettes, dosist™, Docklight Brands, Inc. and Old Pal Holding Company LLC.
Competitive Strengths
We believe our competitive strengths include the following:
Large, Leading Brands with Significant Scale
We have built a portfolio of leading brands with significant scale that are well recognized by consumers, retailers, and wholesalers. Our Zig-Zag® and Stoker’s® brands are each well established and date back 122 and 82 years, respectively. The NewGen Products segment has been built primarily through the acquisitions of VaporBeast, IVG and Solace, leading sellers of e-liquids, devices, and accessories.
| | • | Zig-Zag® is the #1 premium and overall rolling paper brand in the U.S., with significant distribution in Canada as well. Zig-Zag® is also the #1 MYO cigar wrap brand in the U.S., as measured by MSAi. We acquired North American rolling papers distribution rights for Zig-Zag® in 1997. More importantly, we own the Zig-Zag® tobacco trademark in the U.S. which we leverage for our MYO cigar wraps product. Approximately 50% of our total 2021 Zig-Zag® branded net sales are under our own Zig-Zag® marks rather than those we license from under the Distribution and Licensing Agreements described below. |
| | • | Stoker’s® is among the fastest growing MST brands in the industry and is the #1 loose leaf chewing tobacco brand. We manufacture Stoker’s® MST using only 100% American Leaf, utilizing a proprietary process to produce what we believe is a superior product.2 |
1 Brand rankings and market share percentages obtained from MSAi for the 52-week period ended December 25, 2021.
2 Brand ranking and market share percentages obtained from MSAi for the 52-week period ended December 25, 2021.
Zig-Zag® is an iconic brand and has strong, enduring brand recognition among a wide audience of consumers. We believe the Stoker’s® brand is seen as an innovator in both the moist snuff and loose-leaf chewing tobacco markets. VaporBeast is a powerful distribution engine that allows us to further penetrate non-traditional retail outlets. IVG provides us direct access to the highly attractive, high margin B2C segment via the flagship Direct Vapor® and VaporFi® brands. The Solace acquisition provides us with a proven line of e-liquid and a strong new product development platform to launch additional novel products.
Exposure to Growing Cannabinoid Consumption Trends
We believe that the cannabinoid market will expand over the coming years as it becomes increasingly accepted by the public in the U.S. Our product offerings, particularly those in our Zig-Zag Products and NewGen Products segments, are ideally positioned to benefit from continued growth in consumer consumption.
The legal cannabis market in the U.S. is projected to grow from $25 billion in 2021 to $48 billion by 2026, representing a 13% compounded annual growth rate, according to a September 2021 report of BDS Analytics, Inc., providing us with significant opportunity. A recent Gallup poll showed nearly seven in ten Americans now support legalizing cannabis nationwide, approximately twice the amount as twenty years ago. As of the end of 2021, 18 U.S. states and the District of Columbia had legalized cannabis for adult recreational use and a majority of states now allow for comprehensive public medical cannabis programs.
Successful Track Record of New Product Launches and Category Expansions
We have successfully launched new products and entered new product categories by leveraging the strength of our brands and methodically targeting markets which we believe have significant growth potential:
| | • | In 2009, we extended the Zig-Zag® tobacco brand into the MYO cigar wraps market and captured a 50% market share within the first two years. We are now the market share leader for MYO cigar wraps with approximately a 56% share of the cigar wraps category and 78% of the share of the HTL cigar wraps sub-category. 1 We believe our success was driven by the Zig-Zag® tobacco branding, which we feel is widely understood by consumers to represent a favorable, customizable experience ideally suited to MYO products. In late 2021, we extended our Zig-Zag® MYO cigar wraps offering with entries into the growing hemp wraps and natural leaf wraps markets. |
| | • | We extended the Zig-Zag® brand into hemp rolling papers in 2018 and followed that with the launch of paper cones in 2019 with both products quickly establishing leading positions in their respective categories. |
| | • | We leveraged the proud legacy and value of the Stoker’s® brand to introduce a 12 oz. MST tub, a size that was not offered by any other market participant at the time of introduction. Stoker’s® MST has been among the fastest growing moist snuff brands in the industry in terms of pounds sold. While competitors have since introduced larger format tub packaging, the early entry and differentiation of the Stoker’s® product have firmly established us as the market leader with over 50% of the Tub market as of 2021. In 2015, we introduced Stoker’s® MST in 1.2 oz. cans to further expand retail penetration, particularly in convenience stores. |
| | • | VaporBeast quickly established itself as a leading marketer and distributor of liquid vapor products to the non-traditional retail universe. With its national footprint, VaporBeast is leveraging its regional consumer preference insights to further accelerate sales advances. |
| | • | In 2019, the IVG acquisition, and specifically the VaporFi B2C marketing engine, offered us the opportunity to leverage the marketing competencies and processes to sell novel proprietary products across multiple channels and platforms. |
| | • | In 2019, the Solace acquisition provided us with a leading line of liquids and a powerful new product development platform. |
| | • | In 2019, we introduced Zig-Zag® paper cones into the market and have grown it into one of the top brands in the category. |
| | • | In 2021, the acquisition of the Unitabac assets provided a platform to re-introduce the Zig-Zag® brand into a large and growing cigarillo market. |
| | • | In 2022, we will be entering the lighter market through an exclusive distribution agreement for CLIPPER® lighters in the United States and Canada. |
We strategically target product categories that we believe demonstrate significant growth potential and for which the value of our brands is likely to have a meaningful impact. We believe that our track record and existing portfolio of brands provide growth advantages as we continue to evaluate opportunities to extend our product lines and expand into new categories.
E-Commerce Capabilities
With the acquisition of VaporBeast and IVG, we established scaled B2B and B2C e-commerce presence to service the vape market. Our e-commerce capabilities were enhanced by the acquisition and integration of Solace in 2019. We leveraged those capabilities to build a meaningful B2B and B2C e-commerce business for Zig-Zag®.
Extensive Distribution Network and Data Driven Sales Organization
We have taken important steps to enhance our selling and distribution network and consumer marketing capabilities that allow us to grow our business while keeping our capital expenditure requirements relatively low. We have long-standing relationships in the core convenience store channel and wholesale distribution network with access to more than 215,000 retail outlets in North America. Our NewGen Products B2B business reaches thousands of vape stores and our B2C business has approximately 1.6 million unique customers. We are also increasing brand presence through non-traditional channels including headshops, dispensaries, and B2B e-commerce and are expanding our sales team dedicated to these channels. We have added brand dedicated platforms including ZigZag.com and SolaceVapor.com to facilitate our e-commerce brand presence as well as sell on Amazon.
We service our traditional tobacco and vapor customer bases with an experienced sales and marketing organization of approximately 180 professionals who possess in-depth knowledge of the OTP market. We extensively use data supported by leading technology to enable our salesforce to analyze changing trends and effectively identify evolving consumer preferences at the store level. Our market analytics allow us to efficiently and effectively address evolving consumer and market demands. We subscribe to a sales tracking system provided by MSAi that measures all OTP product shipments by all market participants, on a weekly basis, from approximately 600 wholesalers to over 250,000 traditional retail stores in the U.S. This system enables us to understand share and volume trends across multiple categories at the individual store level, allowing us to allocate field salesforce coverage to the highest opportunity stores, thereby enhancing the value of new store placements and sales activity. Within our Stoker’s segment product categories, we have seen a positive correlation between the frequency of store calls by our salesforce and our retail market share.
Asset-light Business Model that Generates Resilient Free Cash Flow
We have a lean, asset-light manufacturing and sourcing model which leverages outsourced supplier relationships and requires low capital expenditures. We believe our asset-light model provides marketplace flexibility, allows us to achieve favorable margins and generates high free cash flow conversion.
As part of our asset-light operating model, we built long-standing and extensive relationships with leading, high-quality producers from whom we source products including loose-leaf chewing tobacco and cigarette paper, among others. We do not outsource our MST production as a result of our proprietary manufacturing processes which are substantively different than those of our competitors.
By outsourcing the production of certain products to a select group of suppliers with whom we have strong relationships, we are able to maintain low overhead costs and minimal capital expenditures. Our supplier relationships allow us to increase the breadth of our product offerings and quickly enter new markets as management is able to focus on brand building and innovation. In 2021, over 80% of our net sales were derived from outsourced production operations and our capital expenditures have ranged between $2.0 million and $6.2 million per year over the previous 5 years.
The stability of our cash flows is enhanced by the resilience of our Zig-Zag Products and Stoker’s Products business segments which we believe have recession-resistant end-markets. These products are primarily staples that are small ticket purchases for repeat consumers. In addition, we believe the secular shift to the value category in the Stoker’s Products segment will benefit the long-term resilience of our brands.
Expertise to Succeed in Dynamic Regulatory Environments
We operate in a highly regulated environment involving many different government agencies. In 2009, the FDA was given jurisdiction over cigarettes and smokeless tobacco, which expanded in 2016 to include all other tobacco products including vaping and cigars. We believe we have a competitive advantage due to our management team’s experience navigating the regulatory environment. We have increased our investments in teams of professionals including regulatory lawyers, scientists, and quality assurance processes to ensure we maintain a competitive advantage in this area.
The FDA is currently implementing a premarket review process, sometimes referred to as the PMTA, or the Pre-market Tobacco Application, process, which required all vape products introduced since 2007 to submit an application to the FDA by September 2020. The PMTA process is a very expensive and resource-intensive process and there are currently hundreds of competitors in the market but very few have the capability and or the resources to get their products successfully through this process.
We spent approximately $17 million in order to file applications covering 250 products, and we believe our application was one of the most extensive portfolios for open tank vaping products that was submitted to the FDA. By developing and submitting for FDA marketing authorization a deep suite of products in the space and leveraging our distribution platform, we believe that we have the opportunity to grow substantial market share with our proprietary products as our competitors navigate this process. We believe this is a transformational event for the industry with potential for us to realize substantial benefits over time as the FDA accelerates enforcement thereby, creating significant barriers for new entrants as well as significant difficulties for existing companies who may not have the ability to comply with these regulatory requirements. See “Risks Related to Legal, Tax and Regulatory Matters” under Item 1A “Risk Factors” of this Annual Report on Form 10-K.
In addition, we have been building an alternative logistics infrastructure across the U.S. to comply with the Prevent All Cigarette Trafficking Act (“PACT Act”) which was recently extended to prohibit the use of the U.S. Postal Service to mail e-cigarette and related products and requires adult signature on delivery.
Experienced Management Team
With extensive experience in consumer products, alternative smoking accessories and tobacco markets, our senior management team has enabled us to grow and diversify our business while improving operational efficiency. Members of management have previous experience at other leading tobacco companies. Given the professional experience of the senior management team we are able to analyze risks and opportunities from a variety of perspectives. Our senior leadership has embraced a collaborative culture in which the combined experience, analytical rigor, and creativity are leveraged to assess opportunities and deliver products that satisfy consumers’ demands. Our management team also brings a proven track record of patient and selective capital deployment into value enhancing transactions.
Growth Strategies
We are focused on building sustainable margins, expanding the availability of our products, developing innovative new products, and enhancing overall operating efficiencies with the goal of improving margins and cash flow. We adopted the following strategies to drive growth in our business and build stockholder value:
Grow Share of Existing Product Lines, Domestically and Internationally
We intend to remain a consumer centric organization with an innovative view and understanding of the alternative smoking accessories and OTP markets. We believe we have strong tailwinds for growth within our existing product lines. Within our Zig-Zag Products segment, we are benefitting from secular growth trends in the industry, driving market share gains in our traditional convenience store channel and expanding our presence into non-traditional channels including headshops, dispensaries and e-commerce to drive growth. Within our Stoker’s Products segment, there is ample runway for growth driven by same store sales growth and further distribution gains as Stoker’s® MST continues to be one of the fastest growing brands in the category.
In 2021, less than 10% of our revenues were generated outside of the U.S. Having established a strong infrastructure and negotiated relationships across multiple segments and products, we are pursuing an international growth strategy to broaden sales and strengthen margins. We believe international sales represent a meaningful growth opportunity. In 2021, we increased our ownership in Turning Point Brands Canada to 65%. Our goals include expanding our presence in the worldwide OTP industry on a targeted basis. For example, we are expanding Zig-Zag®’s retail penetration and product assortment in Canada, and selling our Stoker’s® MST products in South America, Europe, Asia and Africa.
Expand into Adjacent Categories through Innovation and New Partnerships
We continually evaluate opportunities to expand into adjacent product categories by leveraging our current portfolio and through new partnerships. We believe there are meaningful opportunities for growth within the alternative smoking accessories and OTP markets. We maintain a robust product pipeline and plan to strategically introduce new products in attractive, growing markets, both domestically and internationally, with specific focus on our papers and MYO wraps businesses. In particular, the strength of the Zig-Zag® brand provides a great platform to introduce a suite of complementary products similar to our launch and expansion of hemp papers, paper cones, hemp wraps and natural leaf wraps. We have an exciting pipeline of new products and SKUs we plan on introducing over the coming years in both our papers and MYO wraps businesses. In 2022, we will be entering the lighter market through an exclusive distribution agreement for CLIPPER® lighters in the United States and Canada. As we have done successfully in the past, we will leverage our existing sales infrastructure to drive distribution of these new products and are investing to expand our e-commerce distribution capabilities.
We have identified a number of new adjacencies and we intend to leverage our existing brands and partnerships to continue the process of commercializing winning products that satisfy consumer needs.
Increase our Mix of Proprietary Products in Vape Distribution
Our vape distribution business comprises a majority of our revenue with the NewGen Products segment. The NewGen Products segment generates a significant share of our revenue mix but the lowest share of profits with a sales mix of mostly lower gross margin third-party products. We aim to improve the profitability of the segment by generating increased sales from higher gross margin proprietary products within our vape distribution platform.
Accelerate Growth Through National Distribution Network
Our business is built around a powerful sales and distribution infrastructure that currently reaches over 215,000 retail outlets in North America. We have strong presence in independent convenience stores and now service most of the leading chain accounts. Through our e-commerce platforms and our B2B and B2C vape distribution platforms we have alternative avenues through which to sell third-party products and an increasing mix of our proprietary products. This strategy allows new products to be tested with lower risk before we incorporate them into our wider brick and mortar distribution system.
Combining our different platforms, we have an expansive multi-channel distribution infrastructure that gives us a big competitive advantage when we introduce new products or acquire companies that we can integrate into our network. We believe our experienced salesforce, expansive distribution network, and leading market analytics put us in a strong position to swiftly execute new product launches in response to evolving consumer and market preferences.
Strategically Pursue Acquisitions
We believe there are meaningful acquisition opportunities in our fragmented markets. We regularly evaluate acquisition opportunities across our industries. In evaluating acquisition opportunities, our focus is on identifying acquisitions that would leverage our distribution platform and product offerings or enable category expansion in areas with high growth potential.
The vast majority of our 2021 U.S. gross profit was derived from sales of products currently regulated by FDA Center for Tobacco Products. We have significant experience in complying with the FDA regulatory regime with a compliance infrastructure composed of legal and scientific professionals. We believe many smaller OTP manufacturers currently lack this infrastructure, which we believe is necessary to comply with the broad scope of FDA regulations. We believe our regulatory compliance infrastructure, combined with our skilled management and strong distribution platform, position us to act as a consolidator within the OTP industry.
We have a strong track record of enhancing our OTP business with strategic and accretive acquisitions. The Company itself was built through acquisitions that were subsequently grown through distribution gains, market share growth and brand extensions into new product categories. This is a playbook that we have drawn on over time with a consistent track record of success. We acquired the U.S. and Canadian rolling papers distribution rights for Zig-Zag® in 1997 and extended our product offerings including our entry into the MYO cigar wraps category in 2009. Today, Zig-Zag® is the #1 premium and overall rolling paper and MYO cigar wrap brand in the U.S., as measured by MSAi. In 2003, we acquired the Stoker’s® brand. We have since built the brand to a strong #1 position in the chewing tobacco industry while successfully leveraging the brand’s value through our MST expansion where it remains among the fastest growing MST brands in the industry. Subsequent to our initial public offering (“IPO”) in 2016, we completed a series of acquisitions that built the foundation of our NewGen Products segment through (i) VaporBeast, (ii) IVG, and (iii) Solace. Our investment in Turning Point Brands Canada in 2019 is accelerating Zig-Zag®’s growth through alternative channel penetration and introducing our proprietary NewGen products into Canada. In 2020, we acquired certain assets from Durfort including co-ownership of the intellectual property rights for our MYO cigar wraps products. The transaction increased our share of the economics in a MYO cigar wraps business that was benefitting from secular growth tailwinds and gave us access to a complimentary product in Blunt Wrap® through an exclusive distribution agreement. Our investments in Wild Hempettes, dosist™, Docklight and Old Pal give us increased exposure to the large and growing cannabinoid market. In 2021, we acquired certain assets from Unitabac, providing a platform to re-enter the large and growing cigarillo category.
Raw Materials, Product Supply, and Inventory Management
We source our products through a series of longstanding, highly valued relationships which allow us to conduct our business on an asset-light, distribution-focused basis.
The components of inventories were as follows (in thousands):
| | | | | | | |
| Raw materials and work in process | | $ | 6,936 | | | $ | 8,137 | |
| Leaf tobacco | | | 35,900 | | | | 32,948 | |
| Finished goods - Zig-Zag Products | | | 25,663 | | | | 14,903 | |
| Finished goods - Stoker’s Products | | | 8,959 | | | | 9,727 | |
| Finished goods - NewGen Products | | | 8,591 | | | | 18,916 | |
| Other | | | 1,558 | | | | 1,225 | |
| Inventories | | $ | 87,607 | | | $ | 85,856 | |
Zig-Zag Products
Pursuant to the Zig-Zag® distribution agreements, we are required to purchase from RTI all cigarette papers, cigarette tubes, and cigarette injecting machines that we sell, subject to RTI fulfilling its obligations under the Zig-Zag® distribution agreements. See “Distribution and Supply Agreements” for a discussion of the Zig-Zag® distribution agreements. If RTI is unable or unwilling to perform its obligations or ceases its cigarette paper manufacturing operations, in each case, as set forth in the Distribution Agreements, we may seek third-party suppliers and continue the use of the Zig-Zag® trademark to market these products. To ensure we have a steady supply of premium cigarette paper products, as well as cigarette tubes and injectors, RTI is required to maintain, at its expense, a two-month supply of inventory in a bonded, public warehouse in the U.S.
We obtain our MYO cigar wraps from our supplier in the Dominican Republic. We also obtain our Zig-Zag® branded cigar products from the Dominican Republic.
Stoker’s Products
Our moist snuff and loose-leaf chewing tobaccos are produced from air-cured and fire-cured leaf tobacco, respectively. We utilize recognized suppliers that generally maintain 12- to 24-month supplies of our various types of tobacco at their facilities. We do not believe we are dependent on any single country or supplier source for tobacco. We generally maintain up to a two-month supply of finished, moist snuff and loose leaf chewing tobacco on hand. This supply is maintained at our Louisville, Kentucky, facility and in two regional public warehouses to facilitate distribution.
We also utilize a variety of suppliers for the sourcing of additives used in our smokeless products and for the supply of our packaging materials. Thus, we believe we are not dependent on a single supplier for these products. There are no current U.S. federal regulations that restrict tobacco flavor additives in smokeless products. The additives that we use are food-grade, generally accepted ingredients.
All of our moist snuff products are manufactured at our facility in Dresden, Tennessee. Packaging occurs at the Dresden, Tennessee, location in addition to the facility in Louisville, Kentucky. All of our loose-leaf chewing tobacco production is fulfilled through our agreement with Swedish Match. See “Distribution and Supply Agreements” for our discussion of the Swedish Match Manufacturing Agreement.
NewGen Products
We have sourcing relationships that are capable of providing liquid vapor products for other companies’ brands and for producing our own branded product lines in the category. Our acquisitions of VaporBeast, IVG and Solace have (i) accelerated our entry into the non-traditional retail channel, where we believe a significant portion of liquid vapor products are sold; (ii) provided enhanced distribution of products; and (iii) established best-in-class distribution and B2C platforms combining e-commerce selling skills with a national retail salesforce. We believe the VaporBeast B2B competency coupled with the IVG B2C selling strengths and our national retail salesforce is a genuine competitive advantage and one that we intend to leverage on behalf of our actives products. Furthermore, we have established a sourcing group in Asia to ensure timely and cost-effective access to marketplace winners and new product launches, while also maximizing margin through thoughtful logistics strategies.
Distribution and Supply Agreements
The Zig-Zag Distribution and License Agreements
In 1992, we entered into two long-term exclusive distribution agreements with respect to sales of Zig-Zag® cigarette papers, cigarette tubes, and cigarette injector machines in the U.S. and Canada (collectively, the “Distribution Agreements”). The Distribution Agreements had an initial twenty-year term, which automatically renews for successive twenty-year terms unless terminated in accordance with the terms of the Distribution Agreements. The Distribution Agreements renewed for their second twenty-year term in November 2012.
Under the Distribution Agreements, we are required to purchase cigarette papers, cigarette tubes, and cigarette injector machines from the licensor; however, our licensor must provide us with sufficient quantities consistent with specific order-to-delivery timelines outlined in the Distribution Agreements. Our product supply is further protected by additional safeguards, including the right to seek third-party suppliers in certain circumstances and a two-month safety stock inventory to be kept in the U.S. at the licensor’s expense. The Distribution Agreements also provide shared responsibility for duties, insurance, shipping, and taxes. The import duties and taxes in the U.S. and Canada are our responsibility, while the licensor is responsible for insurance, export duties, and shipping costs.
Each of the Distribution Agreements contains customary termination provisions, including failure to meet performance obligations, the assignment of the agreement or the consummation of a change of control, in each case, without consent of the licensor, upon certain material breaches, including our agreement not to promote, directly or indirectly, cigarette paper or cigarette paper booklets of a competitor, or upon our bankruptcy, insolvency, liquidation, or other similar event. The licensor also may terminate the Distribution Agreements if a competitor acquires a significant amount of our common stock or if one of our significant stockholders acquires a significant amount of one of our competitors. In the event of a termination, we have agreed that for a period of five years after the termination we will not engage, directly or indirectly, in the manufacturing, selling, distributing, marketing, or otherwise promoting, in the U.S. and Canada, of cigarette paper or cigarette paper booklets of a competitor without consent. There are certain de minimis exceptions to these provisions. For further details, see ‘‘Risk Factors – We depend on a small number of key third-party suppliers and producers for our products’’.
In subsequent years, we entered into two licensing agreements, giving us the exclusive use of the Zig-Zag® brand name for e-cigarettes and related accessories in the U.S. and for paper cone products in the U.S. and Canada (collectively, the “License Agreements”). Each of the License Agreements terminates if the Distribution Agreements are terminated.
The Distribution Agreements and the License Agreements were initially entered into with Bolloré. In November 2020, Bolloré assigned the Distribution Agreements and the License Agreements to RTI. For a number of years, RTI has been the outsourced manufacturer of cigarette papers, cigarette tubes, cigarette injector machines and certain other products bearing the Zig-Zag® name.
Swedish Match Manufacturing Agreement
In 2008, we entered into a manufacturing and distribution agreement with Swedish Match whereby Swedish Match became the exclusive manufacturer of our loose-leaf chewing tobacco. Under the agreement, production of our loose-leaf chewing tobacco products was completely transitioned to Swedish Match’s plant located in Owensboro, Kentucky, in 2009. We source all of the tobacco Swedish Match uses to manufacture our products along with certain proprietary flavorings and retain all marketing, design, formula, and trademark rights over our loose-leaf products. We also have the right to approve all product modifications and are solely responsible for decisions related to package design and branding of the loose-leaf tobacco produced for us. Responsibilities related to process control, manufacturing activities, and inventory management with respect to our loose-leaf products are allocated between us and Swedish Match as specified in the agreement. We also have rights to monitor production and quality control processes on an ongoing basis.
