Vapor Corp. Enjoyed Strong Growth Through 2013

Headquartered in Dania Beach, Florida, $24 million market cap Vapor Corp. (VPCO) sells vaporizers, e-liquids, e-cigarettes, e-hookahs and other related products. Battery operated, e-cigarettes contain nicotine but not tobacco and, in place of smoke, produce vapor via a heating element that vaporizes a liquid nicotine solution inside. VPCO’s brands include Fifty-One® and VaporX.® The company markets its products in a variety of nicotine strengths and flavors. Through a recent acquisition of competitor Vaporin, Vapor Corp. also operates a growing chain of retail stores under the name The Vape Store. The company enjoyed strong growth for several years and a corollary rise in its share price. However, a contraction in 2014 that mirrored the general contraction in the overall e-cigarette sector has led management to refocus its strategy in order to return to growth.

E-cigarette Market Characterized by Robust Growth 2010-13

While statistics are sparse, the overall e-cigarette market grew rapidly from 2010 to 2013. For example, the percentage of smokers who had used e-cigarettes more than tripled from 9.8% to 36.5%, according to a CDC study. From 2010 to 2013, Vapor Corp.’s revenue grew from $10.9 million to $26.0 million and VPCO shares increased more than 4-fold from $1.75 on December 31, 2010 to $9.15 on December 31, 2013.

Attracted by this growth and reflecting stagnant or declining sales of traditional cigarettes, big tobacco companies entered the e-cigarette sector. Lorillard (LO), one of the leading big tobacco players, got into the niche in 2012 with its $135 million acquisition of blu e-cigarettes. Altria (MO) launched MarkTen and subsequently purchased e-cigarette marketer Green Smoke on February 3, 2014 for $110 million. Reynolds American (RAI) introduced its propriety Vuse brand in 2013. 

Market Shift Towards Vaporizers, Now 60% of Sales

Prior to big tobacco, the sector had been dominated principally by smaller firms and Mom & Pops. Increased competition from the better promoted brands hurt smaller players such as VCPO, while at the same time, demand began to shift away from e-cigarettes towards vaporizers or VMTs (vapors, tanks, and mods). Similar to e-cigarettes, vaporizers also offer a smoking experience without burning tobacco. Vaporizers have a tank or chamber, a heating element and a battery. The user fills the tank with e-liquid or fills the chamber with dry herb or leaf. The vaporizer battery can be recharged and the tank and chamber can be refilled. At