The agreement had an initial ten-year term and will automatically be renewed for five successive ten-year terms unless either party provides at least 180 days’ notice prior to a renewal term of its intent to terminate the agreement, or unless otherwise terminated by mutual agreement of the parties in accordance with the provisions of the agreement. If a notice of non-renewal is delivered, the contract will expire two years after the date on which the agreement would have otherwise been renewed. The terms allow the agreement to be assumed by a buyer, terminated for uncured material breach, or terminated by us subject to a buyout. We also hold a right of first refusal to acquire the manufacturing plant as well as Swedish Match’s chewing tobacco unit. The agreement was automatically renewed for the first of five 10-year renewal periods in September 2018.
Production and Quality Control
We primarily outsource our manufacturing and production processes and focus on packaging, marketing, and distribution. We currently manufacture less than 20% of our products as measured by net sales. Our in-house manufacturing operations are principally limited to (i) the manufacturing of our moist snuff products, which occurs at our facility in Dresden, Tennessee; and (ii) the packaging of our moist snuff products at our facilities in Dresden, Tennessee, and Louisville, Kentucky. Our MST products are processed in-house, rather than outsourced, as a result of our proprietary manufacturing processes which are substantively different than those of our competitors.
We use proprietary production processes and techniques, including strict quality controls. Our quality control group routinely tests the quality of the tobacco, flavorings, application of flavorings, premium cigarette papers, tubes and injectors, cigars, MYO cigar wraps, liquid vapor products, and packaging materials. We utilize sophisticated quality controls to test and closely monitor the quality of our products. The high quality of our tobacco products is largely the result of using high-grade tobacco leaf and food-grade flavorings and, on an ongoing basis, analyzing the tobacco cut, flavorings, and moisture content together with strict specifications for sourced products.
Given the importance of contract manufacturing to our business, our quality control group ensures that established, written procedures and standards are adhered to by each of our contract manufacturers. Responsibilities related to process control, manufacturing activities, quality control, and inventory management with respect to our loose leaf are allocated between us and Swedish Match under the manufacturing agreement.
Sales and Marketing
We have grown the size and capacity of our salesforce and intend to continue strengthening the organization to advance our ability to deepen and broaden the retail availability of our products and brands.
As of December 31, 2021, we had a nationwide sales and marketing organization of approximately 180 professionals. Our sales and marketing group focuses on priority markets and sales channels and seeks to operate with a high level of efficiency. In 2021, our Zig-Zag and Stoker’s Products sales and marketing efforts enabled our products to reach an estimated 215,000 retail outlets in North America and over 800 direct wholesale customers with an additional 200 secondary, indirect wholesalers in the U.S.
Our Zig-Zag and Stoker’s Products sales efforts are focused on wholesale distributors and retail merchants in the independent and chain convenience store, tobacco outlet, food store, mass merchandising, drug store, and non-traditional retail channels. For Zig-Zag Products, we have also developed a growing e-commerce business. Our NewGen sales efforts are focused on alternative channels and winning new stores, increasing store share of requirements and growing the B2C engine to capture a greater share of online sales direct to the consumer. We have expanded, and intend to continue to expand, the sales of our products into previously underdeveloped geographic markets and retail channels. In 2021, we derived more than 90% of our net sales from sales in the U.S., with the remainder primarily from sales in Canada.
We subscribe to a sales tracking system from MSAi that records all traditional OTP product shipments (ours as well as those of our competitors) from approximately 600 wholesalers to over 250,000 traditional retail stores in the U.S. This system enables us to understand individual product share and volume trends across multiple categories down to the individual retail store level, allowing us to allocate field salesforce coverage to the highest opportunity stores. Additionally, the ability to select from a range of parameters and to achieve this level of granularity means we can analyze marketplace trends in a timely manner and swiftly evolve our business planning to meet market opportunities.
We employ marketing activities to grow awareness, trial, and sales including selective trade advertising to expand wholesale availability, point-of-sale advertising and merchandising and permanent and temporary displays to improve consumer visibility, and social media. We comply with all regulations relating to the marketing of tobacco products, such as directing marketing efforts to adult consumers, and are committed to full legal compliance in the sales and marketing of our products. To date, we have neither relied upon, nor conducted, any substantial advertising in the consumer media for our tobacco products.
For the years ended December 31, 2021, 2020, and 2019, we did not have any customer that accounted for 10% or more of our net sales. Our customers use an open purchase order system to buy our products and are not obligated to do so pursuant to ongoing contractual obligations. We perform periodic credit evaluations of our customers and generally do not require collateral on trade receivables. Historically, we have not experienced material credit losses. Sales to customers within our NewGen segment are generally prepaid.
Competition
Many of our competitors are better capitalized than we are and have greater resources, financial and otherwise. We believe our ability to effectively compete and strong market positions in our principal product lines are due to the high recognition of our brand names, the perceived quality of each of our products, and the efforts of our sales, marketing, and distribution teams. We compete against “big tobacco,” including Altria Group, Inc. (formerly Philip Morris International); British American Tobacco p.l.c. (formerly R.J. Reynolds Tobacco Company); Swedish Match; Swisher International, Inc.; and manufacturers including U.K. based Imperial Brands, PLC, across our segments. “Big tobacco” has substantial resources and a customer base that has historically demonstrated loyalty to their brands.
Competition in the OTP market is based upon not only brand quality and positioning but also on price, packaging, promotion, and retail availability and visibility. Given the decreasing prevalence of cigarette consumption, the “big tobacco” companies continue to demonstrate an increased interest and participation in a number of OTP markets.
Zig-Zag Products
Our principal competitors for premium rolling paper sales are Republic Tobacco, L.P. and HBI International. Our major competitors in MYO cigar wraps are Good Times USA, LLC and New Image Global, Inc. We believe MYO cigar wrap products are used interchangeably with both rolling papers and finished cigar products by many consumers.
Stoker’s Products
Our four principal competitors in the moist snuff category are Swedish Match, the American Snuff Company, LLC (a unit of British American Tobacco p.l.c.), Swisher International Group, Inc. and U.S. Smokeless Tobacco Company (a division of Altria Group, Inc.). In the loose-leaf chewing tobacco market, our three principal competitors are Swedish Match, the American Snuff Company, LLC (a unit of British American Tobacco p.l.c.), and Swisher International Group, Inc. We believe moist snuff products are used interchangeably with loose leaf products by many consumers.
NewGen Products
In the NewGen products segment, our competitors are varied as the market is relatively new and highly fragmented. Our direct competitors sell products that are substantially similar to our products through the same channels in which we sell our liquid vapor products. We compete with these direct competitors for sales through wholesalers and retailers including, but not limited to, vapor stores, national chain stores, tobacco shops, and convenience stores and in the online direct to consumer environment. Through our acquisitions we now also compete directly with other non-traditional distributors and retailers.
Patents, Trademarks, and Trade Secrets
We have numerous registered trademarks relating to our products, including: Beech-Nut®, Trophy®, Havana Blossom®, Durango®, Stoker’s®, Tequila Sunrise®, Fred’s Choice®, Old Hillside®, Our Pride®, Red Cap®, Tennessee Chew®, Big Mountain®, Springfield Standard®, Snake River®, Vapor Beast®, Vapor Shark®, DirectVapor®, VaporFi® and South Beach Smoke®. The registered trademarks, which are significant to our business, expire periodically and are renewable for additional 10-year terms upon expiration. Flavor and blend formula trade secrets relating to our tobacco products, which are key assets of our businesses, are maintained under strict secrecy.
The Zig-Zag® trade dress trademark for premium cigarette papers and related products are owned by RTI and have been exclusively licensed to us in the U.S. and Canada. The Zig-Zag® trademark for e-cigarettes is also owned by RTI and has been exclusively licensed to us in the U.S. We own the Zig-Zag® trademark with respect to its use in connection with products made with tobacco including, without limitation, cigarettes, cigars, and MYO cigar wraps in the U.S.
Research and Development and Quality Assurance
We have a research and development and quality assurance function that tests raw materials and finished products in order to maintain a high level of product quality and consistency. Research and development largely bases its new product development efforts on our high-tech data systems. We spent approximately $1.1 million, $1.3 million, and $2.5 million dollars on research and development and quality control efforts for the years ended December 31, 2021, 2020, and 2019, respectively.
Human Capital
As of March 4, 2022, we employed 426 full-time and part-time employees. None of our employees are represented by unions. We believe we have a positive relationship with our employees.
We believe that our success is driven by our employees. Our human capital strategy, which is developed and overseen by our COO, focuses on the health and safety of our employees, development and retention of current employees, and talent attraction. Our COO is also responsible for our diversity, equity and inclusion (“DE&I”) strategies. The CEO, CFO and COO regularly update the board of directors and its committees on the human capital management, as well as the implementation of new initiatives.
Health and Safety: Our health and safety programs are designed to address applicable regulations as well as the specific hazards and work environments of each of our facilities. We regularly conduct safety reviews at each of our locations to ensure compliance with applicable regulations and all policies and procedures. We maintain safety committees that meet regularly to discuss and address any potential issues in our warehouse and manufacturing facilities. In addition, we conduct quarterly Motor Vehicle Safety trainings and annual Motor Vehicle Records checks for those assigned to company vehicles or who are daily drivers. We utilize a number of metrics to assess the performance of our health and safety policies, procedures and initiatives, including lost workdays and any recordable or reportable incidents. Also in 2021, we continued to implement strategies to mitigate the risk of COVID-19 in the workplace.
TPB Culture Committee: We implemented a Culture Committee in 2021 as a platform to discuss and implement ideas for Turning Point Brands to be the employer of choice. The committee is comprised of diverse individuals from different departments and geographic locations. The committee’s focus is to recommend and implement best practices in the areas of health and safety, DE&I, employee engagement, talent development and retention, and community engagement.
Employee Engagement: To assess and improve employee retention and engagement, we implemented a new software system which can frequently survey our workforce and focus our efforts on maximizing employee engagement and retention. The system is configured to use text messaging, in addition to email notifications, to increase participation with our distributed workforce.
Diversity, Equity and Inclusion: We place a high value on DE&I. As of December 31, 2021, approximately 33% of our workforce was female and 24% of our employees in managerial roles were female. As of the same date, underrepresented minorities made up approximately 27% of our workforce, with 19% of our managerial roles held by underrepresented minorities.
Training and Talent Development: We provide technical and leadership training to employees at both the officer and non-officer levels. In 2020, the Company developed Turning Point University, an online training and development tool used by management and employees.
We believe that encouraging continual development for our employees is essential for us to maintain the strength and profitability of the Company, generally, and brands, specifically. The Company posts its openings internally to allow current employees to apply. In 2021, we had 20 internal promotions within the organization.
Retaining Talent: During the year ended December 31, 2021, our employee turnover rate was 16.5%. To retain our employees, we believe it is critical to continually focus on ensuring employees are highly engaged and feel valued. We address these retention efforts in a number of ways, from formal surveys and quarterly business updates, to regular informal discussions with employees that enable us to listen to, understand and address their concerns.
Employee Benefits: We offer comprehensive benefit programs to our employees that provides them with, among other things, medical, dental, and vision healthcare; 401(k) matching contributions; paid parental leave; tuition assistance; paid holidays; and paid vacation time.
Environmental, Social and Governance (“ESG”)
We believe that focusing on our consumers and customers, while proactively and productively addressing the environment, our employees, our community, and society at large, is the key to driving value for all stakeholders. We recognize that incorporating ESG into our business strategy enhances our operating principles of winning with accountability, integrity, and responsibility, and will position our company for greater success in the future. We believe that our Company will maximize its return to shareholders by implementing strategies and establishing goals to address public health, mitigating environmental risks, seeking and integrating a diverse range of viewpoints, and displaying responsible behaviors to suppliers, customers, members of the organization and most of all to its consumers.
The Company’s Board of Directors voted on March 22, 2021, to add Environmental, Social, and Governance oversight to the Nominating and Governance Committee portfolio. In recognition of the committee’s expanded role, the Nominating and Governance Committee was renamed the Nominating and ESG Committee.
The Company engaged Nasdaq Corporate Solutions (NCS) to provide a comprehensive review of the Company’s ESG program and to provide recommendations based on best practices. The results of the review were favorable and the Company is currently implementing action plans to address gaps that were identified by NCS.
Public Health
One key aspect of our ESG program, is our distinct focus on TPB’s role in public health. We market and sell products intended for adult use only, many containing nicotine. As a result, public health plays a central role in all of our product initiatives. We believe in, and work diligently to apply, harm reduction principles to all of our products, from development through distribution and marketing. Turning Point Brands’ vision is built upon the idea that adult consumers, when presented with responsibly marketed and high-quality options, will, in large part, prefer products with a lower risk profile than others. This idea of moving adult consumers down the continuum of risk is a key driver of our Company’s future for sustainable growth. We intend to accomplish this by developing low-risk alternatives according to good product stewardship and manufacturing principles in order to increase adult consumer availability of and access to high-quality products that deliver satisfaction but at a lower risk to the user. We will continue to focus our R&D, scientific, policy, and product resources to increase the number of consumers choosing products that are lower risk.
In September 2020, we submitted to the U.S. Food and Drug Administration Premarket Tobacco Applications (“PMTAs”) covering 250 products. This is an important and necessary step to allow us to offer adult consumers an extensive portfolio of products that serve as alternatives to combustible cigarettes and satisfy a wide variety of consumer preferences. The filings provide detailed scientific data that we believe demonstrates that the products are “appropriate for the protection of public health,” as required by law. Studies to support the applications were performed and included pharmacokinetics studies, a likelihood of use study, and a patterns of use study, in addition to a toxicological review. We also provided a detailed marketing plan to illustrate how it will continue to prevent youth exposure to the products. See “Risks Related to Legal, Tax and Regulatory Matters” under Item 1A “Risk Factors” of this Annual Report on Form 10-K.
Prevention of Youth Access
Our vision is a world where only adult consumers purchase and use products that are not intended for youth. As a seller of products intended for adult-use only, society demands a higher burden of responsibility from us, and we are committed to proactively preventing the underage appeal and access to those products. We are dedicated to the responsible marketing of our adult use products and are fully committed to complying with all applicable laws and regulations governing them. We target marketing activities to both male and female current nicotine, cannabinoid, and other active consumers that are 21 years of age and older. The marketing of our adult use products does not include content directed toward minors, including child-oriented images or other themes where such imagery is reasonably understood to resonate with minors. The Company plans to continue to engage in appropriately targeted marketing activity, consistent with all legal requirements, industry standards, and best practices.
Preventing youth access and use of our adult-use products is a key to our continued success. All of our adult-use products are intended to be sold to and used by adults 21 years of age and older, and we are proactive in implementing programs to prevent youth access. For TPB’s own online retail (B2C) sales, TPB utilizes a robust third-party age verification process for all online purchases by consumers. On its business-to-business (B2B) website section, TPB offers suggestions of resources for its downstream customers related to prevention of youth access. These resources include information related to retailer-focused FDA guidance, third-party age verification software available to both brick-and-mortar and online sellers, and helpful websites that offer compliance tools, e.g., WeCard.
Environmental Stewardship
Being good stewards of the planet will support our business success. We will achieve this by transitioning our fleet to lower emissions vehicles, implementing energy saving initiatives in all of our locations, using renewable energy, and investing in Renewable Energy Credits (RECs) and Verified Emissions Reductions (VERs). We are also focused on reducing our water consumption and lowering our waste streams with increased recycling efforts. Within each of these categories we will continue to define and update our metrics to measure our environmental impact based on Sustainability Accounting Standards Board (SASB), Carbon Disclosure Project (CDP), Task Force on Climate-related Financial Disclosures (TCFD), and the United Nations Sustainable Development Goals (SDGs).
Social Impact
In 2021, we continued to mobilize our internal resources during the COVID-19 crisis to ensure the continuity of supply of our products to our customers and consumers while devoting company resources to assist the community at large, including:
| | • | Implementing processes to keep our team members safe with plantwide safety and cleanliness protocols, split shifts for fulfillment personnel, isolating work units where possible, and providing work from home opportunities. |
| | • | Leveraging our IT strength and implementing videoconferencing to minimize contact and travel. |
| | • | Communicating regularly with our customers and suppliers to understand their challenges and ways to assist them. |
| | • | Providing lunches for our employees from local restaurants that were impacted by the pandemic. |
| | • | Recognizing the commitment of our employees by providing worker incentives for our team members who could not work remotely. |
Our Social program focuses on the safety of our people and the diversity of our workforce. Our goals are to provide an injury-free and diverse workforce in order to provide a winning culture and be the employer of choice. We actively monitor and train against our safety program and have safety committees dedicated to implementing best practices and improving our safe working environment. We have established meaningful measures for our Social program and our targets and actions will allow us to achieve our goals in this area.
Corporate Governance
Good corporate governance is critical to our operating principles of winning with accountability, integrity, and responsibility. Acting with accountability, integrity and responsibility is at the core of our business conduct policy. We train all employees on our business conduct policies. In addition, our Governance program measures the diversity of our Board. We believe that Board diversity is critical to having a winning culture and strategy. We have established meaningful measures for our Governance program and our targets and actions will allow us to achieve our goals in this area.
2021 Highlights
In 2021, we implemented several ESG committees to integrate ESG principles into our business practices. The committees are comprised of diverse individuals from different departments and geographic locations. The committees report to the ESG Executive Committee, comprised of the President and CEO, COO, CFO, General Counsel, and Senior Vice-President of Sustainability. The following committees were formed and are actively working:
| | • | The Public Health, Responsible Marketing, and Youth Access Prevention Committee, provides a platform to enhance our business practices in these areas. The committee is charged with recommending and implementing best practices in the areas of Public Health, Responsible Marketing, and Youth Access Prevention. |
| | • | The Environmental Committee provides a platform to enhance our environmental practices within our business units. The committee is charged with recommending and implementing best practices in the areas of carbon emissions, waste, water, and biodiversity within our business units. |
| | • | The Supplier Committee provides a platform to assure our supply chain aligns with our Environmental, Social, and Governance practices. The committee charged with recommending and implementing best practices in the areas of supplier environmental, social, and governance processes. |
| | • | The Culture Committee provides a platform to achieve the objective of being the employer of choice. The committee is charged with recommending and implementing best practices in the areas of health and safety, DE&I, Talent Development and Retention, and Community Engagement. |
| | • | The Governance Committee as a platform to assure our governance practices are best in class. The committee is charged to recommending and implementing best practices in the areas of business ethics, political engagement, and cybersecurity. |
Further information related to our ESG program can be found on our website.
Internet Address and Company SEC Filings
Our primary Internet address is www.turningpointbrands.com. The SEC maintains a website at https://www.sec.gov that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. On the investor relations portion of our website, www.turningpointbrands.com/investor-relations, we provide a link to our electronic filings with the U.S. Securities and Exchange Commission (the “SEC”), including our annual report on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K, and any amendments to these reports. We make all such filings available free of charge as soon as reasonably practicable after filing. The information found on our website is not part of this or any other report we file with or furnish to the SEC.
The risk factors summarized and detailed below could materially harm our business, operating results and/or financial condition, impair our future prospects and/or cause the price of our common stock to decline. These are not all of the risks we face and other factors not presently known to us or that we currently believe are immaterial may also affect our business if they occur. Material risks that may affect our business, operating results and financial condition include, but are not necessarily limited to, those relating to:
Risks Related to Our Business and Industry
| | • | declining sales of tobacco products, and expected continuing decline of sales, in the tobacco industry overall; |
| | • | our dependence on a small number of third-party suppliers and producers; |
| | • | the possibility that we will be unable to identify or contract with new suppliers or producers in the event of a supply or product disruption, as well as other supply chain concerns, including delays in product shipments and increases in freight cost; |
| | • | the possibility that our licenses to use certain brands or trademarks will be terminated, challenged or restricted; |
| | • | failure to maintain consumer brand recognition and loyalty of our customers; |
| | • | our reliance on relationships with several large retailers and national chains for distribution of our products; |
| | • | intense competition and our ability to compete effectively; |
| | • | competition from illicit sources and the damage caused by illicit products to our brand equity; |
| | • | contamination of our tobacco supply or products; |
| | • | uncertainty and continued evolution of the markets for our NewGen and cigar products; |
| | • | complications with the design or implementation of our new enterprise resource planning system could adversely impact our business and operations; |
Risks Related to Legal, Tax and Regulatory Matters
| | • | substantial and increasing U.S. regulation; |
| | • | regulation or marketing denials of our products by the FDA, which has broad regulatory powers; |
| | • | many of our products contain nicotine, which is considered to be a highly addictive substance; |
| | • | requirement to maintain compliance with master settlement agreement escrow account; |
| | • | possible significant increases in federal, state and local municipal tobacco- and vapor-related taxes; |
| | • | our products are subject to developing and unpredictable regulation, such as court actions that impact obligations; |
| | • | increase in state and local regulation of our NewGen products has been proposed or enacted; |
| | • | increase in tax of our NewGen products could adversely affect our business; |
| | • | sensitivity of end-customers to increased sales taxes and economic conditions including significant increases in the rate of inflation and other declines in purchasing power; |
| | • | possible increasing international control and regulation; |
| | • | failure to comply with environmental, health and safety regulations; |
| | • | imposition of significant tariffs on imports into the U.S.; |
| | • | the scientific community’s lack of information regarding the long-term health effects of certain substances contained in some of our products; |
| | • | significant product liability litigation; |
| | • | the effect of the COVID-19 pandemic on our business; |
Risks Related to Financial Results, Finances and Capital Structure
| | • | our amount of indebtedness; |
| | • | the terms of our indebtedness, which may restrict our current and future operations; |
| | • | our loss of emerging growth status on December 31, 2021 and ability to comply with the additional disclosure requirements applicable to non-emerging growth companies; |
| | • | identification a material weakness in our internal control related to ineffective information technology general controls which, if not remediated appropriately or timely, could result in loss of investor confidence and adversely impact our stock price; |
| | • | Changes in the method for determining LIBOR or the replacement of LIBOR with an alternative reference rate, may adversely affect interest expense related to outstanding debt; |
Risks Related to our Common Stock
| | • | our certificate of incorporation and bylaws, as well as Delaware law and certain regulations, could discourage or prohibit acquisition bids or merger proposals, which may adversely affect the market price of our common stock; |
| | • | our certificate of incorporation limits the ownership of our common stock by individuals and entities that are Restricted Investors. These restrictions may affect the liquidity of our common stock and may result in Restricted Investors (as defined in our Certificate of Incorporation) being required to sell or redeem their shares at a loss or relinquish their voting, dividend and distribution rights; |
| | • | future sales of our common stock in the public market could reduce our stock price, and any additional capital raised by us through the sale of equity or convertible securities may dilute your ownership in us; |
| | • | we may issue preferred stock whose terms could adversely affect the voting power or value of our common stock; |
General Risks
| | • | our business may be damaged by events outside of our or our suppliers’ control, such as the impact of epidemics (e.g., coronavirus), political upheavals, or natural disasters; |
| | • | our reliance on information technology; |
| | • | cybersecurity and privacy breaches; |
| | • | failure to manage our growth; |
| | • | failure to successfully integrate our acquisitions or otherwise be unable to benefit from pursuing acquisitions; |
| | • | fluctuations in our results; |
| | • | exchange rate fluctuations; |
| | • | adverse U.S. and global economic conditions; |
| | • | departure of key management personnel or our inability to attract and retain talent; |
| | • | infringement on or misappropriation of our intellectual property; |
| | • | third-party claims that we infringe on their intellectual property; and |
| | • | failure to meet expectations relating to environmental, social and governance factors |
Risks Related to Our Business and Industry
Sales of tobacco products are generally expected to continue to decline.
As a result of restrictions on advertising and promotions, increases in regulation and excise taxes, health concerns, a decline in the social acceptability of tobacco and tobacco-related products, increased pressure from anti-tobacco groups, and other factors, the overall U.S. market for tobacco products has generally been declining in terms of volume of sales and is expected to continue to decline. The general climate of declining sales of tobacco products is principally driven by the long-standing declines in cigarettes. OTP, on the other hand, as measured by MSAi, have continued to generate modest consumer unit volume gains. Additionally, cigarillo cigars and MYO cigar wraps have each demonstrated MSAi volume gains in recent years.
Our tobacco products comprised approximately 68% of our total 2021 net sales and, while some of our sales volume declines have been offset by higher prices or by increased sales in other product categories, there can be no assurance that these price increases or increased sales can be sustained, especially in an environment of increased regulation, product characteristic restrictions, and taxation and changes in consumer spending habits.
We depend on a small number of key third-party suppliers and producers for our products.
Our operations are largely dependent on a small number of key suppliers and producers to supply or manufacture our products pursuant to long-term contracts. In 2021, our two most important suppliers and producers were: (i) Swedish Match, which produces all of our loose leaf chewing tobacco in the U.S.; and (ii) RTI, which provides us with exclusive access to the Zig-Zag® cigarette paper and related accessories in the U.S. and Canada. See “Item 1 – Business – Distribution and Supply Agreements”
All of our loose-leaf tobacco products are manufactured for us by Swedish Match pursuant to a ten-year renewable agreement, which we entered into in 2008. The agreement will automatically be renewed for five successive ten-year terms unless either party provides at least 180 days’ notice prior to a renewal term of its intent to terminate the agreement or unless otherwise terminated in accordance with the provisions of the agreement. If a notice of non-renewal is delivered, the contract will expire two years after the date on which the agreement would have otherwise been renewed. Under this agreement, we retain the rights to all marketing, distribution and trademarks over the loose-leaf brands that we own or license. The agreement renewed for an additional ten-year term in 2018. We share responsibilities with Swedish Match related to process control, manufacturing activities, quality control, and inventory management with respect to our loose-leaf products. We rely on the performance by Swedish Match of its obligations under the agreement for the production of our loose-leaf tobacco products. Any significant disruption in Swedish Match’s manufacturing capabilities or our relationship with Swedish Match, a deterioration in Swedish Match’s financial condition, or an industry-wide change in business practices with respect to loose leaf tobacco products could have a material adverse effect on our business, results of operations, and financial condition.
All of our Zig-Zag® premium cigarette papers, cigarette tubes, and injectors are sourced from RTI, pursuant to the Distribution Agreements. In November 2020, Bolloré sold its rights to its trademarks for the Zig-Zag® brand name in the U.S. and Canada to RTI and, in connection with the sale, assigned the Distribution Agreements and the License Agreements to RTI. RTI is an affiliate of one of our competitors. The Distribution Agreements were most recently renewed in 2012 and pursuant to such agreements, we renegotiate pricing terms every five years. The Distribution Agreements were initially entered into with Bolloré, the original holder of the cigarette paper-related trademarks for the Zig-Zag® brand name.
Pursuant to agreements with certain suppliers, we have agreed to store tobacco inventory purchased on our behalf and generally maintain a 12- to 24-month supply of our various tobacco products at their facilities. We cannot guarantee our supply of these products will be adequate to meet the demands of our customers. Further, a major fire, violent weather conditions, or other disasters that affect us or any of our key suppliers or producers, including RTI or Swedish Match, as well as those of our other suppliers and vendors, could have a material adverse effect on our operations. Although we have insurance coverage for some of these events, a prolonged interruption in our operations, as well as those of our producers, suppliers, or vendors, could have a material adverse effect on our business, results of operations, and financial condition. In addition, we do not know whether we will be able to renew any or all of our agreements on a timely basis, on terms satisfactory to us, or at all.
Any disruptions in our relationships with RTI or Swedish Match or any other significant supplier, a failure to renew any of our agreements, an inability or unwillingness by any supplier to produce sufficient quantities of our products in a timely manner or finding a new supplier would have a significant impact on our ability to continue distributing the same volume and quality of products and maintain our market share, even during a temporary disruption, which could have a material adverse effect on our business, results of operations and financial condition.
We may be unable to identify or contract with new suppliers or producers in the event of a disruption to our supply of products.
In order to continue selling our products in the event of a disruption to our supply, we would have to identify new suppliers or producers that would be required to satisfy significant regulatory requirements. Only a limited number of suppliers or producers (if any) may have the ability to produce our products at the volumes we need, and it could be costly or time-consuming to locate and approve such alternative sources. Moreover, it may be difficult or costly to find suppliers to produce small volumes of our new products in the event we are looking only to supplement current supply as suppliers may impose minimum order requirements. In addition, we may be unable to negotiate pricing or other terms with our existing or new suppliers as favorable as those we currently enjoy. Even if we were able to successfully identify new suppliers and contract with them on favorable terms, these new suppliers would also be subject to stringent regulatory approval procedures that could result in prolonged disruptions to our sourcing and distribution processes.
Furthermore, there is no guarantee that a new third-party supplier could accurately replicate the production process and taste profile of our existing products. We cannot guarantee that a failure to adequately replace our existing suppliers would not have a material adverse effect on our business, results of operations, and financial condition.
Our licenses to use certain brands and trademarks may be terminated or not renewed.
We are reliant upon brand recognition in the OTP markets in which we compete as the OTP industry is characterized by a high degree of brand loyalty and a reluctance to switch to new or unrecognizable brands on the part of consumers. Some of the brands and trademarks under which our products are sold are licensed to us for a fixed period of time in respect of specified markets, such as our Distribution and License Agreements for use of the Zig-Zag® name and associated trademarks in connection with certain of our cigarette papers and related products.
We have a number of Licensing Agreements with RTI. The first of these governs licensing, sourcing and the use of the Zig-Zag® name with respect to cigarette papers, cigarette tubes, and cigarette injector machines, the second of which governs licensing, sourcing and the use of the Zig-Zag® name with respect to e-cigarettes, vaporizers, and e-liquids, and the third of which governs the licensing, sourcing and use of the Zig-Zag trademark on paper cones. In 2021, we generated approximately $163 million in net sales of Zig-Zag® products, of which approximately $79 million was generated from products sold through the License Agreements. In the event that one or more of these Licensing Agreements are not renewed, the terms of the agreements bind us under a five-year non-compete clause, under which we cannot engage in direct or indirect manufacturing, selling, distributing or otherwise promoting of cigarette papers of a competitor to Zig-Zag® without RTI’s consent, except in limited instances. We do not know whether we will renew these agreements on a timely basis, on terms satisfactory to us, or at all. As a result of these restrictions, if our licensing agreements with respect to the Zig-Zag® trademark are terminated, we may not be able to access the markets with recognizable brands that would be positioned to compete in these segments.
In the event that the licenses to use the brands and trademarks in our portfolio are terminated or are not renewed after the end of the term, there is no guarantee we will be able to find a suitable replacement, or if a replacement is found, that it will be on favorable terms. Any loss in our brand-name appeal to our existing customers as a result of the lapse or termination of our licenses could have a material adverse effect on our business, results of operations, and financial condition.
We may not be successful in maintaining the consumer brand recognition and loyalty of our products.
We compete in a market that relies on innovation and the ability to react to evolving consumer preferences. The alternative smoking accessories and tobacco industries in general, and the OTP industry, in particular, are subject to changing consumer trends, demands, and preferences. Therefore, products once favored may over time become disfavored by consumers or no longer perceived as the best option. Consumers in the OTP market have demonstrated a high degree of brand loyalty, but producers must continue to adapt their products in order to maintain their status among these customers as the market evolves. The Zig-Zag® brand has strong brand recognition among smokers, and our continued success depends in part on our ability to continue to differentiate the brand names that we own or license and maintain similarly high levels of recognition with target consumers. Trends within the alternative smoking accessories and OTP industries change often. Our failure to anticipate, identify, or react to changes in these trends could, among other things, lead to reduced demand for our products. Factors that may affect consumer perception of our products include health trends and attention to health concerns associated with tobacco, price-sensitivity in the presence of competitors’ products or substitute products, and trends in favor of new NewGen products that are currently being researched and produced by participants in our industry. For example, in recent years, we have witnessed a shift in consumer purchases from chewing tobacco to moist snuff due to its increased affordability. Along with our biggest competitors in the chewing tobacco market, which also produce moist snuff, we have been able to shift priorities and adapt to this change. A failure to react to similar trends in the future could enable our competitors to grow or establish their brands’ market shares in these categories before we have a chance to respond.
Consumer perceptions of tobacco-based products are likely to continue to shift, and our success depends, in part, on our ability to anticipate these shifting tastes and the rapidity with which the markets in which we compete will evolve in response to these changes on a timely and affordable basis. If we are unable to respond effectively and efficiently to changing consumer preferences, the demand for our products may decline, which could have a material adverse effect on our business, results of operations, and financial condition.
Regulations may be enacted in the future, particularly in light of increasing restrictions on the form and content of marketing of tobacco products, that would make it more difficult to appeal to our consumers or to leverage existing recognition of the brands that we own or license. Furthermore, even if we are able to continue to distinguish our products, there can be no assurance that the sales, marketing, and distribution efforts of our competitors will not be successful in persuading consumers of our products to switch to their products. Many of our competitors have greater access to resources than we do, which better positions them to conduct market research in relation to branding strategies or costly marketing campaigns. Any loss of consumer brand loyalty to our products or reduction of our ability to effectively brand our products in a recognizable way will have a material effect on our ability to continue to sell our products and maintain our market share, which could have a material adverse effect on our business, results of operations, and financial condition.
Our distribution efforts rely in part on our ability to leverage relationships with large retailers and national chains.
Our distribution efforts rely in part on our ability to leverage relationships with large retailers and national chains to sell and promote our products, which is dependent upon the strength of the brand names that we own or license and our salesforce effectiveness. In order to maintain these relationships, we must continue to supply products that will bring steady business to these retailers and national chains. We may not be able to sustain these relationships or establish other relationships with such entities, which could have a material adverse effect on our ability to execute our branding strategies, our ability to access the end-user markets with our products or our ability to maintain our relationships with the producers of our products. For example, if we are unable to meet benchmarking provisions in contracts or if we are unable to maintain and leverage our retail relationships on a scale sufficient to make us an attractive distributor, it would have a material adverse effect on our ability to source products, and on our business, results of operations and financial condition. In addition, there are factors beyond our control that may prevent us from leveraging existing relationships, such as industry consolidation. If we are unable to develop and sustain relationships with large retailers and national chains, or we are unable to leverage those relationships due to factors such as a decline in the role of brick-and-mortar retailers in North America, our capacity to maintain and grow brand and product recognition and increase sales volume will be significantly undermined. In such an event, we may ultimately be forced to pursue and rely on local and more fragmented sales channels, which will have a material adverse effect on our business, results of operations and financial condition.
We face intense competition and may fail to compete effectively.
We are subject to significant competition across our segments and compete against companies in all segments that have access to significant resources in terms of technology, relationships with suppliers and distributors and access to cash flow and financial markets.
The OTP industry is characterized by brand recognition and loyalty, with product quality, price, marketing and packaging constituting the primary methods of competition. Substantial marketing support, merchandising display, competitive pricing and other financial incentives generally are required to introduce a new brand or to improve or maintain a brand’s market position. Our principal competitors are “big tobacco,” Altria Group, Inc. (formerly Phillip Morris) and British American Tobacco p.l.c. (formerly Reynolds) as well as Swedish Match, Swisher International and manufacturers of electronic cigarettes, including U.K.-based Imperial Brands PLC. These competitors are significantly larger than us and aggressively seek to limit the distribution or sale of other companies’ products, both at the wholesale and retail levels. For example, certain competitors have entered into agreements limiting retail-merchandising displays of other companies’ products or imposing minimum prices for OTP products, thereby limiting their competitors’ ability to offer discounted products. In addition, the tobacco industry is experiencing a trend toward industry consolidation, most recently evidenced by the December 2018 investment in Juul Labs by Altria, the July 2017 acquisition of Reynolds American, Inc., by British American Tobacco p.l.c., and the June 2015 acquisition of Lorillard, Inc., by Reynolds American, Inc. Additional industry consolidation could result in a more competitive environment if our competitors are able to increase their combined resources, enhance their access to national distribution networks, or become acquired by established companies with greater resources than ours. Any inability to compete due to our smaller scale as the industry continues to consolidate and be dominated by “big tobacco” could have a material adverse effect on our business, results of operations and financial condition.
“Big tobacco” has also established its presence in the NewGen products market and has begun to make investments in the alternative space. There can be no assurance that our products will be able to compete successfully against these companies or any of our other competitors, some of which have far greater resources, capital, experience, market penetration, sales and distribution channels than us. In addition, there are currently relatively few U.S. restrictions on advertising electronic cigarettes and vaporizer products and competitors, including “big tobacco,” may have more resources than us for advertising expenses, which could have a material adverse effect on our ability to build and maintain market share, and thus have a material adverse effect on our business, results of operations and financial condition.
The competitive environment and our competitive position are also significantly influenced by economic conditions, the state of consumer confidence, competitors’ introduction of low-priced products or innovative products, higher taxes, higher absolute prices and larger gaps between price categories and product regulation that diminishes the consumer’s ability to differentiate tobacco products. Due to the impact of these factors, as well as higher state and local excise taxes and the market share of deep discount brands, the tobacco industry has become increasingly price competitive. As we seek to adapt to the price competitive environment, our competitors that are better capitalized may be able to sustain price discounts for long periods of time by spreading the loss across their expansive portfolios, with which we are not positioned to compete.
Competition from illicit sources may have an adverse effect on our overall sales volume, restricting the ability to increase selling prices and damaging brand equity.
Illicit trade and tobacco trafficking in the form of counterfeit products, smuggled genuine products and locally manufactured products on which applicable taxes or regulatory requirements are evaded, represent a significant and growing threat to the legitimate tobacco industry. Factors such as increasing tax regimes, regulatory restrictions, and compliance requirements have resulted in more consumers switching to illegal, cheaper tobacco products and providing greater rewards for smugglers. We expect that this trend will continue and even accelerate if additional regulatory requirements make it more difficult or expensive to obtain genuine products. Illicit trade can have an adverse effect on our overall sales volume, restrict the ability to increase selling prices, damage brand equity and may lead to commoditization of our products.
Although we combat counterfeiting of our products by engaging in certain tactics, such as requiring all sales force personnel to randomly collect our products from retailers in order to be reviewed for authenticity and using a private investigation firm to help perform surveillance of retailers we suspect are selling counterfeit products, no assurance can be given that we will be able to detect or stop sales of all counterfeit products. In addition, we have in the past and will continue to bring suits against retailers and distributors that sell certain counterfeit products. While we have been successful in securing financial recoveries from and helping to obtain criminal convictions of counterfeiters in the past, no assurance can be given that we will be successful in any such suits or that such suits will be successful in stopping other retailers or distributors from selling counterfeit products. Even if we are successful, such suits could consume a significant amount of management’s time and could also result in significant expenses to the company. Any failure to track and prevent counterfeiting of our products could have a material adverse on our ability to maintain or effectively compete for the products we distribute under our brand names, which would have a material adverse effect on our business, results of operations and financial condition.
Contamination of, or damage to, our products could adversely impact sales volume, market share and profitability.
Our market position may be affected through the contamination of our tobacco supply or products during the manufacturing process or at different points in the entire supply chain. We keep significant amounts of inventory of our products in warehouses and it is possible that this inventory could become contaminated during the storage period. In addition, our suppliers generally keep significant amounts of our inventory on hand and it is probable that such inventory could become contaminated even prior to arrival at our premises. If contamination of our inventory or packaged products occurs, whether as a result of a failure in quality control by us or by one of our suppliers, we may incur significant costs in replacing the inventory and recalling products. We may be unable to meet customer demand and may lose customers who purchase alternative brands or products. In addition, consumers may lose confidence in the affected product.
Under the terms of our contracts, we impose requirements on our major suppliers to maintain quality and comply with product specifications and requirements, and on our third-party co-manufacturer to comply with all federal, state and local laws. These third-party suppliers, however, may not continue to produce products that are consistent with our standards or that are in compliance with applicable laws, and we cannot guarantee that we will be able to identify instances in which our third-party suppliers fail to comply with our standards or applicable laws.
A loss of sales volume from a contamination event may also affect our ability to supply our current customers and, in turn, recapture their business in the event they are forced to switch products or brands, even if on a temporary basis. We may also be subject to legal action as a result of a contamination, which could result in negative publicity and affect our sales. During this time, our competitors may benefit from an increased market share that could be difficult and costly to regain. Such a contamination event could have a material adverse effect on our business, results of operations and financial condition.
The market for NewGen products is subject to a great deal of uncertainty and is still evolving.
Vaporizer products and electronic cigarettes, having recently been introduced to market over the past ten years, are at a relatively early stage of development, and represent core components of a market that is evolving rapidly, highly regulated and characterized by a number of market participants. Rapid growth in the use of, and interest in, vaporizer products and electronic cigarettes is recent, and may not continue on a lasting basis. The demand and market acceptance for these products is subject to a high level of uncertainty. Therefore, we are subject to all of the business risks associated with a new enterprise in an evolving market. Continued evolution, uncertainty and the resulting increased risk of failure of our new and existing product offerings in this market could have a material adverse effect on our ability to build and maintain market share and on our business, results of operations and financial condition. Further, there can be no assurance that we will be able to continue to effectively compete in the NewGen products marketplace.
Complications with the design or implementation of our new enterprise resource planning system could adversely impact our business and operations.
We rely extensively on information systems and technology to manage our business and summarize operating results. We are beginning to engage in what we expect will be a multi-year implementation of a new enterprise resource planning (“ERP”) system. This ERP system will replace our existing operating and financial systems. The ERP system is designed to accurately maintain the Company’s financial records, enhance operational functionality and provide timely information to the Company’s management team related to the operation of the business. The ERP system implementation process will require the investment of significant personnel and financial resources. We may not be able to successfully implement the ERP without experiencing delays, increased costs and other difficulties. If we are unable to successfully design and implement the new ERP system as planned, or successfully update or integrate our systems when necessary, our financial positions, results of operations and cash flows could be negatively impacted.
Risks Related to Legal, Tax and Regulatory Matters
We are subject to substantial and increasing regulation.
The tobacco industry has been under public scrutiny for over 50 years. Industry critics include special interest groups, the U.S. Surgeon General, and many legislators and regulators at the local, state and federal levels. A wide variety of federal, state, and local laws limit the advertising, sale, and use of tobacco, and these laws have proliferated in recent years. For instance, on April 29, 2021, the FDA announced plans to propose two tobacco products standards related to combusted tobacco products: (1) a ban on menthol as a characterizing flavor of cigarettes; and (2) a ban on all characterizing flavors (including menthol) in cigars. Together with changing public attitudes towards tobacco consumption, the constant expansion of regulations has been a major cause of the overall decline in the consumption of tobacco products since the early 1970s. These regulations relate to, among other things, the importation of tobacco products and shipping throughout the U.S. market, increases in the minimum age to purchase tobacco products, imposition of taxes, sampling and advertising bans or restrictions, flavor bans or restrictions, ingredient and constituent disclosure requirements, and media campaigns and restrictions on where consumers may use tobacco products. Additional restrictions may be legislatively imposed or agreed to in the future. These limitations may make it difficult for us to maintain the value of any brand.
Moreover, the current trend is toward increasing regulation of the tobacco industry, which is likely to differ between the various U.S. states and Canadian provinces in which we currently conduct the majority of our business. Extensive and inconsistent regulation by multiple states and at different governmental levels could prove to be particularly disruptive to our business as we may be unable to accommodate such regulations in a cost-effective manner that allows us to continue to compete in an economically viable way. Regulations are often introduced without the tobacco industry’s input and have been a significant reason behind reduced industry sales volumes and increased illicit trade.
In 1986, federal legislation was enacted regulating smokeless tobacco products (including dry and moist snuff and chewing tobacco) by, among other things, requiring health warnings on smokeless tobacco packages and prohibiting the advertising of smokeless tobacco products on media subject to the jurisdiction of the Federal Communications Commission (“FCC”). Since 1986, other proposals have been made at the federal, state, and local levels for additional regulation of tobacco products. It is likely that additional proposals will be made in the coming years. For example, the Prevent All Cigarette Trafficking Act (“PACT Act”) initially prohibited the use of the U.S. Postal Service to mail cigarette and smokeless tobacco products and also amended the Jenkins Act, which established cigarette sales reporting requirements for state excise tax collection, to require individuals and businesses that make interstate sales of certain cigarette or smokeless tobacco comply with state tax laws. The PACT Act was recently extended to also cover e-cigarette and related products. The extension of the PACT Act has resulted in increased costs and disruption to our NewGen business, and those costs may continue to rise if we are unable to adjust our operations to respond relative to our competitors. See “—Many of our NewGen and cigar products have not obtained premarket authorization from the FDA and are currently marketed pursuant to a policy of FDA enforcement discretion, which could change. There could be a material adverse impact on our NewGen business development efforts if the FDA determines that our products are not subject to this compliance policy, or if our products become subject to increased regulatory compliance burdens imposed by the FDA and other regulatory or legislative bodies.” for further details. Additional federal or state regulation relating to the manufacture, sale, distribution, advertising, labeling, mandatory ingredients disclosure and nicotine yield information disclosure of tobacco products could reduce sales, increase costs, and have a material adverse effect on our business, results of operations, and financial condition.
On June 22, 2009, the Family Smoking Prevention and Tobacco Control Act (the “Tobacco Control Act”) granted the FDA regulatory authority over tobacco products. The Act also amended the Federal Cigarette Labeling and Advertising Act, which governs how cigarettes can be advertised and marketed, as well as the Comprehensive Smokeless Tobacco Health Education Act (“CSTHEA”), which governs how smokeless tobacco can be advertised and marketed. In addition to the FDA and FCC, we are subject to regulation by numerous other federal agencies, including the Federal Trade Commission (“FTC”), the Department of Justice (“DOJ”), the Alcohol and Tobacco Tax and Trade Bureau (“TTB”), the U.S. Environmental Protection Agency (“EPA”), the U.S. Department of Agriculture (“USDA”), the Consumer Product Safety Commission (“CPSC”), the U.S. Customs and Border Protection (“CBP”) and the U.S. Center for Disease Control and Prevention’s (“CDC”) Office on Smoking and Health. There have also been adverse legislative and political decisions and other unfavorable developments concerning cigarette smoking and the tobacco industry, which we believe have received widespread public attention. The FDA has, and other governmental entities have, expressed concerns about the use of flavors in tobacco products and an interest in significant regulation of such use, up to and including bans in certain products. There can be no assurance as to the ultimate content, timing or effect of any regulation of tobacco products by governmental bodies, nor can there be any assurance that potential corresponding declines in demand resulting from negative media attention would not have a material adverse effect on our business, results of operations and financial condition. Any such regulation has the potential to increase costs and have a material adverse effect on our business, results of operations, ability to compete, and financial condition.
Our products are regulated by the FDA, which has broad regulatory powers.
The vast majority of our 2021 U.S. net sales are derived from the sale of products that are currently regulated by the FDA. The Tobacco Control Act grants the FDA broad regulatory authority over the design, manufacture, sale, marketing and packaging of tobacco products. Among the regulatory powers conferred to the FDA under the Tobacco Control Act is the authority to impose tobacco product standards that are appropriate for the protection of the public health, require manufacturers to obtain FDA review and authorization for the marketing of certain new or modified tobacco products and impose various additional restrictions. Such restrictions may include requiring reduction or elimination of the use of particular constituents or components, requiring product testing, or addressing other aspects of tobacco product construction, constituents, properties or labeling.
Specifically, the Tobacco Control Act (i) increases the number of health warnings required on cigarette and smokeless tobacco products, increases the size of warnings on packaging and in advertising, requires the FDA to develop graphic warnings for cigarette packages, and grants the FDA authority to require new warnings, (ii) imposes restrictions on the sale and distribution of tobacco products, including significant restrictions on tobacco product advertising and promotion as well as the use of brand and trade names, (iii) bans the use of “light,” “mild,” “low” or similar descriptors on tobacco products, (iv) bans the use of “characterizing flavors” in cigarettes other than tobacco or menthol, (v) requires manufacturers to report ingredients and harmful constituents and requires the FDA to disclose certain constituent information to the public, (vi) authorizes the FDA to require the reduction of nicotine and the potential reduction or elimination of other constituents or additives, including menthol, (vii) establishes resource-intensive pre-market and “substantial equivalence” review pathways for tobacco products that are considered new, (viii) gives the FDA broad authority to deny product applications thereby preventing the sale or distribution of the product subject to the application (and requiring such product to be removed from the market, if applicable), and (ix) requires tobacco product manufacturers (and certain other entities) to register with the FDA.
The FDA charges user fees based on the USDA unit calculations pro-rated to the annualized FDA congressionally allocated budget. These fees only apply to certain products currently regulated by the FDA, which include our core products (other than cigarette paper products), but we may in the future be required to pay such fees on more of our products, and we cannot accurately predict which additional products may be subject to such fees or the magnitude of such fees, which could become significant.
Although the Tobacco Control Act prohibits the FDA from issuing regulations banning all cigarettes, all smokeless tobacco products, all little cigars, all cigars other than little cigars, all pipe tobacco, or all roll-your-own tobacco, or requiring the reduction of nicotine yields of a tobacco product to zero, it is likely that regulations with the FDA promulgated pursuant to the Tobacco Control Act could nonetheless result in a decrease in sales of these products in the U.S. We believe that such regulation could adversely affect our ability to compete against our larger competitors, who may be able to more quickly and cost-effectively comply with these new rules and regulations. Our ability to gain efficient and timely market clearance for new tobacco products, or even to keep existing products on the market, could also be affected by FDA rules, regulations and enforcement policies. Some of our currently marketed products that are subject to FDA regulation will require marketing authorizations from the FDA for us to continue marketing them (e.g., pre-market or substantial equivalence marketing authorizations, as applicable to the product), which we cannot guarantee we will be able to obtain. In addition, failure to comply with new or existing tobacco laws under which the FDA imposes regulatory requirements could result in significant financial penalties and government investigations of us. To the extent we are unable to respond to, or comply with, new FDA regulations it could have a material adverse effect on our business, results of operations and financial condition.
Many of our products contain nicotine, which is considered to be a highly addictive substance.
Many of our products contain nicotine, a chemical that is considered to be highly addictive. The Tobacco Control Act empowers the FDA to regulate the amount of nicotine found in tobacco products, but not to require the reduction of nicotine yields of a tobacco product to zero. Any FDA regulation, whether of nicotine levels or other product attributes, may require us to reformulate, recall and/or discontinue certain of the products we may sell from time to time, which may have a material adverse effect on our ability to market our products and have a material adverse effect on our business, results of operations and financial condition.
We are required to maintain cash amounts within an escrow account in order to be compliant with a settlement agreement between us and certain U.S. states and territories.
In November 1998, the major U.S. cigarette manufacturers entered into the Master Settlement Agreement (“MSA”) and the Smokeless Tobacco Master Settlement Agreement (“STMSA”) with 46 U.S. states and certain U.S. territories and possessions. Pursuant to the MSA and subsequent states’ statutes, a “cigarette manufacturer” (which is defined to also include a manufacturer of RYO/MYO cigarette tobacco) has the option of either becoming a signatory to the MSA, or, as we have elected, operating as a non-participating manufacturer (“NPM”) by funding and maintaining an escrow account, with sub-accounts on behalf of each settling state. These NPM escrow accounts are governed by states’ escrow and complementary statutes that are generally monitored by the Office of the State Attorney General. The statutes require NPM companies to deposit, on an annual basis, into qualified banks’ escrow funds based on the number of cigarettes or cigarette equivalents, which is measured by pounds of RYO/MYO tobacco sold. NPM companies are, within specified limits, entitled to direct the investment of the escrowed funds and withdraw any interest or appreciation, but cannot withdraw the principal for twenty-five years from the year of each annual deposit, except to withdraw funds deposited pursuant to an individual state’s escrow statute to pay a final judgment to that state’s plaintiffs in the event of such a final judgment. The investment vehicles available to us are specified in the state escrow agreements and are limited to low-risk government securities.
Various states have enacted or proposed complementary legislation intended to curb the activity of certain manufacturers and importers of cigarettes or MYO tobacco that are selling into MSA states without signing the MSA or who have failed to properly establish and fund a qualifying escrow account. We believe we have been fully compliant with all applicable laws, regulations, and statutes, although compliance-related issues may, from time to time, be disruptive to our business, any of which could have a material adverse effect on our business, results of operations, and financial condition.
Although no such legislation has been proposed or enacted, future changes to the MSA, such as legislation that extends the MSA to products to which it does not currently apply or legislation that limits the ability of companies to receive unused escrow funds after 25 years, may have a material adverse effect on our business, results of operations and financial condition. Despite the amounts maintained and funded to the escrow account, compliance with the funding requirements for the escrow account does not necessarily prevent future federal and/or state regulations with respect to the OTP industry from having a material adverse effect on our business, results of operations and financial condition.
Increases in tobacco-related taxes have been proposed or enacted and are likely to continue to be proposed or enacted in numerous jurisdictions.
Tobacco products, premium cigarette papers and tubes have long been subject to substantial federal, state and local excise taxes. Such taxes have frequently been increased or proposed to be increased, in some cases significantly, to fund various legislative initiatives or further disincentivize tobacco usage. Since 1986, smokeless products have been subject to federal excise tax. Federally, smokeless products are taxed by weight (in pounds or fractional parts thereof) manufactured or imported.
Since the State Children’s Health Insurance Program (“S-CHIP”) reauthorization in early 2009, which utilizes, among other things, taxes on tobacco products to fund health insurance coverage for children, the federal excise tax increases adopted have been substantial and have materially reduced sales in the “roll your own” (“RYO”) /MYO cigarette smoking products market, and also caused volume declines in other markets. Although the RYO/MYO cigarette smoking tobacco and related products market had been one of the fastest growing markets in the tobacco industry in the five years prior to 2009, the reauthorization of S-CHIP increased the federal excise tax on RYO tobacco from $1.10 to $24.78 per pound, and materially reduced the MYO cigarette smoking tobacco market in the U.S. There have not been any increases announced since 2009, but we cannot guarantee that we will not be subject to further increases, nor whether any such increases will affect prices in a way that further deters consumers from purchasing our products and/or affects our net revenues in a way that renders us unable to compete effectively.
In addition to federal excise taxes, every state and certain city and county governments have imposed substantial excise taxes on sales of tobacco products, and many have raised or proposed to raise excise taxes in recent years. Approximately one-half of the states tax MST on a weight-based versus ad valorem system of taxation. Additional states may consider adopting such revised tax structures as well. Tax increases, depending on their parameters, may result in consumers switching between tobacco products or depress overall tobacco consumption, which is likely to result in declines in overall sales volumes.
Any future enactment of increases in federal or state excise taxes on our tobacco products or rulings that certain of our products should be categorized differently for excise tax purposes could adversely affect demand for our products and may result in consumers switching between tobacco products or a depression in overall tobacco consumption, which would have a material adverse effect on our business, results of operations and financial condition.
Many of our NewGen and cigar products have not obtained premarket authorization from the FDA and are currently marketed pursuant to a policy of FDA enforcement discretion, which could change. There could be a material adverse impact on our NewGen business development efforts if the FDA determines that our products are not subject to this compliance policy, of if our products become subject to increased regulatory compliance burdens imposed by the FDA and other regulatory or legislative bodies.
Since their introduction, there has been significant uncertainty regarding whether, how and when tobacco regulations would apply to NewGen products, such as electronic cigarettes or other vaporizer products. Based on a decision in December 2010 by the U.S. Court of Appeals for the D.C. Circuit (the “Sottera decision”), the FDA is permitted to regulate electronic cigarettes containing tobacco-derived nicotine as “tobacco products” under the Tobacco Control Act.
Effective August 8, 2016, FDA’s regulatory authority under the Tobacco Control Act was extended to all remaining tobacco products, including: (i) certain NewGen products (such as electronic cigarettes, vaporizers and e-liquids) and their components or parts (such as tanks, coils and batteries); (ii) cigars and their components or parts (such as cigar tobacco); (iii) pipe tobacco; (iv) hookah products; or (v) any other tobacco product “newly deemed” by FDA. These deeming regulations apply to all products made or derived from tobacco intended for human consumption, but excluding accessories of tobacco products (such as lighters).
The deeming regulations require us to (i) register with the FDA and report product and ingredient listings; (ii) market newly deemed products only after FDA review and approval; (iii) only make direct and implied claims of reduced risk if the FDA approves after finding that scientific evidence supports the claim and that marketing the product will benefit public health as a whole; (iv) refrain from distributing free samples; (v) implement minimum age and identification restrictions to prevent sales to individuals under age 18; (vi) develop an approved warning plan and include prescribed health warnings on packaging and advertisements; and (vii) refrain from selling the products in vending machines, unless the machine is located in a facility that never admits youth. Newly deemed tobacco products are also subject to the other requirements of the Tobacco Control Act, such as that they not be adulterated or misbranded. The FDA could in the future promulgate good manufacturing practice regulations for these and our other products, and indeed has indicated it intends to do so, which could have a material adverse impact on our ability and the cost to manufacture our products.
Marketing authorizations will be necessary in order for us to continue our distribution of certain of our NewGen and cigar products. The FDA has announced various compliance policies whereby it does not intend to prioritize enforcement for lack of premarket authorization against newly-deemed products, provided that such tobacco products were marketed as of August 8, 2016; are not marketed in certain manners likely to be attractive to youth; and for which premarket applications were timely submitted. As a result of recent litigation and subsequent FDA Guidance, marketing applications for newly-deemed products were required to have been submitted no later than September 9, 2020, with the exception of our “grandfathered” products (products in commerce as of February 15, 2007) which are already authorized. Under the FDA’s compliance policy, such products could remain on the market until September 9, 2021, unless the FDA makes an adverse determination prior to that date. Subsequent to September 9, 2021, the FDA indicated its enforcement priority is those applicants who have received negative action on their application, such as a Marketing Denial Order (“MDO”) or Refuse to File notification and who continue to illegally sell those unauthorized products, as well as products for which manufacturers failed to submit a marketing application.
In September 2020, we submitted applications on a timely basis for the appropriate authorizations for our products that are deemed products not otherwise grandfathered. We believe that these products satisfy the criteria for current marketing pursuant to the FDA’s compliance policy. However, there can be no guarantee that the FDA will agree, and the FDA may bring an enforcement action against our products for lack of premarket authorization and/or deny our premarket applications. We have no assurances that the outcome of such application review processes will result in our products receiving marketing authorizations from the FDA. For instance, on September 14, 2021, the FDA issued a marketing denial order (“MDO”) for certain of the Company’s proprietary e-liquid products subject of these PMTAs. The Company filed a Petition for Review in the Sixth Circuit Court of Appeals on September 23, 2021, followed by an Emergency Motion for a Stay Pending Review on September 30, 2021. On October 7, 2021, we were informed that the FDA had rescinded its September 14, 2021, MDO. We therefore withdrew both the Petition and Emergency Stay on October 8, 2021. The Rescission Letter indicated that the FDA had found additional relevant information that was not adequately assessed. If the FDA were to issue additional MDOs that remained in effect it could have an adverse impact on our business.
We also have certain previously regulated tobacco products which FDA removed from review but remain subject to “provisional” substantial equivalence submissions made on March 22, 2011; however, FDA has the discretion to reinitiate review of these products. If the FDA establishes regulatory processes that we are unable or unwilling to comply with, our business, results of operations, financial condition and prospects could be adversely affected.
The anticipated costs of complying with future FDA regulations will be dependent on the rules issued by the FDA, the timing and clarity of any new rules or guidance documents accompanying these rules, the reliability and simplicity (or complexity) of the electronic systems utilized by FDA for information and reports to be submitted, and the details required by FDA for such information and reports with respect to each regulated product. Failure to comply with existing or new FDA regulatory requirements could result in significant financial penalties and could have a material adverse effect on our business, results of operations, financial condition and ability to market and sell our products. Compliance and related costs could be substantial and could significantly increase the costs of operating in our NewGen and cigar product markets.
In addition, failure to comply with the Tobacco Control Act and with FDA regulatory requirements could result in litigation, criminal convictions or significant financial penalties and could impair our ability to market and sell certain of our NewGen and cigar products. At present, we are not able to predict whether the Tobacco Control Act will impact our products to a greater degree than competitors in the industry, thus affecting our competitive position.
Furthermore, in addition to the FDA, there are restrictions being proposed or in effect at the federal, state, and local level related to NewGen products. For example, the PACT Act has now been amended to apply to certain NewGen products, which has impacts at the federal and state levels. These requirements are in addition to any increased regulation of internet sales that may be in effect or passed legislatively at the federal, state, or local levels, or promulgated via rulemaking by a government agency. Additionally, state attorneys general have monitored, and in some cases, have issued investigative requests and/or initiated litigation with regard to companies that sell these products related to online sales, marketing practices, and other aspects of the NewGen business. Increased regulation of additives in tobacco products through federal, state, or local governments may also adversely affect NewGen and cigar products. The application of these types of restrictions, and of any new laws or regulations which may be adopted in the future, to these products could result in additional expenses and require us to change our advertising and labeling, and methods of marketing and distribution of our products, any of which could have a material adverse effect on our business, results of operations and financial condition.
Some products we sell are subject to developing and unpredictable regulation.
Some of the products sold through our NewGen distribution vehicles may be subject to uncertain and evolving federal, state and local regulations concerning hemp, CBD and other non-tobacco consumable products, such as synthetically-derived nicotine, which recently became subject of legislation that would require premarket application filings similar to those required for products currently regulated under the Tobacco Control Act and potentially negatively impact sales of these products in the near future. See “Many of our NewGen and cigar products have not obtained premarket authorization from the FDA and are currently marketed pursuant to a policy of FDA enforcement discretion, which could change. There could be a material adverse impact on our NewGen business development efforts if the FDA determines that our products are not subject to this compliance policy, of if our products become subject to increased regulatory compliance burdens imposed by the FDA and other regulatory or legislative bodies.” Regulatory and related enforcement initiatives by authorities related to such products are unpredictable and impossible to anticipate. We anticipate that all levels of government, that have not already done so, are likely to seek in some way to regulate these products, but the type, timing, and impact of such regulations remains uncertain. These regulations include or could include restrictions prohibiting certain form factors, such as smokable hemp products, or age restrictions. Accordingly, we cannot give any assurance that such actions would not have a material adverse effect on this emerging business and our NewGen strategy.
For instance, on October 21, 2021, the USPS published a Final Rule entitled “Treatment of E-Cigarettes in the Mail,” which followed its earlier publication of the Proposed Rule on February 19, 2021. This Final Rule was required as a result of the inclusion of Preventing Online Sales of E-Cigarettes to Children (“POSECA”) in the Further Consolidated Appropriations Act, 2021. POSECA, among other things, expanded the definition of “cigarettes” in the Jenkins Act and PACT Act to expressly capture electronic nicotine delivery systems (“ENDS”). Consistent with the Proposed Rule, the Final Rule extends the existing prohibition on and exceptions to the mailing of “cigarettes” via USPS to include ENDS products, other than the Consumer Testing and Public Health exceptions. POSECA’s definition of ENDS also captures non-tobacco products, such as e-liquids that do not contain tobacco-derived nicotine.
Significant increases in state and local regulation of our NewGen products have been proposed or enacted and are likely to continue to be proposed or enacted in numerous jurisdictions.
There has been increasing activity on the state and local levels with respect to scrutiny of NewGen products. State and local governmental bodies across the U.S. have indicated NewGen products may become subject to new laws and regulations at the state and local levels. Further, some states and cities, have enacted regulations that require obtaining a tobacco retail license in order to sell electronic cigarettes and vaporizer products. If one or more states from which we generate or anticipate generating significant sales of NewGen products bring actions to prevent us from selling our NewGen products unless we obtain certain licenses, approvals or permits, and if we are not able to obtain the necessary licenses, approvals or permits for financial reasons or otherwise and/or any such license, approval or permit is determined to be overly burdensome to us, then we may be required to cease sales and distribution of our products to those states, which could have a material adverse effect on our business, results of operations and financial condition.
Certain states and cities have already restricted the use of electronic cigarettes and vaporizer products in smoke-free venues, imposed excise taxes, or limited sales of flavored NewGen products. Additional city, state or federal regulators, municipalities, local governments and private industry may enact additional rules and regulations restricting electronic cigarettes and vaporizer products. Because of these restrictions, our customers may reduce or otherwise cease using our NewGen products, which could have a material adverse effect on our business, results of operations and financial condition.
Canada and some Canadian provinces have restricted or are contemplating restrictions on the sales and marketing of electronic cigarettes. Furthermore, some Canadian provinces have limited the use of electronic cigarettes and vaporizer products in public places. These measures, and any future measures taken to limit the marketing, sale and use of NewGen products may have a material adverse effect on our sales into Canada.
If our NewGen products become subject to increased taxes it could adversely affect our business.
Presently the federal government and many states do not tax the sale of NewGen products like they do the sale of conventional cigarettes or other tobacco products, all of which generally have high tax rates and have faced significant increases in the amount of taxes collected on their sales. In recent years, however, state and local governments have taken actions to move towards imposing excise taxes on NewGen products. As of December 31, 2021, over half of the states, as well as, certain localities impose excise taxes on electronic cigarettes and/or liquid vapor. These tax structures may benefit one type of NewGen product over another, which may result in consumers switching between NewGen products, other traditional tobacco products, or depress overall consumption in general. Should federal, state and local governments and or other taxing authorities begin or continue to impose excise taxes similar to those levied against conventional cigarettes and tobacco products on NewGen products, it may have a material adverse effect on the demand for these products, as consumers may be unwilling to pay the increased costs, which in turn could have a material adverse effect on our business, results of operations and financial condition.
Our supply to our wholesalers and retailers is dependent on the demands of their customers who are sensitive to increased sales taxes and economic conditions affecting their disposable income.
Consumer purchases of tobacco products are historically affected by economic conditions, such as changes in employment, salary and wage levels, the availability of consumer credit, inflation, interest rates, fuel prices, sales taxes, and the level of consumer confidence in prevailing and future economic conditions. Discretionary consumer purchases, such as of OTP, may decline during recessionary periods or at other times when disposable income is lower, and taxes may be higher.
In addition, some states have begun collecting taxes on internet sales where companies have used independent contractors in those states to solicit sales from residents of those states. These taxes apply to our online sales of NewGen products into those states and may result in reduced demand from the independent wholesalers who may not be able to absorb the increased taxes or successfully pass them onto the end-user without experiencing reduced demand. Further, as a result of recent court decisions related to the taxability of internet purchases, states are now able to impose sales tax on internet purchases made from out-of-state sellers, even if the seller does not have a physical presence in the taxing state. Consequently, additional states are likely to seek or have begun to impose sales tax on our online sales. The requirement to collect, track and remit taxes may require us to increase our prices, which may affect demand for our products or conversely reduce our net profit margin, which could have a material adverse effect on our business, results of operations and financial condition.
We may be subject to increasing international control and regulation.
The World Health Organization’s Framework Convention on Tobacco Control (“FCTC”) is the first international public health treaty that establishes a global agenda to reduce initiation of tobacco use and regulate tobacco in an effort to encourage tobacco cessation. Over 170 governments worldwide have ratified the FCTC. The FCTC has led to increased efforts to reduce the supply and demand of tobacco products and to encourage governments to further regulate the tobacco industry. The tobacco industry expects significant regulatory developments to take place over the next few years, driven principally by the FCTC. Regulatory initiatives that have been proposed, introduced or enacted include:
| | • | the levying of substantial and increasing tax and duty charges; |
| | • | restrictions or bans on advertising, marketing and sponsorship; |
| | • | the display of larger health warnings, graphic health warnings and other labeling requirements; |
| | • | restrictions on packaging design, including the use of colors and generic packaging; |
| | • | restrictions or bans on the display of tobacco product packaging at the point of sale, and restrictions or bans on cigarette vending machines; |
| | • | requirements regarding testing, disclosure and performance standards for tar, nicotine, carbon monoxide and other smoke constituents levels; |
| | • | requirements regarding testing, disclosure and use of tobacco product ingredients; |
| | • | increased restrictions on smoking in public and work places and, in some instances, in private places and outdoors; |
| | • | elimination of duty-free allowances for travelers; and |
| | • | encouraging litigation against tobacco companies. |
If the U.S. becomes a signatory to the FCTC and/or national laws are enacted in the U.S. that reflect the major elements of the FCTC, our business, results of operations and financial condition could be materially and adversely affected. If NewGen products become subject to one or more of the significant regulatory initiatives proposed under the FCTC, our NewGen products segment may also be materially adversely affected.
As part of our strategy, we have begun to expand our business into key international locations, such as introducing our moist snuff tobacco products in South America. International expansion may subject us to additional or increasing international regulation, either by the countries that are the object of the strategic expansion or through international regulatory regimes, such as the FCTC, to which those countries may be signatories.
To the extent our existing or future products become subject to international regulatory regimes that we are unable to comply with or fail to comply with, they may have a material adverse effect on our business, results of operations and financial condition.
Our failure to comply with certain environmental, health and safety regulations could adversely affect our business.
The storage, distribution and transportation of some of the products that we sell are subject to a variety of federal and state environmental regulations. In addition, our manufacturing facilities are similarly subject to federal, state and local environmental laws. We are also subject to operational, health and safety laws and regulations. Our failure to comply with these laws and regulations could cause a disruption in our business, an inability to maintain our manufacturing resources, and additional and potentially significant remedial costs and damages, fines, sanctions or other legal consequences that could have a material adverse effect on our business, results of operations and financial condition.
Imposition of significant tariffs on imports into the U.S., could have a material and adverse effect on our business.
We are required to purchase all our cigarette papers, cigarette tubes and cigarette injector machines under the Distribution Agreements from the supplier in France. Additionally, a substantial portion of our NewGen products are sourced from China. In 2018, President Trump and his administration imposed significant additional tariffs on certain goods imported from outside the U.S., and future administrations could impose additional tariffs in the future. These additional tariffs apply to a significant portion of our NewGen products and may result in increased prices for our customers. These increased prices may reduce demand where customers are unable to absorb the increased prices or successfully pass them onto the end-user. If the U.S. were to impose additional tariffs on goods we import, it is likely to make it more costly for us to import goods from other countries. While the current or future administrations may have a desire to repeal some or all of the tariffs imposed by the Trump administration, no assurance can be given that they will do so. As a result, our business, financial condition and results of operations could be materially adversely affected.
The scientific community has not yet studied extensively the long-term health effects of certain substances contained in some of our products.
Electronic cigarettes, vaporizers and many of our NewGen products were recently developed and therefore the scientific community has not had a sufficient period of time to study the long-term health effects of their use. Currently, there is no way of knowing whether these products are safe for their intended use. If the scientific community were to determine conclusively that use of any or all of these products poses long-term health risks, market demand for these products and their use could materially decline. Such a determination could also lead to litigation and significant regulation. Loss of demand for our product, product liability claims and increased regulation stemming from unfavorable scientific studies on these products could have a material adverse effect on our business, results of operations and financial condition.
We are subject to significant product liability litigation.
The tobacco industry has experienced, and continues to experience, significant product liability litigation. Most tobacco liability lawsuits have been brought against manufacturers and sellers of cigarettes by individual plaintiffs, often participating on a class-action basis, for injuries allegedly caused by cigarette smoking or by exposure to cigarette smoke. However, several lawsuits have also been brought against manufacturers and sellers of smokeless products for injuries to health allegedly caused by use of smokeless products. In addition to the risks to our business, results of operations and financial condition resulting from adverse results in any such action, ongoing litigation may divert management’s attention and resources, which could have an impact on our business and operations. There can be no assurance that we will not sustain losses in connection with such lawsuits and that such losses will not have a material adverse effect on our business, results of operations and financial condition.
In addition to current and potential future claims related to our core tobacco products, we are subject to several lawsuits alleging personal injuries resulting from malfunctioning vaporizer devices and may be subject to claims in the future relating to our other NewGen products. We are still evaluating these claims and the potential defenses to them. As a result of their relative novelty, electronic cigarette and vaporizer product manufacturers and sellers have only recently become subject to litigation. We may see increasing litigation over NewGen products or the regulation of our products, as the regulatory regimes surrounding these products develop. For a description of current material litigation to which we or our subsidiaries are a party, see “Item 3. Legal Proceedings” and “Note 18 – Contingencies” in the Notes to the Consolidated Financial Statements in Part II, Item 8 of this Annual Report on Form 10-K, for additional information.
As a result, we may face substantial costs due to increased product liability litigation relating to new regulations or other potential defects associated with NewGen products we ship, which could have a material adverse effect on our business, results of operations and financial condition.
The COVID-19 pandemic and related economic repercussions may affect our business.
The COVID-19 pandemic and related economic repercussions have created significant volatility, uncertainty, and turmoil in the business environment generally. While these events have not yet had a material adverse effect on our business and B2C platforms like ours have seen elevated sales levels from consumer shifts to online purchasing, we can offer no assurance that the COVID-19 pandemic will not have an adverse effect in the future, particularly if the pandemic worsens or endures for an extended period of time.
The COVID-19 pandemic may adversely impact our financial results. Our third-party cigar wrap manufacturer in the Dominican Republic was temporarily shut down for three months, as a result of government efforts to curb the spread of COVID-19. Since the temporary shutdown, the manufacturer has operated without COVID-19 related interruptions. While our supply chain has not experienced other pandemic related interruptions, we have experienced some increase in costs. We can offer no assurance that the Company will not be adversely affected by the pandemic and related governmental actions in the future, particularly if the COVID-19 pandemic continues and/or other variants emerge. Similarly, because we have more than 100 employees, should the federal government reintroduce testing mandates or other measures to combat COVID-19, our workforce and ultimately our results of operations may be impacted if we have a significant number of employees unwilling to comply with such measures.
If the COVID-19 pandemic continues for an extended period of time or worsens, it could have a material adverse effect on our supply chain or workforce, either of which could have a material adverse effect on our business, financial condition and liquidity. In addition, if the impact of the COVID-19 pandemic continues it may heighten other risks that could affect our business.
Risks Related to Financial Results, Finances and Capital Structure
We have a substantial amount of indebtedness that could affect our financial condition.
As of December 31, 2021, we had $250 million in aggregate principal amount of our 5.625% senior secured notes due 2026 (the “Senior Secured Notes”) outstanding and $172.5 million in aggregate principal amount outstanding under our 2.50% Convertible Senior Notes due July 15, 2024 (the “Convertible Senior Notes”). We also have the ability to borrow up to $25 million under our new revolving credit facility entered into in February 2021 (the “New Revolving Credit Facility”) under which only letters of credit of $3.6 million were outstanding as of December 31, 2021. If we cannot generate sufficient cash flow from operations to service our debt, we may need to further refinance our debt, dispose of assets or issue equity to obtain necessary funds. We do not know whether we will be able to do any of this on a timely basis or on terms satisfactory to us or at all.
Our substantial amount of indebtedness could limit our ability to:
| | • | obtain necessary additional financing for working capital, capital expenditures or other purposes in the future; |
| | • | plan for, or react to, changes in our business and the industries in which we operate; |
| | • | make future acquisitions or pursue other business opportunities; |
| | • | react in an extended economic downturn; and |
The terms of the agreement governing our indebtedness may restrict our current and future operations, which would adversely affect our ability to respond to changes in our business and to manage our operations.
The indenture governing the Senior Secured Notes and our New Revolving Credit Facility each contain, and any future indebtedness of ours would likely contain, a number of restrictive covenants that impose significant operating and financial restrictions on us, including restrictions on our ability to, among other things:
| | • | incur additional debt, disqualified stock and preferred stock; |
| | • | pay dividends and make other restricted payments; |
| | • | make investments and acquisitions; |
| | • | engage in sales of assets and subsidiary stock; |
| | • | enter into sale-leaseback transactions; |
| | • | enter into transactions with affiliates; and |
| | • | transfer all or substantially all of our assets or enter into merger or consolidation transactions. |
Our New Revolving Credit Facility also requires us to maintain certain financial ratios under certain limited circumstances. A failure by us to comply with the covenants or financial ratios in our debt instruments could result in an event of default under the facility, which could adversely affect our ability to respond to changes in our business and manage our operations. In the event of any default under our debt instruments, the lenders under the facility could elect to declare all amounts outstanding under such instruments to be due and payable and require us to apply all of our available cash to repay these amounts. If the indebtedness under one of our debt instruments were to be accelerated, it could cause an event of default and/or a cross-acceleration of our obligations under our other debt instruments and there can be no assurance that our assets would be sufficient to repay this indebtedness in full, which could have a material adverse effect on our business, results of operations, and financial condition.
Our status as an emerging growth company.
We ceased to be an emerging growth company on December 31, 2021. As a result, beginning on January 1, 2022 we are required to comply with the disclosure requirements applicable to non-emerging growth companies, including the requirement to obtain an auditor attestation of our internal control over financial reporting pursuant to the requirements of Section 404 of the Sarbanes-Oxley Act (“Section 404”) as well as the requirement to provide enhanced disclosure regarding executive compensation and hold a non-binding advisory vote on executive compensation. Compliance with these new disclosure obligations could be costly and will require our management to devote increased effort toward ensuring compliance with the non-emerging growth company requirements. We cannot predict or estimate the amount of additional costs we may incur as a result of the change in our status or the timing of such costs, though such costs may be substantial. In addition, if we are unable to comply with the disclosure requirements applicable to non-EGCs in a timely manner we may be unable to file our current and periodic reports with the SEC on time, which could cause investors to lose confidence in our reports and also affect our ability to quickly access the capital markets.
If we fail to establish and maintain proper and effective internal control over financial reporting, our operating results and our ability to operate our business could be harmed.
Section 404 of the Sarbanes-Oxley Act of 2002 requires that we establish and maintain internal control over financial reporting, and we are also required to establish disclosure controls and procedures under applicable SEC rules. An effective internal control environment is necessary to enable us to produce reliable financial reports and is an important component of our efforts to prevent and detect financial reporting errors and fraud. Management is required to provide an annual assessment on the effectiveness of our internal control over financial reporting and, as a result of ceasing to be an Emerging Growth Company, our independent registered public accounting firm is now also required to attest to the effectiveness of our internal control over financial reporting. Our and our auditor’s testing may reveal deficiencies in our internal control over financial reporting that are deemed to be material weaknesses and render our internal control over financial reporting ineffective. As noted below, this year’s assessment led management to conclude that a material weakness exists in our information technology control environment. No assurance can be given that we won’t discover additional material weaknesses in the future. We have incurred and we expect to continue to incur substantial accounting and auditing expense and expend significant management time in complying with the requirements of Section 404, including the requirement to have such controls tested by our independent registered public accounting firm. While an effective internal control environment is necessary to enable us to produce reliable financial statements and is an important component of our efforts to prevent and detect financial reporting errors and fraud, disclosure controls and internal control over financial reporting are generally not capable of preventing or detecting all financial reporting errors and all fraud. A control system, no matter how well-designed and operated, is designed to reduce rather than eliminate the risk of material misstatements in our financial statements. There are inherent limitations on the effectiveness of internal controls, including collusion, management override and failure in human judgment. A control system can provide only reasonable, not absolute, assurance of achieving the desired control objectives and the design of a control system must reflect the fact that resource constraints exist.
If we are not able to comply with the requirements of Section 404, or if we or our independent registered public accounting firm identify deficiencies in our internal control over financial reporting that are deemed to be material weaknesses:
| | • | our reputation may be adversely affected and our business and operating results could be harmed; |
| | • | the market price of our stock could decline; |
| | • | we could fail to meet our financial reporting obligations; and |
| | • | we could be subject to litigation and/or investigations or sanctions by the Securities and Exchange Commission (the “SEC”), the New York Stock Exchange or other regulatory authorities. |
We identified a material weakness in our internal control related to ineffective information technology general controls which, if not remediated appropriately or in a timely manner, could result in loss of investor confidence and adversely impact our stock price.
A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our annual or interim consolidated financial statements will not be prevented or detected on a timely basis.
In connection with the preparation of our consolidated financial statements for the year ended December 31, 2021, during the fourth quarter of 2021, management identified a material weakness in internal control related to ineffective information technology general controls (“ITGCs”) in the areas of user access and program change-management over certain information technology (“IT”) systems that support the Company’s financial reporting processes. See Part II, Item 9A for additional information. Internal controls related to the operation of technology systems are critical to maintaining adequate internal control over financial reporting.
As a result, management concluded that our internal control over financial reporting was not effective as of December 31, 2021. We are implementing remedial measures and, while there can be no assurance that our efforts will be successful, we plan to remediate the material weakness prior to the end of 2022. These measures will result in additional technology and other expenses. If we are unable to remediate the material weakness, or are otherwise unable to maintain effective internal control over financial reporting or disclosure controls and procedures, our ability to record, process and report financial information accurately, and to prepare financial statements within required time periods, could be adversely affected, which could subject us to litigation or investigations requiring management resources and payment of legal and other expenses, negatively affect investor confidence in our financial statements and in turn, adversely impact our stock price.
Changes in the method of determining the London Interbank Offered Rate (“LIBOR”), or the replacement of LIBOR with an alternative reference rate, may adversely affect interest expense related to outstanding debt.
Amounts drawn under certain of our debt instruments may bear interest at rates based on LIBOR. On July 27, 2017, the Financial Conduct Authority in the United Kingdom (the “FCA”) announced that it would phase out LIBOR as a benchmark by the end of 2021. The publication of USD LIBOR will cease after June 30, 2023, and the FCA confirmed that use of USD LIBOR will not be permitted in most new contracts after December 31, 2021. We are currently evaluating the impact of the potential replacement of the LIBOR interest rate. In addition, the overall financial markets may be disrupted as a result of the phase-out or replacement of LIBOR. Uncertainty as to the nature of such potential phase-out and alternative reference rates or disruption in the financial market could have a material adverse effect on our financial condition, results of operations and cash flows.
Risks Related to our Common Stock
Our certificate of incorporation and bylaws, as well as Delaware law and certain regulations, could discourage or prohibit acquisition bids or merger proposals, which may adversely affect the market price of our common stock.
Our certificate of incorporation authorizes our board of directors to issue preferred stock without stockholder approval. If our board of directors elects to issue preferred stock, it could be more difficult for a third party to acquire us. In addition, some provisions of our certificate of incorporation, bylaws and applicable law could make it more difficult for a third party to acquire control of us, even if the change of control would be beneficial to our stockholders, including:
| | • | limitations on the removal of directors; |
| | • | limitations on the ability of our stockholders to call special meetings; |
| | • | limitations on stockholder action by written consent; |
| | • | establishing advance notice provisions for stockholder proposals and nominations for elections to the board of directors to be acted upon at meetings of stockholders; and |
| | • | limitations on the ability of our stockholders to fill vacant directorships or amend the number of directors constituting our board of directors. |
Our certificate of incorporation limits the ownership of our common stock by individuals and entities that are Restricted Investors. These restrictions may affect the liquidity of our common stock and may result in Restricted Investors being required to sell or redeem their shares at a loss or relinquish their voting, dividend and distribution rights.
For so long as we or one of our subsidiaries is party to any of the Distribution Agreements, our certificate of incorporation will limit the ownership of our common stock by any “Restricted Investor” to 14.9% of our outstanding common stock and shares convertible or exchangeable therefor (including our non-voting common stock) (the “Permitted Percentage”). A “Restricted Investor” is defined as: (i) any entity that directly or indirectly manufactures, sells, markets, distributes or otherwise promotes cigarette paper booklets, filter tubes, injector machines or filter tips in the United States, the District of Columbia, the territories, possessions and military bases of the United States and the Dominion of Canada (a “RTI Competitor”), (ii) any entity that owns more than a 20% equity interest in any RTI Competitor, or (iii) any person who serves as a director or officer of, or any entity that has the right to appoint an officer or director of, any RTI Competitor or of any entity that owns more than a 20% equity interest in any RTI Competitor (each, a “Restricted Investor”). Our certificate of incorporation further provides that any issuance or transfer of shares to a Restricted Investor in excess of the Permitted Percentage will be ineffective as against us and that neither we nor our transfer agent will register the issuance or transfer of shares or be required to recognize the transferee or owner as a holder of our common stock for any purpose except to exercise our remedies described below. Any shares in excess of the Permitted Percentage in the hands of a Restricted Investor will not have any voting or dividend rights and are subject to redemption by us in our discretion. The liquidity or market value of the shares of our common stock may be adversely impacted by such transfer restrictions.
As a result of the above provisions, a proposed transferee of our common stock that is a Restricted Investor may not receive any return on its investment in shares it purchases or owns, as the case may be, and it may sustain a loss. We are entitled to redeem all or any portion of such shares acquired by a Restricted Investor in excess of the Permitted Percentage (“Excess Shares”) at a redemption price based on a fair market value formula that is set forth in our certificate of incorporation, which may be paid in any form, including cash or promissory notes, at our discretion. Excess Shares not yet redeemed will not be accorded any voting, dividend or distribution rights while they constitute Excess Shares. As a result of these provisions, a stockholder who is a Restricted Investor may be required to sell its shares of our common stock at an undesirable time or price and may not receive any return on its investment in such shares. However, we may not be able to redeem Excess Shares for cash because our operations may not have generated sufficient excess cash flow to fund the redemption and we may incur additional indebtedness to fund all or a portion of such redemption, in which case our financial condition may be materially weakened.
Our certificate of incorporation permits us to require that owners of any shares of our common stock provide certification of their status as a Restricted Investor. In the event that a person does not submit such documentation, our certificate of incorporation provides us with certain remedies, including the suspension of the payment of dividends and distributions with respect to shares held by such person and deposit of any such dividends and distributions into an escrow account. As a result of non-compliance with these provisions, an owner of the shares of our common stock may lose significant rights associated with those shares.
Although our certificate of incorporation contains the above provisions intended to assure compliance with the restrictions on ownership of our common stock by Restricted Investors, we may not be successful in monitoring or enforcing the provisions. A failure to enforce or otherwise maintain compliance could lead RTI to exercise its termination rights under the agreements, which would have a material and adverse effect on the Company’s financial position and its results of operations.
In addition to the risks described above, the foregoing restrictions could delay, defer or prevent a transaction or change in control that might involve a premium price for our common stock or that might otherwise be in the best interest of our stockholders.
Future sales of our common stock in the public market could reduce our stock price, and any additional capital raised by us through the sale of equity or convertible securities may dilute our stockholders.
We may sell additional shares of common stock in public or private offerings and may also sell securities convertible to common stock, such as the Convertible Senior Notes. We may also be required to issue common stock and conversion of our Convertible Senior Notes at the exercise or vesting of certain awards, see Note 13, “Notes Payable and Long-Term Debt,” in the Notes to Consolidated Financial Statements included in this Annual Report for further discussion..
We cannot predict the size of future issuances of our common stock or securities convertible into common stock or the effect, if any, that future issuances and sales of shares of our common stock will have on the market price of our common stock. Sales of substantial amounts of our common stock (including shares issued in connection with an acquisition), or the perception that such sales could occur, may adversely affect prevailing market prices of our common stock.
We may issue preferred stock whose terms could adversely affect the voting power or value of our common stock.
Our certificate of incorporation authorizes us to issue, without the approval of our stockholders, one or more classes or series of preferred stock having such designations, preferences, limitations and relative rights, including preferences over our common stock respecting dividends and distributions, as our board of directors may determine. The terms of one or more classes or series of preferred stock could adversely impact the voting power or value of our common stock. For example, we might grant holders of preferred stock the right to elect some number of our directors in all events or on the happening of specified events or the right to veto specified transactions. Similarly, the repurchase or redemption rights or liquidation preferences we might assign to holders of preferred stock could affect the residual value of the common stock.
General Risks
Our business may be damaged by events outside of our or our suppliers’ control, such as the impact of epidemics (e.g., coronavirus), political upheavals, or natural disasters.
We have manufacturing operations in Tennessee and Kentucky. Additionally, we have critical suppliers of raw materials and finished products in other countries. Events may impact our ability to manufacture products or prevent critical suppliers from performing their obligations to us, through no fault of any party. Examples of such events could include the effect of potential epidemics, such as COVID-19; political upheavals including violent changes in government, regional conflicts and the reaction of the governments throughout the world to those conflicts such as the implementation of sanctions, widespread labor unrest, or breakdowns in civil order; and natural disasters, such as hurricanes, tornados, earthquakes or floods. If such events were to occur and disrupt our manufacturing capabilities or supply arrangements, there can be no assurance that we could quickly remedy the impact and there could be a material adverse impact on our business, results of operations, and financial condition.
Reliance on information technology means a significant disruption could affect our communications and operations.
We increasingly rely on information technology systems for our internal communications, controls, reporting and relations with customers and suppliers and information technology is becoming a significantly important tool for our sales staff. Our marketing and distribution strategy are dependent upon our ability to closely monitor consumer and market trends on a highly specified level, for which we are reliant on our highly sophisticated data tracking systems, which are susceptible to disruption or failure. In addition, our reliance on information technology exposes us to cyber-security risks, which could have a material adverse effect on our ability to compete. Security and privacy breaches may expose us to liability and cause us to lose customers or may disrupt our relationships and ongoing transactions with other entities with whom we contract throughout our supply chain. The failure of our information systems to function as intended, or the penetration by outside parties’ intent on disrupting business processes, could result in significant costs, loss of revenue, assets or personal or other sensitive data and reputational harm.
Additionally, in connection with the preparation of our consolidated financial statements for the year ended December 31, 2021, during the fourth quarter of 2021, management identified a material weakness in internal control related to ineffective ITGCs in the areas of user access and program change-management over certain IT systems that support the Company’s financial reporting processes. See Part II, Item 9A for additional information. In the event we are unable to remediate the material weakness, or are otherwise unable to maintain effective internal control over financial reporting or disclosure controls and procedures, our ability to record, process and report financial information accurately, and to prepare financial statements within required time periods, could be adversely affected, which could subject us to litigation or investigations requiring management resources and payment of legal and other expenses, negatively affect investor confidence in our financial statements and, in turn, adversely impact our stock price.
Security and privacy breaches may expose us to liability and cause us to lose customers.
Federal and state laws require us to safeguard our wholesalers’, retailers’ and consumers’ financial information, including credit information. Although we have established security procedures to protect against identity theft and the theft of our customers’ financial information, our security and testing measures may not prevent security breaches. We have been in the past and may again in the future be subject to cyberattacks, including attacks that have resulted in the theft of customer financial information, such as credit card information; however, no cyberattack we have suffered to date has resulted in material liability to us. These attacks have become increasingly sophisticated over time and maybe conducted or “sponsored” by nation states with significant resources. We cannot guarantee that a future breach would not result in material liability or otherwise harm our business. In the event of any such breach, we may be required to notify governmental authorities or consumers under breach disclosure laws, indemnify consumers or other third parties for losses resulting from the breach, and expend resources investigating and remediating any vulnerabilities that contributed to the occurrence of the breach. Typically, we rely on encryption and authentication technology licensed from third parties to enhance transmission security of confidential information in relation to financial and other sensitive information that we have on file. Advances in computer capabilities, new discoveries in the field of cryptography, inadequate facility security or other developments may result in a compromise or breach of the technology used by us to protect customer data. Any compromise of our security, even a security breach that does not result in a material liability, could harm our reputation and therefore, our business and financial condition. In addition, a party who is able to circumvent our security measures or exploit inadequacies in our security measures, could, among other effects, misappropriate proprietary information (including trade secrets), cause interruptions in our operations or expose customers and other entities with which we interact to computer viruses or other disruptions. Actual or perceived vulnerabilities may lead to claims against us. While we maintain cyber errors and omissions insurance that covers certain cyber risks, our insurance coverage may be insufficient to cover all claims or losses. To the extent the measures we have taken prove to be insufficient or inadequate, we may become subject to litigation or administrative sanctions, which could result in significant fines, penalties or damages and harm to our reputation.
We may fail to manage our growth.
We have expanded over our history and intend to grow in the future. We acquired the Stoker’s® brand in 2003 and have continued to develop it through the introduction of new products, such as moist snuff. Our acquisition of the Vapor Beast® brand in 2016 accelerated our entry into non-traditional retail channels while the 2018 acquisition of IVG added a top B2C platform which enhances our marketing and selling of proprietary and third-party vapor products to adult consumers. More recently, the acquisition of Solace provided us with a leading line of e-liquids and a powerful new product development platform, the acquisition of certain tobacco assets and distribution rights from Durfort and BluntWrap USA secured long-term control of our Zig-Zag MYO cigar wrap products and provided us access to a portfolio of tobacco products with significant strategic value, and the acquisition of certain tobacco assets from Unitabac expanded our capabilities in the growing cigar market. However, any future growth will place additional demands on our resources, and we cannot be sure we will be able to manage our growth effectively. If we are unable to manage our growth while maintaining the quality of our products and profit margins, or if new systems that we implement to assist in managing our growth do not produce the expected benefits, our business, financial position, results of operations and cash flows could be adversely affected. We may not be able to support, financially or otherwise, future growth, or hire, train, motivate and manage the required personnel. Our failure to manage growth effectively could also limit our ability to achieve our goals as they relate to streamlined sales, marketing and distribution operations and the ability to achieve certain financial metrics.
We may fail to successfully integrate our acquisitions or otherwise be unable to benefit from pursuing acquisitions.
We believe there are meaningful opportunities to grow through acquisitions and joint ventures across all OTP and adjacent product categories and we expect to continue a strategy of selectively identifying and acquiring businesses with complementary products. We may be unable to identify, negotiate, and complete suitable acquisition opportunities on reasonable terms. There can be no assurance that any business acquired by us will be successfully integrated with our operations or prove to be profitable to us. We may incur future liabilities related to acquisitions. Should any of the following problems, or others, occur as a result of our acquisition strategy, the impact could be material:
| | • | difficulties integrating personnel from acquired entities and other corporate cultures into our business; |
| | • | difficulties integrating information systems; |
| | • | the potential loss of key employees of acquired companies; |
| | • | the assumption of liabilities and exposure to undisclosed or unknown liabilities of acquired companies; or |
| | • | the diversion of management attention from existing operations |
We are subject to fluctuations in our results that make it difficult to track trends and develop strategies in the short-term.
In response to competitor actions and pricing pressures, we have engaged in significant use of promotional and sales incentives. We regularly review the results of our promotional spending activities and adjust our promotional spending programs in an effort to maintain our competitive position. Accordingly, unit sales volume and sales promotion costs in any period are not necessarily indicative of sales and costs that may be realized in subsequent periods. Additionally, promotional activity significantly increases net sales in the month in which it is initiated, and net sales are adversely impacted in the month after a promotion. Accordingly, based upon the timing of our marketing and promotional initiatives, we have and may continue to experience significant variability in our results, which could affect our ability to formulate strategies that allow us to maintain our market presence across volatile periods. If our fluctuations obscure our ability to track important trends in our key markets, it may have a material adverse effect on our business, results of operations and financial condition.
We are subject to the risks of exchange rate fluctuations.
Currency movements and suppliers’ price increases relating to premium cigarette papers and cigarette tubes are the primary factors affecting our cost of sales. These products are purchased under the Distribution Agreements and the License Agreements, and we make payments in euros. Thus, we bear certain foreign exchange rate risk for certain of our inventory purchases. In addition, as part of our strategy, we have begun strategic international expansions. As a result, we may be more sensitive to the risks of exchange rate fluctuations. To manage this risk, we sometimes utilize short-term forward currency contracts to purchase euros for our inventory purchases. We have a foreign exchange currency policy which governs our hedging of risk. While we engage in hedging transactions from time to time, no assurance can be made that we will be successful in eliminating currency exchange risks or that changes in currency rates will not have a material adverse effect on our business, results of operations and financial condition.
Adverse U.S. and global economic conditions could negatively impact our business, prospects, results of operations, financial condition or cash flows.
Our business and operations are sensitive to global economic conditions. These conditions include interest rates, energy costs, inflation, recession, fluctuations in debt and equity capital markets and the general condition of the U.S. and world economy, including as a result of the effect of the COVID-19 pandemic. A material decline in the economic conditions affecting consumers, which cause a reduction in disposable income for the average consumer, may change consumption patterns, and may result in a reduction in spending on OTP or a switch to cheaper products or products obtained through illicit channels. Material inflation may also lead to significant increases in property, E&O and other insurance premiums which could affect our results of operations and liquidity and may also result in us self-insuring if the premiums become uneconomical. Electronic cigarettes, vaporizer, e-liquid, and other NewGen products are relatively new to market and may be regarded by users as a novelty item and expendable. As such, demand for our NewGen products may be particularly sensitive to economic conditions such as inflation, recession, high energy costs, unemployment, changes in interest rates and money supply, changes in the political environment, the ultimate effect on the economy of the COVID-19 pandemic and other factors beyond our control, any combination of which could result in a material adverse effect on our business, results of operations and financial condition.
The departure of key management personnel and the failure to attract and retain talent could adversely affect our operations.
Our success depends upon the continued contributions of our senior management. Our ability to implement our strategy of attracting and retaining the best talent may be impaired by the decreasing social acceptance of tobacco usage. The tobacco industry competes for talent with the consumer products industry and other companies that enjoy greater societal acceptance. As a result, we may be unable to attract and retain the best talent, which could have a material adverse effect on our business, results of operations and financial condition.
Our intellectual property rights may be infringed or misappropriated.
We currently rely on trademark and other intellectual property rights to establish and protect our products, including the brand names and logos we own or license. Third parties have in the past infringed on and misappropriated and may in the future infringe or misappropriate, these trademarks and our other intellectual property rights. Our ability to maintain and further build brand recognition is dependent on the continued and exclusive use of these trademarks, service marks and other proprietary intellectual property rights, including the names and logos we own or license. Despite our attempts to ensure these intellectual property rights are protected, third parties may take actions that could materially and adversely affect our rights or the value of this intellectual property. Any enforcement concerning our intellectual property rights, whether successful or unsuccessful, could result in substantial costs to us and diversions of our resources. Expenses related to protecting and enforcing our intellectual property rights, the loss or compromise of any of these rights or the loss of revenues as a result of infringement or misappropriation could have a material adverse effect on our business, results of operations and financial condition, and may prevent the brands we own or license from growing or maintaining market share.
Third parties may claim that we infringe or misappropriate their intellectual property rights.
Competitors in the tobacco products and NewGen markets may claim that we infringe on or misappropriate their intellectual property rights. Such claims, whether or not meritorious, may result in the expenditure of significant financial and managerial resources, injunctions against us and/or the payment of damages. Further, our vapor distribution businesses distribute third party product brands with those suppliers’ branding and imagery. If that branding or imagery is alleged by other parties to infringe or otherwise violate intellectual property rights, we could be drawn into such litigation.
We may fail to meet expectations relating to environmental, social and governance factors.
Market participants, including investors, analysts, customers and other key stakeholders are increasingly focused on environmental, social and governance (“ESG”) factors. We have recently determined to adopt a more comprehensive ESG initiative with an initial focus on public health and began to roll-out this new initiative in 2020. However, the ESG factors by which companies’ corporate responsibility practices are assessed differ among market participants, are constantly evolving and could result in greater expectations of us and/or cause us to undertake costly initiatives to satisfy such new criteria. We risk damage to our brand and reputation in the event that our corporate responsibility procedures or standards do not meet the standards expected by us. Furthermore, we could fail, or be perceived to fail, in our achievement of our publicly disclosed ESG initiatives or goals and we could also be criticized for the scope of such initiatives or goals. If we fail to satisfy the expectations of investors and other key stakeholders or our initiatives are not executed as planned, our reputation and financial results could be materially and adversely affected.
Item 1B. Unresolved Staff Comments
None
As of December 31, 2021, we operated manufacturing, distribution, office, and warehouse space in the U.S., all of which is leased with the exception of our Dresden, Tennessee, manufacturing facility which is owned. To provide a cost-efficient supply of products to our customers, we maintain centralized management of internal manufacturing and nationwide distribution facilities. Our two manufacturing and distribution facilities located in Louisville, Kentucky and Sheperdsville, Kentucky are used by all our segments. Our third manufacturing and distribution facilities located in Dresden, Tennessee is used by our Stoker’s Product segment. We believe our facilities are generally adequate for our current and anticipated future use.
Item 3. Legal Proceedings
For a description of our material pending legal proceedings, please see Contingencies in Note 18 to the Notes to the Consolidated Financial Statements in Part II, Item 8 of this Annual Report on Form 10-K, which is incorporated herein by reference.
Also see ‘Risk Factors—We are subject to significant product liability litigation’ for additional details.
Item 4. Mine Safety Disclosures
Not applicable.
Information about our Executive Officers
Listed below are the executive officers of the Company. Our executive officers are appointed by, and serve at the discretion of, our board of directors. There are no family relationships between any of the executive officers, and there is no arrangement or understanding between any executive officer and any other person pursuant to which the executive officer was selected.
Yavor Efremov, age 49, has served as our President and CEO since January 2022. Prior to January 2022, Mr. Efremov served as a director of our Company since July 2021. Mr. Efremov currently serves on the board of MDH Acquisition Corp. From April 2019 to November 2019, Mr. Efremov was the CEO of Motorsport Network, a global company with 630 employees, and was responsible for restructuring the company, hiring a management team, developing a vision for the company and executing on that vision. Prior to Motorsport Network, Mr. Efremov spent 5 years at Liberty Media as SVP, Corporate Development. Prior to that, Mr. Efremov spent 8 years in the Technology, Media and Telecom group of Goldman, Sachs & Co. in New York and, prior to that, Mr. Efremov was an M&A lawyer with Cleary, Gottlieb, Steen & Hamilton for 5 years, also in New York. Mr. Efremov holds a J.D. from the Yale Law School, a Ph.D. in Economics from Yale, B.S. (Mathematics) and B.A. (Economics) from Furman University.
Graham Purdy, age 50, was appointed as Chief Operating Officer in November 2019 after serving as President of our New Ventures Division since December 2017. Mr. Purdy joined the Company in 2004 and has held various leadership positions since that time. Prior to joining the Company, Mr. Purdy spent 7 years at Philip Morris, USA where he served in senior sales and sales management positions. Mr. Purdy holds a Bachelor of Arts from California State University, Chico.
Luis Reformina, age 44, was appointed Chief Financial Officer in May 2021 after serving as the Company’s Chief Business Development Officer since October 2020. He joined the Company as Vice President of Business Development in 2019. Prior to joining the Company, Mr. Reformina spent nearly two decades in the finance and investment industry working at Point72 Asset Management, Waterfront Capital Partners, Perella Weinberg Partners and Vestar Capital Partners in various roles deploying capital across different industries. He began his career as an investment banker at Goldman Sachs & Co. Mr. Reformina holds a B.S, Summa Cum Laude, in Electrical Engineering from Cornell University and an M.B.A from Stanford Graduate School of Business where he was an Arjay Miller Scholar.
Brittani N. Cushman, age 37, has been our Senior Vice President, General Counsel, and Secretary since November 2020 and has served in various roles in our legal department since joining the Company in October 2014. Prior to joining the Company, Ms. Cushman spent five years at Xcaliber International, Ltd., L.L.C., where she was most recently the General Counsel, responsible for all legal affairs. Ms. Cushman holds a Bachelor of Science in Business Administration in business management from the University of Tulsa and a J.D. from Washington and Lee University School of Law.
PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Information
The principal stock exchange on which Turning Point Brands, Inc.’s common stock (par value $0.01 per share) is listed is the New York Stock Exchange under the symbol “TPB.” At March 4, 2022, there were 145 holders of record of Turning Point Brands, Inc.’s common stock.
Dividends. On November 9, 2017, our Board of Directors approved the initiation of a cash dividend to shareholders. The initial quarterly dividend of $0.04 per common share was paid on December 15, 2017 to shareholders of record at the close of business on November 27, 2017. The most recent dividend of $0.055 per common share, an increase of approximately 38% compared to the initial dividend, was paid on January 7, 2022, to shareholders of record at the close of business on December 17, 2021. Future dividend amounts will be considered after reviewing financial results and capital needs and will be declared at the discretion of the Company’s board of directors.
Performance graph. The graph below compares the cumulative total shareholder return of Turning Point Brands, Inc.’s common stock since our initial public offering on May 11, 2016, with the Russell 3000 Index and the S&P Small Cap 600 Consumer Staples Index. The information presented assumes an initial investment of $100 on May 11, 2016, and that all dividends were reinvested. The cumulative returns shown represent the value that these investments would have had on December 31, 2021.
Issuer purchases of equity securities.
On February 25, 2020, the Company’s Board of Directors approved a $50.0 million share repurchase program, which is intended for opportunistic execution based upon a variety of factors including market dynamics. On October 25, 2021, the Board increased the approved share repurchase program by $30.7 million bringing the authority at the time back to $50 million (including approximately $19.3 million available for repurchases under the Board’s previous authorization). As of December 31, 2021, we had $31.8 million of remaining authority under the repurchase program. This share repurchase program has no expiration date and is subject to the ongoing discretion of the Board. All repurchases to date under our stock repurchase programs have been made through open market transactions, but in the future, we may also purchase shares through privately negotiated transactions or 10b5-1 repurchase plans. On February 24, 2022, the Board increased the approved share repurchase program by $24.6 million bringing total authority at that time to $50 million.
The following table includes information regarding purchases of our common stock made by us during the quarter ended December 31, 2021 in connection with the repurchase program described above:
| Period | | Total Number of Shares Purchased | | | Average Price Paid per Share | | | Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs | | | Maximum Number (or Approximate Dollar Value) of Shares that May Yet Be Purchased Under the Plans or Programs | |
| October 1 to October 31 | | | - | | | $ | - | | | | - | | | $ | 50,028,385 | |
| November 1 to November 30 | | | 253,000 | | | $ | 39.30 | | | | 253,000 | | | $ | 40,085,485 | |
| December 1 to December 31 | | | 224,707 | | | $ | 36.73 | | | | 224,707 | | | $ | 31,831,997 | |
| Total | | | 477,707 | | | | | | | | 477,707 | | | | | |
Item 6. Selected Financial Data
Reserved
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
You should read the following discussion of the historical financial condition and results of operations in conjunction with our historical consolidated financial statements and accompanying notes, which are included elsewhere in this Annual Report on Form 10-K. In addition, this discussion includes forward-looking statements subject to risks and uncertainties that may result in actual results differing from statements we make. See “Cautionary Note Regarding Forward-Looking Statements.” Factors that could cause actual results to differ include those risks and uncertainties discussed in “Risk Factors.”
The following discussion relates to the audited financial statements of Turning Point Brands, Inc., included elsewhere in this Annual Report on Form 10-K. In this discussion, unless the context requires otherwise, references to “our Company” “we,” “our,” or “us” refer to Turning Point Brands, Inc., and its consolidated subsidiaries. References to “TPB” refer to Turning Point Brands, Inc., without any of its subsidiaries. We were incorporated in 2004 under the name North Atlantic Holding Company, Inc. On November 4, 2015, we changed our name to Turning Point Brands, Inc. Many of the amounts and percentages in this discussion have been rounded for convenience of presentation.
Overview
We are a leading manufacturer, marketer and distributor of branded consumer products. We sell a wide range of products to adult consumers consisting of staple products with our iconic brands Zig-Zag® and Stoker’s® to our next generation products to fulfill evolving consumer preferences. Among other markets, we compete in the alternative smoking accessories and Other Tobacco Products (“OTP”) industries. The alternative smoking accessories market is a dynamic market experiencing robust secular growth driven by cannabinoid legalization in the U.S. and Canada and positively evolving consumer perception and acceptance in North America. The OTP industry, which consists of non-cigarette tobacco products, exhibited mid-single-digit consumer unit annualized growth over the three year period ending 2021 as reported by Management Science Associates, Inc. (“MSAi”), a third-party analytics and information company. Our three focus segments are led by our core, proprietary brands: Zig-Zag® in the Zig-Zag Products segment; Stoker’s® along with Beech-Nut® and Trophy® in the Stoker’s Products segment; and our distribution platforms (Vapor Beast®, VaporFi® and Direct Vapor®) along with Solace® in the NewGen Products segment. Our businesses generate solid cash flow which we use to invest in our business, finance acquisitions, increase brand support, expand our distribution infrastructure, and strengthen our capital position. We currently ship to approximately 800 distributors with an additional 200 secondary, indirect wholesalers in the U.S. that carry and sell our products. Under the leadership of a senior management team with extensive experience in the consumer products, alternative smoking accessories and tobacco industries, we have grown and diversified our business through new product launches, category expansions, and acquisitions while concurrently improving operational efficiency.
We believe there are meaningful opportunities to grow through acquisitions and joint ventures across all product categories. As of December 31, 2021, our products are available in approximately 195,000 U.S. retail locations which, with the addition of retail stores in Canada, brings our total North American retail presence to an estimated 215,000 points of distribution. Our sales team targets widespread distribution to all traditional retail channels, including convenience stores, and we have a growing e-commerce business.
Products
We operate in three segments: Zig-Zag Products, Stoker’s Products and NewGen Products. In our Zig-Zag Products segment, we principally market and distribute (i) rolling papers, tubes, and related products; and (ii) finished cigars and make-your-own (“MYO”) cigar wraps. In our Stoker’s Products segment, we (i) manufacture and market moist snuff tobacco (“MST”) and (ii) contract for and market loose leaf chewing tobacco products. In our NewGen Products segment, we (i) market and distribute liquid vapor products and certain other products without tobacco and/or nicotine; (ii) distribute a wide assortment of products to non-traditional retail via VaporBeast; and (iii) market and distribute a wide assortment of products to individual consumers via the VaporFi B2C online platform. Refer to the ‘Recent Developments’ section below for details regarding the Turning Point Brands Canada (formerly ReCreation Marketing) investment.
Our portfolio of brands includes some of the most widely recognized names in the alternative smoking accessories and OTP industries, such as Zig-Zag®, Stoker’s®, Vapor Beast® and VaporFi®. The following table sets forth the market share and category rank of our core products and demonstrates their industry positions:
| Brand | | Product | | TPB Segment | | Market Share(1) | | Category Rank(1) |
Zig-Zag® | | Cigarette Papers | | Zig-Zag Products | | 33.6% | | #1 premium, #1 overall |
Zig-Zag® | | MYO Cigar Wraps | | Zig-Zag Products | | 56.2% | | #1 overall |
Stoker’s® | | Moist Snuff | | Stoker’s Products | | 5.6% | | #3 discount, #6 overall |
Stoker’s® | | Chewing Tobacco | | Stoker’s Products | | 25.6% | | #1 discount, #1 overall |
| | | | | | | | | |
| (1) Market share and category rank data for all products are derived from MSAi data 52 weeks ended 12/25/21. |
We subscribe to a sales tracking system from MSAi that records all OTP product shipments (ours as well as those of our competitors) from approximately 600 wholesalers to over 250,000 traditional retail stores in the U.S. This system enables us to understand individual product share and volume trends across multiple categories down to the individual retail store level, allowing us to allocate field salesforce coverage to the highest opportunity stores. Our sales and marketing group of approximately 180 professionals utilize the MSAi system to efficiently target markets and sales channels with the highest sales potential.
Our core Zig-Zag Products and Stoker’s Products segments primarily generate revenues from the sale of our products to wholesale distributors who, in turn, resell the products to retail operations. Our acquisition of VaporBeast in 2016 expanded our revenue streams as we began selling directly to non-traditional retail outlets. Our acquisition of IVG in 2018 enhanced our B2C revenue stream with the addition of the Vapor-Fi online platform. The acquisition of Solace in 2019 provided us with a line of leading liquids and a powerful new product development platform. Our net sales, which include federal excise taxes, consist of gross sales net of cash discounts, returns, and selling and marketing allowances.
We rely on long-standing relationships with high-quality, established manufacturers to provide the majority of our produced products. More than 80% of our production, as measured by net sales, is outsourced to suppliers. The remaining production consists primarily of our moist snuff tobacco operations located in Dresden, Tennessee, and Louisville, Kentucky. Our principal operating expenses include the cost of raw materials used to manufacture the limited number of our products which we produce in-house; the cost of finished products, which are generally purchased goods; federal excise taxes; legal expenses; and compensation expenses, including benefits and costs of salaried personnel. Our other principal expenses include interest expense and other expenses.
Key Factors Affecting Our Results of Operations
We consider the following to be the key factors affecting our results of operations:
| | • | Our ability to further penetrate markets with our existing products; |
| | • | Our ability to introduce new products and product lines that complement our core business; |
| | • | Decreasing interest in tobacco products among consumers; |
| | • | Price sensitivity in our end-markets; |
| | • | Marketing and promotional initiatives, which cause variability in our results; |
| | • | General economic conditions, including consumer access to disposable income and other conditions affecting purchasing power such as inflation; |
| | • | Cost and increasing regulation of promotional and advertising activities; |
| | • | Cost of complying with regulation, including “deeming regulation”; |
| | • | Increasing and unpredictable regulation of NewGen products; |
| | • | Counterfeit and other illegal products in our end-markets; |
| | • | Our ability to identify attractive acquisition opportunities; and |
| | • | Our ability to successfully integrate acquisitions. |
Recent Developments
CLIPPER® Lighters
In February 2022, we entered into an agreement with Flamagas, a renowned lighter manufacturer, for exclusive distribution of CLIPPER® lighters in the United States and Canada.
Final Rule Related to PACT Act Published
On October 21, 2021, the United States Postal Service (“USPS”) published a Final Rule entitled “Treatment of E-Cigarettes in the Mail,” which followed its earlier publication of the Proposed Rule on February 19, 2021. This Final Rule was required as a result of the inclusion of Division FF, Title VI (Preventing Online Sales of E-Cigarettes to Children or “POSECA”) in the Further Consolidated Appropriations Act, 2021. POSECA, among other things, expanded the definition of “cigarettes” in the Jenkins Act and Prevent All Cigarette Trafficking (“PACT”) Act to expressly capture “electronic nicotine delivery systems,” i.e., ENDS. Consistent with the Proposed Rule, the Final Rule extends the existing prohibition on and exceptions to the mailing of “cigarettes” via USPS to ENDS products, other than the Consumer Testing and Public Health exceptions. Specifically, the Final Rule extends the following exceptions to the prohibition on mailing of ENDS products: the Business/Regulatory Purposes Exception, the Certain Individuals Exception, and the exception for intra-Alaska and intra-Hawaii shipments. We have received certain shipping exemptions from carrier services to carry the affected freight and have created a supplemental logistical network for those shipments not covered by the exemptions.
Unitabac
On July 23, 2021, we acquired certain assets of Unitabac, a marketer of mass-market cigars, for $10.7 million in total consideration, comprised of $9.6 million in cash and $1.1 million of capitalized transaction costs. In the acquisition, we acquired a robust portfolio of cigarillo products and all related intellectual property, including Cigarillo Non-Tip (NT) Homogenized Tobacco Leaf (HTL) products and Rolled Leaf and Natural Leaf Cigarillo Products.
Old Pal
On July 21, 2021, we invested $8 million in Old Pal Holding Company LLC (“Old Pal”), a leading brand in the cannabis lifestyle space that operates a non-plant touching licensing model. We invested in the form of a convertible note which includes additional follow-on investment rights. Our investment will enable Old Pal to expand product offerings in existing states, which include California, Nevada, Michigan, Oklahoma, Ohio, Washington and Massachusetts, and will help create the infrastructure necessary to support continued territory and product expansion.
Direct Value Wholesale
In April 2021, Turning Point Brands Canada, a VIE for which we are considered the primary beneficiary, purchased 100% of the equity interest of Westhem Ventures LTD d/b/a Direct Value Wholesale (“DVW”) for $3.9 million in total consideration, comprised of $3.5 million paid in cash and $0.5 million in accrued consideration paid during 2021. DVW is Canadian distribution entity that operates in markets not primarily served by Turning Point Brands Canada. The acquisition expands Turning Point Brands Canada’s markets in Canada.
Docklight Brands, Inc.
On April 19, 2021, we invested $8.7 million in Docklight Brands, Inc., a pioneering consumer products company with celebrated brands including Marley Natural® cannabis and Marley™ CBD. We have additional follow-on investment rights. As part of the investment, we have obtained exclusive U.S. distribution rights for Docklight’s Marley™ CBD topical products.
Premarket Tobacco Applications
We submitted Premarket Tobacco Applications (“PMTAs”) covering 250 products to the FDA prior to the September 9, 2020 filing deadline. The PMTAs cover a broad assortment of products in the vapor category including multiple proprietary e-liquid offerings in varying nicotine strengths, technologies and sizes; proprietary replacement parts and components of open system tank devices through partnerships with two leading manufacturers for exclusive distribution of products in the United States; and a closed system e-cigarette. On September 14, 2021, the FDA issued a Marketing Denial Order (“MDO”) for certain of the Company’s proprietary e-liquid products subject of these PMTAs. The Company filed a Petition for Review in the Sixth Circuit Court of Appeals on September 23, 2021, followed by an Emergency Motion for a Stay Pending Review on September 30, 2021. On October 7, 2021, we were informed that the FDA had rescinded its September 14, 2021, MDO. We therefore withdrew both the Petition and Emergency Stay on October 8, 2021. The Rescission Letter indicated that the FDA had found additional relevant information that was not adequately assessed. The Rescission Letter further clarified that the FDA presently has no intention of initiating any regulatory enforcement action against the products.
Critical Accounting Policies and Uses of Estimates
The accompanying consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States. When more than one accounting principle, or the method of its application, is generally accepted, we select the principle or method that is appropriate in the specific circumstances. Application of these accounting principles requires us to make estimates about the future resolution of existing uncertainties. Actual results could differ from these estimates. We evaluate our estimates, including those related to revenue recognition, collectability of accounts receivable, inventory valuation and obsolescence, goodwill, intangibles, income taxes, litigation, and contingencies on an ongoing basis. We base these estimates on our historical experience and other assumptions we believe are appropriate under the circumstances. In preparing these consolidated financial statements, we have made our best estimates and judgments of the amounts and disclosures included in the consolidated financial statements.
Revenue Recognition
We recognize revenues in accordance with Accounting Standards Codification (“ASC”) 606, Revenue from Contracts with Customers (Topic 606), which include excise taxes and shipping and handling charges billed to customers, net of cash discounts for prompt payment, sales returns and sales incentives, upon delivery of goods to the customer—at which time our performance obligation is satisfied—at an amount that we expect to be entitled to in exchange for those goods in accordance with the five-step analysis outlined in Topic 606: (i) identify the contract with the customer, (ii) identify the performance obligations in the contract, (iii) determine the transaction price, (iv) allocate the transaction price to the performance obligations, and (v) recognize revenue when (or as) performance obligations are satisfied. We exclude from the transaction price, sales taxes and value-added taxes imposed at the time of sale (which do not include excise taxes on smokeless tobacco, cigars or vaping products billed to customers).
We record an allowance for sales returns, based principally on historical volume and return rates, which is included in accrued liabilities on the consolidated balance sheets. We record sales incentives, which consist of consumer incentives and trade promotion activities, as a reduction in revenues (a portion of which is based on amounts estimated as being due to wholesalers, retailers and consumers at the end of the period) based principally on historical volume and utilization rates. Expected payments for sales incentives are included in accrued liabilities on the consolidated balance sheets.
A further requirement of ASC 606 is for entities to disaggregate revenue recognized from contracts with customers into categories that depict how the nature, amount, timing, and uncertainty of revenue and cash flows are affected by economic factors. Our management views business performance through segments that closely resemble the performance of major product lines. Thus, the primary, and most useful, disaggregation of our contract revenue for decision making purposes is the disaggregation by segment which can be found in Note 21 of our Notes to Consolidated Financial Statements. An additional disaggregation of contract revenue by sales channel can be found within Note 21 as well.
Derivative Instruments – Currency Forward Contracts
We use foreign currency forward contracts to hedge a portion of our exposure to changes in foreign currency exchange rates from time to time. We account for our forward contracts under the provisions of ASC 815, Derivatives and Hedging. Under our policy, as amended, we may hedge up to 100% of our anticipated purchases of inventory in the denominated invoice currency over a forward period not to exceed twelve months. We may also, from time to time, hedge up to ninety percent of our non-inventory purchases in the denominated invoice currency. Forward contracts that qualify as hedges are adjusted to their fair value through other comprehensive income as determined by market prices on the measurement date except any hedge ineffectiveness which is recognized currently in income. Gains and losses on these contracts are transferred from other comprehensive income into inventory as the related inventories are received and are transferred to net income as inventory is sold. Changes in fair value of any contracts that do not qualify for hedge accounting or are not designated as hedges are recognized in income currently.
Derivative Instruments - Interest Rate Swaps
We enter into interest rate swap contracts to manage interest rate risk and reduce the volatility of future cash flows. We account for interest rate swap contracts under the provisions of ASC 815, Derivatives and Hedging. Swap contracts that qualify as hedges are adjusted to their fair value through other comprehensive income as determined by market prices on the measurement date, except any hedge ineffectiveness which is recognized currently in income. Gains and losses on these swap contracts are transferred from other comprehensive income into net income upon settlement of the derivative position or at maturity of the interest rate swap contract. Changes in fair value of any contracts that do not qualify for hedge accounting or are not designated as hedges are recognized currently in income.
Goodwill and Other Intangible Assets
We follow the provisions of ASC 350, Intangibles – Goodwill and Other in accounting for our goodwill and other intangible assets. Goodwill and indefinite-lived intangible assets are reviewed for impairment annually on December 31, or more frequently if certain indicators are present, in accordance with ASC 350-20-35 and ASC 350-30-35, respectively. If the carrying value of the goodwill or indefinite-life intangible asset exceeds its fair value, determined using the discounted cash flows method and the relief-from-royalty method, respectively, the goodwill or intangible asset is considered impaired. The carrying value of the goodwill or indefinite-life intangible asset would then be reduced to fair value. For goodwill, the determination of a reporting unit’s fair value involves, among other things, our market capitalization and application of the income approach, which includes developing forecasts of future cash flows and determining an appropriate discount rate.
Based on our annual goodwill impairment testing, the estimated fair values of each of our reporting units were in excess of the respective carrying values at December 31, 2021. We had no such impairment of goodwill or other intangible assets during the year ended December 31, 2021. However, there could be an impairment of the goodwill of the NewGen reporting unit if future revenues do not achieve our expected future cash flows or if macroeconomic conditions result in future increases in the weighted average cost of capital used to estimate fair value. Refer to Note 10 of Notes to Consolidated Financial Statements for further details regarding our goodwill and other intangible assets as of December 31, 2021.
Fair Value
GAAP establishes a framework for measuring fair value. That framework provides a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (level 1) and the lowest priority to unobservable inputs (level 3). The three levels of the fair value hierarchy under GAAP are described below:
| | • | Level 1 – Inputs to the valuation methodology are unadjusted quoted prices for identical assets or liabilities in active markets at the measurement date. |
| | • | Level 2 – Inputs to the valuation methodology include: quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in inactive markets; inputs other than quoted prices that are observable for the asset or liability; and inputs that are derived principally from or corroborated by observable market data by correlation or other means. |
| | • | Level 3 – Unobservable inputs that reflect management’s best estimate of what market participants would use in pricing the asset or liability at the measurement date. |
Retirement Plans
We follow the provisions of ASC 715, Compensation – Retirement Benefits in accounting for our retirement plans, which requires an employer to (i) recognize in its statement of financial position the funded status of a benefit plan, measured as the difference between the fair value of plan assets and benefit obligations; (ii) recognize, net of tax, the gains or losses and prior service costs or credits that arise during the period but are not recognized as components of net periodic benefit cost; and (iii) measure defined benefit plan assets and obligations as of the date of the employer’s statement of financial position.
Income Taxes
We account for income taxes under ASC 740. We record the effects of income taxes under the liability method in which deferred income tax assets and liabilities are recognized based on the difference between the financial and tax basis of assets and liabilities using the enacted tax rates in effect for the years in which the differences are expected to reverse. We assess our ability to realize future benefits of deferred tax assets by determining if they meet the “more likely than not” criteria in ASC 740, Income Taxes. If we determine that future benefits do not meet the “more likely than not” criteria, a valuation allowance is recorded.
Stock-Based Compensation
We measure stock compensation costs related to our stock options on the fair value-based method under the provisions of ASC 718, Compensation – Stock Compensation, which requires compensation cost for stock options to be recognized based on the fair value of stock options granted. We determine the fair value of these awards using the Black-Scholes option pricing model.
We grant performance-based restricted stock units (“PRSU”) subject to both performance-based and service-based vesting conditions. The fair value of each PRSU is our stock price on the date of grant. For purposes of recognizing compensation expense as services are rendered in accordance with ASC 718, we assume all employees involved in the PRSU grant will provide service through the end of the performance period. Stock compensation expense is recorded based on the probability of achievement of the performance conditions specified in the PRSU grant.
We grant restricted stock units (“RSU”) subject to service-based vesting conditions. The fair value of each RSU is our stock price on the date of grant. We recognize compensation expense as services are rendered in accordance with ASC 718. Stock compensation expense is recorded over the service period in the RSU grant.
Accounts Receivable
Accounts receivable are recognized at their net realizable value. All accounts receivable are trade-related and are recorded at the invoiced amount and do not bear interest. We maintain allowances for doubtful accounts receivable for estimated uncollectible invoices resulting from the customer’s inability to pay, which may result in write-offs. We recorded an allowance for doubtful accounts of $0.3 million and $0.2 million at December 31, 2021 and 2020, respectively.
Inventories
Inventories are stated at the lower of cost or net realizable value. Cost was determined using the first-in, first-out (“FIFO”) method. Leaf tobacco is presented in current assets in accordance with standard industry practice, notwithstanding the fact that such tobaccos are carried longer than one year for the purpose of curing. We recorded an inventory valuation allowance of $7.7 million and $9.9 million at December 31, 2021 and 2020, respectively.
Results of Operations
Summary
The table and discussion set forth below relates to our consolidated results of operations for the years ended December 31 (in thousands):
| | | For the year ended December 31, | |
| | | 2021 | | | 2020 | | | % Change | | | 2019 | | | % Change | |
| Consolidated Results of Operations Data: | | | | | | | | | | | | | | | |
| Net sales | | | | | | | | | | | | | | | |
| Zig-Zag products | | $ | 176,491 | | | $ | 132,812 | | | | 32.9 | % | | $ | 108,733 | | | | 22.1 | % |
| Stoker’s products | | | 124,280 | | | | 115,866 | | | | 7.3 | % | | | 99,894 | | | | 16.0 | % |
| NewGen products | | | 144,700 | | | | 156,433 | | | | -7.5 | % | | | 153,362 | | | | 2.0 | % |
| Total net sales | | | 445,471 | | | | 405,111 | | | | 10.0 | % | | | 361,989 | | | | 11.9 | % |
| Cost of sales | | | 227,637 | | | | 215,121 | | | | 5.8 | % | | | 224,872 | | | | -4.3 | % |
| Gross profit | | | | | | | | | | | | | | | | | | | | |
| Zig-Zag products | | | 102,739 | | | | 78,278 | | | | 31.2 | % | | | 59,414 | | | | 31.8 | % |
| Stoker’s products | | | 68,084 | | | | 61,764 | | | | 10.2 | % | | | 52,620 | | | | 17.4 | % |
| NewGen products | | | 47,011 | | | | 49,948 | | | | -5.9 | % | | | 25,083 | | | | 99.1 | % |
| Total gross profit | | | 217,834 | | | | 189,990 | | | | 14.7 | % | | | 137,117 | | | | 38.6 | % |
| | | | | | | | | | | | | | | | | | | | | |
| Selling, general, and administrative expenses | | | 127,513 | | | | 125,563 | | | | 1.6 | % | | | 109,887 | | | | 14.3 | % |
| Operating income | | | 90,321 | | | | 64,427 | | | | 40.2 | % | | | 27,230 | | | | 136.6 | % |
| Interest expense, net | | | 20,500 | | | | 13,487 | | | | 52.0 | % | | | 14,435 | | | | -6.6 | % |
| Investment loss (income) | | | 6,673 | | | | (198 | ) | | | -3470.2 | % | | | (2,648 | ) | | | -92.5 | % |
| (Gain) loss on extinguishment of debt | | | (2,154 | ) | | | - | | | NM | | | | 1,308 | | | | -100.0 | % |
| Net periodic benefit cost (income), excluding service cost | | | - | | | | 989 | | | | -100.0 | % | | | (4,961 | ) | | | -119.9 | % |
| Income before income taxes | | | 65,302 | | | | 50,149 | | | | 30.2 | % | | | 19,096 | | | | 162.6 | % |
| Income tax expense | | | 14,040 | | | | 11,957 | | | | 17.4 | % | | | 2,863 | | | | 317.6 | % |
| Consolidated net income | | | 51,262 | | | | 38,192 | | | | 34.2 | % | | | 16,233 | | | | 135.3 | % |
| Net loss attributable to non-controlling interest | | | (797 | ) | | | - | | | NM | | | | - | | | NM | |
| Net income attributable to Turning Point Brands, Inc. | | $ | 52,059 | | | $ | 38,192 | | | | 36.3 | % | | $ | 16,233 | | | | 135.3 | % |
Comparison of Year Ended December 31, 2021, to Year Ended December 31, 2020
Net Sales. For the year ended December 31, 2021, overall net sales increased to $445.5 million from $405.1 million for the year ended December 31, 2020, an increase of $40.4 million or 10.0%. The increase in net sales was primarily driven by increased sales volume in the Zig-Zag Products segment.
For the year ended December 31, 2021, net sales in the Zig-Zag Products segment increased to $176.5 million from $132.8 million for the year ended December 31, 2020, an increase of $43.7 million or 32.9%. For the year ended December 31, 2021, Zig-Zag Products volumes increased 29.7%, and price/mix increased 3.2%. The increase in net sales was by led by double-digit growth in sales of our MYO cigar wraps and U.S. rolling papers business. This growth was complemented by our Canadian business which benefited from the consolidation of Turning Point Brands Canada in the current year period.
For the year ended December 31, 2021, net sales in the Stoker’s Products segment increased to $124.3 million from $115.9 million for the year ended December 31, 2020, an increase of $8.4 million or 7.3%. For the year ended December 31, 2021, Stoker’s Products volume increased 1.3% and price/mix increased 6.0%. The increase in net sales was driven by the continuing double-digit growth of Stoker’s® MST offset by low single-digit decline in loose-leaf chewing tobacco. MST represented 63% of Stoker’s Products revenue in 2021, up from 59% a year earlier.
For the year ended December 31, 2021, net sales in the NewGen products segment decreased to $144.7 million from $156.4 million for the year ended December 31, 2020, a decrease of $11.7 million or 7.5%. The decrease in net sales was primarily the result of declines in the vape distribution businesses as a result of strong B2C orders during stay-at-home provisions in the prior year as well as the changing regulatory environment.
Gross Profit. For the year ended December 31, 2021, overall gross profit increased to $217.8 million from $190.0 million for the year ended December 31, 2020, an increase of $27.8 million or 14.7%. Gross profit as a percentage of net sales increased to 48.9% for the year ended December 31, 2021, from 46.9% for the year ended December 31, 2020. The increase in gross profit as a percentage of net sales was driven by increased margin in the Stoker’s Products segment as a result of strong incremental margin contribution of MST.
For the year ended December 31, 2021, gross profit in the Zig-Zag Products segment increased to $102.7 million from $78.3 million for the year ended December 31, 2020, an increase of $24.5 million or 31.2%. Gross profit as a percentage of net sales decreased to 58.2% of net sales for the year ended December 31, 2021, from 58.9% of net sales for the year ended December 31, 2020. The decrease in gross profit as a percentage of net sales is a result of the consolidation of Turning Point Brands Canada in the current year period which operates at lower margins than our traditional business.
For the year ended December 31, 2021, gross profit in the Stoker’s Products segment increased to $68.1 million from $61.8 million for the year ended December 31, 2020, an increase of $6.3 million or 10.2%. Gross profit as a percentage of net sales increased to 54.8% of net sales for the year ended December 31, 2021, from 53.3% of net sales for the year ended December 31, 2020. The increase in gross profit as a percentage of net sales is primarily a result of pricing and strong incremental margin contribution of MST.
For the year ended December 31, 2021, gross profit in the NewGen products segment decreased to $47.0 million from $49.9 million for the year ended December 31, 2020, a decrease of $2.9 million or 5.9%. NewGen gross profit includes $1.1 million of tariff expenses in 2021 compared to $10.1 million in 2020. Gross profit as a percentage of net sales increased to 32.5% of net sales for the year ended December 31, 2021, from 31.9% of net sales for the year ended December 31, 2020, primarily as a result of increased margins in the vape distribution businesses.
Selling, General and Administrative Expenses. For the year ended December 31, 2021, selling, general and administrative expenses increased to $127.5 million from $125.6 million for the year ended December 31, 2020, an increase of $2.0 million or 1.6%. Selling, general, and administrative expenses for the year ended December 31, 2021, included $7.6 million of stock options, restricted stock and incentives expense, $1.3 million of transaction expenses, $0.8 million of restructuring expenses and $2.6 million of expense related to PMTA. Selling, general, and administrative expenses for the year ended December 31, 2020, included $2.6 million of stock options, restricted stock and incentives expense, $3.1 million of transaction expenses, $0.5 million of restructuring expenses and $14.4 million of expense related to PMTA. The increase in selling, general and administrative expenses is a result of variable costs in our online business as well as increased shipping costs from PACT Act implementation for vape products and higher freight rates across all segments combined with the impact of the consolidation of Turning Point Brands Canada in the current year period.
Interest Expense, net. For the year ended December 31, 2021, interest expense, on a net basis, increased to $20.5 million from $13.5 million for the year ended December 31, 2020, primarily as a result the issuance of the Senior Secured Notes and related refinancing of the 2018 First Lien Credit Facility which increased the Company’s outstanding debt.
Investment Loss (Income). For the year ended December 31, 2021, investment loss increased to $6.7 million compared to $0.2 million of investment income for the year ended December 31, 2020, primarily as a result of $7.1 million impairment of our investment in dosist. See Note 11 Other Assets in the Consolidated Financial Statements for additional information on the dosist investment.
(Gain) Loss on Extinguishment of Debt. For the year ended December 31, 2021, gain on extinguishment of debt was $2.2 million as a result of forgiveness of the unsecured loan issued to us under the Coronavirus Aid, Relief, and Economic Security Act of 2020 (the “CARES Act”) partially offset by the repayment of the 2018 First Lien Credit Facility. For the year ended December 31, 2020, there was no loss on extinguishment of debt.
Net Periodic Benefit Cost (Income), excluding service cost. For the year ended December 31, 2021, there was no net periodic benefit cost or income. For the year ended December 31, 2020, net periodic cost was $0.9 million primarily as a result of the curtailment from the shutdown of the pension plan.
Income Tax Expense. The Company’s income tax expense was $14.0 million, or 21.5% of income before income taxes, for the year ended December 31, 2021, and included discrete tax deductions of $7.5 million related to the forgiveness of the $7.5 million unsecured loan and $7.2 million relating to stock option exercises during the year. The Company’s income tax expense was $12.0 million, or 23.8% of income before income taxes, for the year ended December 31, 2020, and included a discrete tax deduction of $3.3 million relating to stock option exercises during the year and a discrete tax benefit of $0.6 million from the shutdown of the pension plan.
Net Loss Attributable to Non-Controlling Interest. Net loss attributable to non-controlling interest was $0.8 million for the year ended December 31, 2021, compared to $0.0 million for the year ended December 31, 2020.
Net Income Attributable to Turning Point Brands, Inc. Due to the factors described above, net income attributable to Turning Point Brands, Inc. for the years ended December 31, 2021 and 2020, was $52.1 million and $38.2 million, respectively.
Comparison of Year Ended December 31, 2020, to Year Ended December 31, 2019
Net Sales. For the year ended December 31, 2020, overall net sales increased to $405.1 million from $362.0 million for the year ended December 31, 2019, an increase of $43.1 million or 11.9%. The increase in net sales was primarily driven by increased sales volume across all segments.
For the year ended December 31, 2020, net sales in the Zig-Zag Products segment increased to $132.8 million from $108.7 million for the year ended December 31, 2019, an increase of $24.1 million or 22.1%. For the year ended December 31, 2020, Zig-Zag Products volumes increased 19.7%, and price/mix increased 2.4%. The increase in net sales was primarily related to double digit growth in US papers and wraps, partially offset by a $1.8 million decline in non-focus cigars and MYO pipe.
For the year ended December 31, 2020, net sales in the Stoker’s Products segment increased to $115.9 million from $99.9 million for the year ended December 31, 2019, an increase of $16.0 million or 16.0%. For the year ended December 31, 2020, Stoker’s Products volume increased 12.0% and price/mix increased 4.0%. The increase in net sales was primarily driven by the continuing double-digit volume growth of Stoker’s® MST. Sales in chewing tobacco products were up mid-single digits as compared to prior year. MST represented 59% of Stoker’s Products revenue in 2020, up from 54% a year earlier.
For the year ended December 31, 2020, net sales in the NewGen products segment increased to $156.4 million from $153.4 million for the year ended December 31, 2019, an increase of $3.1 million or 2.0%. The increase in net sales was primarily the result of growth in both the Nu-X and vape distribution businesses.
Gross Profit. For the year ended December 31, 2020, overall gross profit increased to $190.0 million from $137.1 million for the year ended December 31, 2019, an increase of $52.9 million or 38.6%, due to growth across all segments and $24.2 million of costs in 2019 that did not recur primarily related to inventory reserves. Consolidated gross profit for the year ended December 31, 2019, included $1.2 million of introductory launch costs and $23.0 million of restructuring costs primarily inventory reserves. Gross profit as a percentage of net sales increased to 46.9% for the year ended December 31, 2020, from 37.9% for the year ended December 31, 2019.
For the year ended December 31, 2020, gross profit in the Zig-Zag Products segment increased to $78.3 million from $59.4 million for the year ended December 31, 2019, an increase of $18.9 million or 31.8%. Gross profit as a percentage of net sales increased to 58.9% of net sales for the year ended December 31, 2020, from 54.6% of net sales for the year ended December 31, 2019. The increase in gross profit as a percentage of net sales is a result of increased US paper sales and increased margin in MYO cigar sales as a result of the Durfort transaction.
For the year ended December 31, 2020, gross profit in the Stoker’s Products segment increased to $61.8 million from $52.6 million for the year ended December 31, 2019, an increase of $9.1 million or 17.4%. Gross profit as a percentage of net sales increased to 53.3% of net sales for the year ended December 31, 2020, from 52.7% of net sales for the year ended December 31, 2019. The increase in gross profit as a percentage of net sales is primarily a result of strong incremental margin contribution of MST.
For the year ended December 31, 2020, gross profit in the NewGen products segment increased to $49.9 million from $25.1 million for the year ended December 31, 2019, an increase of $24.9 million or 99.1%. NewGen gross profit for the year ended December 31, 2019, included $1.2 million of introductory launch costs and $23.2 million of restructuring expenses that did not recur in 2020. Additionally, the gross profit includes $10.1 million of tariff expenses in 2020 compared to $9.3 million in 2019. Gross profit as a percentage of net sales increased to 31.9% of net sales for the year ended December 31, 2020, from 16.4% of net sales for the year ended December 31, 2019, primarily due to the impact of the $23.2 million of related write-offs and reserves in 2019 associated with the vape distribution business.
Selling, General and Administrative Expenses. For the year ended December 31, 2020, selling, general and administrative expenses increased to $125.6 million from $109.9 million for the year ended December 31, 2019, an increase of $15.7 million or 14.3%. Selling, general, and administrative expenses for the year ended December 31, 2020, included $2.6 million of stock options, restricted stock and incentives expense, $3.1 million of transaction expenses, $0.5 million of restructuring expenses and $14.4 million of expense related to PMTA. Selling, general, and administrative expenses for the year ended December 31, 2019, included $1.8 million of transaction costs (primarily relating to Solace and Turning Point Brands Canada as well as earnout expense for IVG), $5.0 million of introductory launch costs, $3.2 million of restructuring expenses, and $2.2 million in PMTA expenses.
Interest Expense, net. For the year ended December 31, 2020, interest expense, on a net basis, decreased to $13.5 million from $14.4 million for the year ended December 31, 2019, primarily as a result of a decrease in interest expense on our 2018 First Lien Term Loan as result of lower interest rates partially offset by increased interest expense from our Convertible Senior Notes.
Investment Income. For the year ended December 31, 2020, investment income decreased to $0.2 million from $2.6 million for the year ended December 31, 2019, primarily due to the impact of the $2.0 million gain on the CASH investment as a result of marking the investment to fair value in 2019. See Note 11 Other Assets in the Consolidated Financial Statements for additional information on the CASH investment.
Loss on Extinguishment of Debt. For the year ended December 31, 2020, there was no loss on extinguishment of debt. For the year ended December 31, 2019, loss on extinguishment of debt was $1.3 million as the result of paying off the 2018 Second Lien Credit Facility.
Net Periodic Benefit Cost (Income), excluding service cost. For the year ended December 31, 2020, net periodic cost was $0.9 million primarily as a result of the curtailment from the shutdown of the pension plan. For the year ended December 31, 2019, net periodic income was $5.0 million primarily due to the gain on the termination of the postretirement plan.
Income Tax Expense. The Company’s income tax expense was $12.0 million, or 23.8% of income before income taxes, for the year ended December 31, 2020, and included a discrete tax deduction of $3.3 million relating to stock option exercises during the year and a discrete tax benefit of $0.6 million from the shutdown of the pension plan. The Company’s income tax expense of $2.9 million, or 15.0% of income before income taxes, for the year ended December 31, 2019, was lower than the expected annual effective tax rate as a result of discrete tax benefits of $4.6 million from the exercise of stock options during the year.
Net Income Attributable to Turning Point Brands, Inc . Due to the factors described above, net income for the year ended December 31, 2020 and 2019, was $38.2 million and $16.2 million, respectively.
EBITDA and Adjusted EBITDA
To supplement our financial information presented in accordance with U.S. GAAP, we use non-U.S. GAAP financial measures including EBITDA and Adjusted EBITDA. We believe Adjusted EBITDA provides useful information to management and investors regarding certain financial and business trends relating to our financial condition and results of operations. Adjusted EBITDA is used by management to compare our performance to that of prior periods for trend analyses and planning purposes and is presented to our Board of Directors. We believe that EBITDA and Adjusted EBITDA are appropriate measures of operating performance because they eliminate the impact of expenses that do not relate to operating performance. In addition, our debt instruments contain covenants which use Adjusted EBITDA calculations.
We define “EBITDA” as net income before interest expense, loss on extinguishment of debt, provision for income taxes, depreciation, and amortization. We define “Adjusted EBITDA” as net income before interest expense, loss (gain) on extinguishment of debt, provision for income taxes, depreciation, amortization, other non-cash items, and other items we do not consider ordinary course in our evaluation of ongoing operating performance.
Non-U.S. GAAP measures should not be considered a substitute for, or superior to, financial measures calculated in accordance with U.S. GAAP. Adjusted EBITDA excludes significant expenses required to be recorded in our financial statements by U.S. GAAP and is subject to inherent limitations. Other companies in our industry may calculate this non-U.S. GAAP measure differently than we do or may not calculate it at all, limiting its usefulness as a comparative measure. The table below provide a reconciliation between net income, EBITDA and Adjusted EBITDA.
| (in thousands) | | Years ended December 31, | |
| | | 2021 | | | 2020 | | | 2019 | |
| Consolidated net income | | $ | 52,059 | | | $ | 38,192 | | | $ | 16,233 | |
| Add: | | | | | | | | | | | | |
| Interest expense, net | | | 20,500 | | | | 13,487 | | | | 14,435 | |
| (Gain) loss on extinguishment of debt | | | (2,154 | ) | | | - | | | | 1,308 | |
| Income tax expense | | | 14,040 | | | | 11,957 | | | | 2,863 | |
| Depreciation expense | | | 3,105 | | | | 3,237 | | | | 2,638 | |
| Amortization expense | | | 1,907 | | | | 1,781 | | | | 1,451 | |
| EBITDA | | $ | 89,457 | | | $ | 68,654 | | | $ | 38,928 | |
| Components of Adjusted EBITDA | | | | | | | | | | | | |
| Other (a) | | | - | | | | 988 | | | | (11 | ) |
| Stock options, restricted stock, and incentives expense (b) | | | 7,557 | | | | 2,555 | | | | 4,626 | |
| Transactional expenses and strategic initiatives (c) | | | 1,267 | | | | 3,087 | | | | 1,764 | |
| New product launch costs (d) | | | - | | | | - | | | | 6,185 | |
| FDA PMTA (e) | | | 1,668 | | | | 14,435 | | | | 2,153 | |
| Corporate and vapor restructuring (f) | | | 1,026 | | | | 517 | | | | 19,214 | |
| Non-cash asset impairment (g) | | | 7,100 | | | | - | | | | - | |
| Vendor settlement (h) | | | - | | | | - | | | | (5,522 | ) |
| Adjusted EBITDA | | $ | 108,075 | | | $ | 90,236 | | | $ | 67,337 | |
| (a) | Represents non-cash pension expense (income) and foreign exchange hedging. |
| (b) | Represents non-cash stock options, restricted stock, incentives expense and Solace performance stock units. |
| (c) | Represents the fees incurred for transaction expenses and strategic initiatives. |
| (d) | Represents product launch costs for our new product lines. |
| (e) | Represents costs associated with applications related to FDA premarket tobacco product application (“PMTA”). |
| (f) | Costs during the year ended December 31, 2021, represent the write-down and disposal cost of discontinued vape inventory and cost of retail store lease termination. Costs during the year ended December 31, 2020, represent the costs from the retirement of a senior executive. Costs during the year ended December 31, 2019, represent the costs associated with corporate and vapor restructuring including severance and inventory reserves |
| (g) | Represents impairment of investment in dosist. |
| (h) | Represents net gain associated with the settlement of a vendor contract. |
Liquidity and Capital Resources
Our principal uses for cash are working capital, debt service, and capital expenditures. We believe our cash flows from operations and borrowing availability under our New Revolving Credit Facility are adequate to satisfy our operating cash requirements for the foreseeable future.
Our working capital, which we define as current assets less cash and current liabilities, increased $15.5 million to $80.5 million at December 31, 2021, compared with $65.0 million at December 31, 2020. The increase in working capital is primarily due to decrease in the current portion of long-term debt as a result of paying off the 2018 Second Lien Credit Facility and the Promissory Note issued to the sellers in connection with the Durfort acquisition.
| | | As of | |
(in thousands) | | | | | | |
| | | | | | | |
| Current assets | | $ | 120,849 | | | $ | 121,638 | |
| Current liabilities | | | 40,336 | | | | 56,629 | |
| Working capital | | $ | 80,513 | | | $ | 65,009 | |
During the year ended December 31, 2021 and 2020, we invested $6.2 million and $6.1 million, respectively, in capital expenditures. We had unrestricted cash on hand of $128.3 million and $41.8 million as of December 31, 2021 and 2020, respectively. The significant increase in cash on hand is primarily the result of the proceeds from the Senior Secured Note issuance. We had restricted assets of $34.7 million and $35.1 million as of December 31, 2021 and 2020, respectively. Restricted assets consist of escrow deposits under the MSA and insurance deposits. On the 25th anniversary of each annual deposit, we are entitled to receive reimbursement of the principal amount of escrow remaining for that year. See “Master Settlement Agreement” below for details.
Cash Flows from Operating Activities
For the year ended December 31, 2021, net cash provided by operating activities increased to $68.2 million from $43.7 million for the year ended December 31, 2020, an increase of $24.5 million or 56%, primarily due to higher net income due to increased sales combined with the timing of changes in working capital.
For the year ended December 31, 2020, net cash provided by operating activities increased to $43.7 million from $37.8 million for the year ended December 31, 2019, an increase of $5.9 million or 16%, primarily due to higher net income due to increased sales offset by the timing of changes in working capital.
Cash Flows from Investing Activities
For the year ended December 31, 2021, net cash used in investing activities decreased to $58.8 million from $64.8 million for the year ended December 31, 2020, a decrease of $6.0 million or 9%, primarily due to the decrease in acquisitions partially offset by the purchase of investments in our MSA escrow account which reflects the change in restricted cash.
For the year ended December 31, 2020, net cash used in investing activities was $64.8 million compared to net cash provided by investing activities of $15.9 million for the year ended December 31, 2019, a decrease of $80.7 million or 508%, primarily due to increases in cash paid for acquisitions and investments in 2020.
Cash Flows from Financing Activities
For the year ended December 31, 2021, net cash provided by financing activities was $57.1 million compared to net cash used in financing activities $29.3 million for the year ended December 31, 2020, an increase of $86.4 million or 295%, primarily due to the net proceeds from the Senior Secured Notes partially offset by the repayment in full of the 2018 First Lien Term Loan in the first quarter of 2021 with the proceeds of the Senior Secured Notes and the repurchase of $38.7 million of common stock during 2021.
For the year ended December 31, 2020, net cash used in financing activities was to $29.3 million compared to net cash provided by financing activities $68.0 million for the year ended December 31, 2019, a decrease of $97.3 million or 143%, primarily due to lapping the net proceeds from the issuance of the Convertible Senior Notes and the payment of the revolving credit facility and second lien term loan in 2019.
Long-Term Debt
Notes payable and long-term debt consisted of the following at December 31, 2021 and 2020, in order of preference:
| | | | | | | |
| Senior Secured Notes | | $ | 250,000 | | | $ | - | |
| 2018 First Lien Term Loan | | | - | | | | 130,000 | |
| Convertible Senior Notes | | | 172,500 | | | | 172,500 | |
| Note payable - Promissory Note | | | - | | | | 10,000 | |
| Note payable - Unsecured Loan | | | - | | | | 7,485 | |
| Gross notes payable and long-term debt | | | 422,500 | | | | 319,985 | |
| Less deferred finance charges | | | (8,328 | ) | | | (5,873 | ) |
| Less current maturities | | | - | | | | (12,000 | ) |
| Net notes payable and long-term debt | | $ | 414,172 | | | $ | 302,112 | |
As noted above under “—Recent Developments—Senior Secured Notes and New Revolving Credit Facility,” on February 11, 2021, the Company completed a comprehensive refinancing transaction pursuant to which the Company issued $250 million of its Senior Secured Notes entered into the New Revolving Credit Facility. The proceeds from the Offering of the Senior Secured Notes were used to (i) repay all obligations under and terminate the 2018 First Lien Term Loan and 2018 First Lien Revolver, (ii) pay related fees, costs, and expenses and (iii) for general corporate purposes.
Senior Secured Notes
On February 11, 2021, we closed a private offering (the “Offering”) of $250 million aggregate principal amount of our 5.625% senior secured notes due 2026 (the “Senior Secured Notes”). The Senior Secured Notes bear interest at a rate of 5.625% and will mature on February 15, 2026. Interest on the Senior Secured Notes is payable semi-annually in arrears on February 15 and August 15 of each year, commencing on August 15, 2021.We used the proceeds from the Offering (i) to repay all obligations under and terminate the 2018 First Lien Credit Facility, (ii) to pay related fees, costs, and expenses and (iii) for general corporate purposes.
Obligations under the Senior Secured Notes are guaranteed by the Company’s existing and future wholly-owned domestic subsidiaries (the “Guarantors”) that guarantee any Credit Facility (as defined in the Indenture governing the Senior Secured Notes or the “Senior Secured Notes Indenture”), including the 2021 Revolving Credit Facility, or capital markets debt securities of the Company or Guarantors in excess of $15.0 million. The Senior Secured Notes and the related guarantees are secured by first-priority liens on substantially all of the assets of the Company and the Guarantors, subject to certain exceptions.
We may redeem the Senior Secured Notes, in whole or in part, at any time prior to February 15, 2023, at a price equal to 100% of the principal amount of the Notes redeemed plus accrued and unpaid interest, if any, to, but excluding the applicable redemption date, plus a “make-whole” premium. Thereafter, we may redeem the Senior Secured Notes, in whole or in part, at established redemption prices set forth in the Senior Secured Notes Indenture, plus accrued and unpaid interest, if any. In addition, on or prior to February 15, 2023, we may redeem up to 40% of the aggregate principal amount of the Senior Secured Notes with the net cash proceeds from certain equity offerings at a redemption price equal to 105.625%, plus accrued and unpaid interest, if any to the redemption date; provided, however, that at least 50% of the original aggregate principal amount of the Senior Secured Notes (calculated after giving effect to the issuance of any additional notes) remains outstanding. In addition, at any time and from time to time prior to February 15, 2023, but not more than once in any twelve-month period, we may redeem up to 10% of the aggregate principal amount of the Senior Secured Notes at a redemption price of 103% of the aggregate principal amount of Senior Secured Notes redeemed plus accrued and unpaid interest, if any to but not including the redemption date, on the Senior Secured Notes to be redeemed.
If we experience a change of control (as defined in the Senior Secured Notes Indenture), we must offer to repurchase the Senior Secured Notes at a repurchase price equal to 101% of the principal amount of the Notes to be repurchased, plus accrued and unpaid interest.
The Indenture contains covenants that, among other things, limit the ability of the Company and its restricted subsidiaries to: (i) grant or incur liens; (ii) incur, assume or guarantee additional indebtedness; (iii) sell or otherwise dispose of assets, including capital stock of subsidiaries; (iv) make certain investments; (v) pay dividends, make distributions or redeem or repurchase capital stock; (vi) engage in certain transactions with affiliates; and (vii) consolidate or merge with or into, or sell substantially all of our assets to another entity. These covenants are subject to a number of limitations and exceptions set forth in the Indenture. The Indenture provides for customary events of default.
We incurred debt issuance costs attributable to the issuance of the Senior Secured Notes of $6.4 million which are amortized to interest expense using the effective interest method over the expected life of the Senior Secured Notes.
2021 Revolving Credit Facility
In connection with the Offering, we also entered into a new $25 million senior secured revolving credit facility (the “2021 Revolving Credit Facility”) with the lenders party thereto (the “Lenders”) and Barclays Bank PLC, as administrative agent and collateral agent (in such capacity, the “Agent”). The 2021 Revolving Credit Facility provides for a revolving line of credit of up to $25.0 million. Letters of credit are limited to $10 million (and are a part of, and not in addition to, the revolving line of credit). We have not drawn any borrowings under the 2021 Revolving Credit Facility but do have letters of credit of approximately $3.6 million outstanding under the facility. The 2021 Revolving Credit Facility will mature on August 11, 2025 if none of our Convertible Senior Notes are outstanding, and if any Convertible Senior Notes are outstanding, the date which is 91 days prior to the maturity date of July 15, 2024 for such Convertible Senior Notes.
Interest is payable on the 2021 Revolving Credit Facility at a fluctuating rate of interest determined by reference to the Eurodollar rate plus an applicable margin of 3.50% (with step-downs upon de-leveraging). We also have the option to borrow at a rate determined by reference to the base rate.
The obligations under the 2021 Revolving Credit Agreement are guaranteed on a joint and several basis by the Guarantors. The Company’s and Guarantors’ obligations under the 2021 Revolving Credit Facility are secured on a pari passu basis with the Senior Secured Notes.
The 2021 Revolving Credit Agreement contains covenants that are substantially the same as the covenants in the Senior Secured Notes Indenture. The 2021 Revolving Credit Facility also requires the maintenance of a Consolidated Leverage Ratio (as defined in the 2021 Revolving Credit Agreement) of 5.50 to 1.00 (with a step down to 5.25 to 1.00 beginning with the fiscal quarter ending March 31, 2023) at the end of each fiscal quarter when extensions of credit under the 2021 Revolving Credit Facility and certain drawn and undrawn letters of credit (excluding (a) letters of credit that have been cash collateralized and (b) letters of credit having an aggregate face amount less than $5,000,000) in the aggregate outstanding exceeds 35% of the total commitments under the 2021 Revolving Credit Facility.
We incurred debt issuance costs attributable to the issuance of the 2021 Revolving Credit Facility of $0.5 million which are amortized to interest expense using the effective interest method over the expected life of the 2021 Revolving Credit Facility.
The 2021 Revolving Credit Agreement provides for customary events of default.
2018 Credit Facility
In the first quarter of 2021, we used a portion of the proceeds from the issuance of the Senior Secured Notes to prepay all outstanding amounts under and terminate the 2018 First Lien Credit Facility in the amount of $130.0 million, and the transaction resulted in a $5.7 million loss on extinguishment of debt, which includes a $3.6 million loss from the early termination of the interest rate swap agreement. See Note 13
, “Notes Payable and Long-Term Debt,” in the Notes to Consolidated Financial Statements included in this Annual Report for further discussion.
Convertible Senior Notes
In July 2019 we closed an offering of $172.5 million in aggregate principal amount of our Convertible Senior Notes. The Convertible Senior Notes bear interest at a rate of 2.50% per year, payable semiannually in arrears on January 15 and July 15 of each year, beginning on January 15, 2020. The Convertible Senior Notes will mature on July 15, 2024, unless earlier repurchased, redeemed or converted. The Convertible Senior Notes are senior unsecured obligations.
The Convertible Senior Notes are convertible into approximately 3,208,172 shares of our voting common stock under certain circumstances prior to maturity at a conversion rate of 18.598 shares per $1,000 principal amount of the Convertible Senior Notes, which represents a conversion price of approximately $53.77 per share, subject to adjustment under certain conditions, but will not be adjusted for any accrued and unpaid interest. Upon conversion, we may pay cash, shares of our common stock or a combination of cash and stock, as determined by us at our discretion. The conditions required to allow the holders to convert their Convertible Senior Notes were not met as of December 31, 2021.
The indenture covering the Convertible Senior Notes contains customary events of default.
We early adopted ASU 2020-06 effective January 1, 2021, on a retrospective basis to all periods presented. Under ASU 2020-06, the Company accounts for the Convertible Senior Notes entirely as a liability and will no longer separately account for the Convertible Senior Notes with liability and equity components. See Note 2, “Summary of Significant Accounting Policies,” in the Notes to Consolidated Financial Statements included in this Annual Report for further discussion of the impact of the adoption of ASU 2020-06.
We incurred debt issuance costs attributable to the Convertible Senior Notes of $5.9 million which are amortized to the interest expense using the effective interest method over the expected life of the Convertible Senior Notes.
In connection with the Convertible Senior Notes offering, we entered into privately negotiated capped call transactions with certain financial institutions. The capped call transactions have a strike price of $53.77 per and a cap price of $82.86 per, and are exercisable when, and if, the Convertible Senior Notes are converted. We paid $20.53 million for these capped calls and charged that amount to additional paid-in capital.
On June 10, 2020, in connection with the acquisition of certain Durfort assets, we issued an unsecured subordinated promissory note (“Promissory Note”) in the principal amount of $10.0 million (the “Principal Amount”), with an annual interest rate of 7.5%, payable quarterly, with the first payment due September 10, 2020. The Principal Amount was payable in two $5.0 million installments, with the first installment due 18 months after the closing date of the acquisition (June 10, 2020), and the second installment due 36 months after the closing date of the acquisition. The second installment was subject to reduction for certain amounts payable to us as a holdback. We prepaid all outstanding amounts under and terminated the Promissory Note in the third quarter of 2021 in the amount of $9.6 million. The transaction resulted in a $0.4 million gain on extinguishment of debt.
On April 17, 2020, National Tobacco Company, L.P., a wholly-owned subsidiary of the Company, entered into a loan agreement with Regions Bank guaranteed by the Small Business Administration for a $7.5 million unsecured loan issued pursuant to the CARES Act. The proceeds of the loan were received on April 27, 2020. The loan was scheduled to mature on April 17, 2022 and had a 1.00% interest rate. Under the CARES Act we were permitted to apply for forgiveness of the loan if the proceeds were used as required for certain purposes. During 2021, we applied for forgiveness for the loan. On October 15, 2021, we received notice that our application for forgiveness was fully approved. The extinguishment of the unsecured loan occurred in the fourth quarter of 2021 resulting in a $7.5 million gain on extinguishment of debt
. We are subject to audit relating to the unsecured loan until 2027 which could result in repayment of some or all of the unsecured loan previously forgiven. However, we believe that repayment of any amount is not probable.
Distribution Agreements
For a description of our material distribution agreements, see “Business—Distribution and Supply Agreements.”
Master Settlement Agreement
On November 23, 1998, the major U.S. cigarette manufacturers, Philip Morris USA, Inc., Brown & Williamson Tobacco Corporation, Lorillard Tobacco Company and R.J. Reynolds Tobacco Company, entered into the MSA with attorneys general representing states that agreed to settle certain recovery actions (the “Settling States”). In order to be in compliance with the MSA and subsequent states’ statutes, we were required to fund an escrow account with each of the Settling States based on the number of cigarettes or cigarette equivalents (which is measured by pounds of MYO cigarette smoking tobacco) sold in such state. We discontinued our generic category of MYO in 2019 and our Zig-Zag branded MYO cigarette smoking tobacco in 2017. Thus, pending a change in MSA legislation, we have no remaining product lines covered by the MSA and will not be required to make future escrow deposits. Each year’s deposit will be released from escrow after 25 years. We are scheduled to begin receiving payments as our escrow deposits are released from escrow beginning in 2024.
The following table summarizes our escrow deposit balances (in thousands) by sales year as of:
| Sales | | Deposits as of December 31, | |
| Year | | 2021 | | | 2020 | |
| | | | | | | |
| 1999 | | $ | 211 | | | $ | 211 | |
| 2000 | | | 1,017 | | | | 1,017 | |
| 2001 | | | 1,673 | | | | 1,673 | |
| 2002 | | | 2,271 | | | | 2,271 | |
| 2003 | | | 4,249 | | | | 4,249 | |
| 2004 | | | 3,714 | | | | 3,714 | |
| 2005 | | | 4,553 | | | | 4,553 | |
| 2006 | | | 3,847 | | | | 3,847 | |
| 2007 | | | 4,167 | | | | 4,167 | |
| 2008 | | | 3,364 | | | | 3,364 | |
| 2009 | | | 1,619 | | | | 1,619 | |
| 2010 | | | 406 | | | | 406 | |
| 2011 | | | 193 | | | | 193 | |
| 2012 | | | 199 | | | | 199 | |
| 2013 | | | 173 | | | | 173 | |
| 2014 | | | 143 | | | | 143 | |
| 2015 | | | 101 | | | | 101 | |
| 2016 | | | 91 | | | | 91 | |
| 2017 | | | 82 | | | | 83 | |
| | | | | | | | | |
| Total | | $ | 32,073 | | | $ | 32,074 | |
Off-balance Sheet Arrangements
During 2021, we did not execute any forward contracts. We had no forward contracts at December 31, 2021. During 2020, we executed various forward contracts for the purchase of €19.7 million and sale of €21.4 million with maturity dates ranging from December 2020 to November 2021. At December 31, 2020, we had forward contracts for the purchase of €18.0 million and sale of €19.6 million. The fair value of the foreign currency contracts were based on quoted market prices and resulted in an asset of $0.4 million included in Other current assets and liability of $0.0 million included in Accrued liabilities at December 31, 2020. We had no interest rate swap contracts at December 31, 2021. We had interest rate swap contracts for a total notional amount of $70 million at December 31, 2020. The fair values of the interest rate swap contracts were based upon quoted market prices and resulted in a liability of $3.7 million as of December 31, 2020, included in other long-term liabilities.
Future Cash Requirements
The Company’s primary future cash requirements will be to fund operations, lease payments, debt service and capital expenditures. The Company’s contractual obligations primarily include long-term debt and lease obligations. For information regarding our long-term debt obligations and cash payment obligations thereunder, please see Note 13, “Notes Payable and Long-Term Debt” in the Notes to the Consolidated Financial Statements in Part II, Item 8 of this Annual Report on Form 10-K. For information regarding our lease obligations and cash payment obligations thereunder, please see Note 16, “Lease Commitments” in the Notes to the Consolidated Financial Statements in Part II, Item 8 of this Annual Report on Form 10-K.
In 2021, we increased our share repurchase authorization by an additional $30.7 million during the fourth quarter and spent $18.2 million to repurchase 477,707 shares at an average price of $38.09 per share. Subsequent to the quarter end, the Company spent $6.6 million to repurchase 178,196 shares at an average price of $37.08 per share.
Inflation
We believe that any effect of inflation at current levels will be minimal. Historically, we have been able to increase prices at a rate equal to or greater than that of inflation and believe that we will continue to be able to do so for the foreseeable future. In addition, we have been able to maintain a relatively stable variable cost structure for our products due, in part, to our successful procurement with regard to our tobacco products and, in part, to our existing contractual agreement for the purchase of our premium cigarette papers.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Foreign Currency Sensitivity
Our inventory purchases from RTI are denominated in euros. Accordingly, we have exposure to potentially adverse movements in the euro exchange rate. In addition, RTI provides a contractual hedge against catastrophic currency fluctuation in our agreement. We do not use derivative financial instruments for speculative trading purposes, nor do we hedge our foreign currency exposure in a manner that offsets the effects of changes in foreign exchange rates.
We regularly review our foreign currency risk and hedging programs and may as part of that review determine at any time to change our hedging policy. During 2021, we executed no forward contracts for the purchase of euros. At December 31, 2021, we had no forward contracts for the purchase of euros. A 10% change in the euro to U.S. dollars exchange rate would change pre-tax income by approximately $1.7 million per year.
Credit Risk
At December 31, 2021 and 2020, we had bank deposits, including MSA escrows, in excess of federally insured limits of approximately $137.2 million and $69.7 million, respectively. The Company has chosen to invest a portion of the MSA escrows, from time to time, in U.S. Government securities including Treasury Notes and Treasury Bonds.
We sell our products to distributors, retail establishments, and individual consumers throughout the U.S. and also have sales of Zig-Zag® premium cigarette papers in Canada. In 2021, 2020, and 2019, we had no customers that accounted for more than 10% of our net sales. We perform periodic credit evaluations of our customers and generally do not require collateral on trade receivables. Historically, we have not experienced significant losses due to customer credit issues.
Interest Rate Sensitivity
In February 2021, we issued the Senior Secured Notes in an aggregate principal amount of $250 million. In July 2019, we issued Convertible Senior Notes in an aggregate principal amount of $172.5 million. We carry the Senior Secured Notes and Convertible Senior Notes at face value. Since the Senior Secured Notes and Convertible Senior Notes bear interest at a fixed rate, we have no financial statement risk associated with changes in interest rates. However, the fair value of the Convertible Senior Notes changes when the market price of our stock fluctuates, or interest rates change. Our remaining debt instruments bear interest at fixed rates and are not subject to interest rate volatility.
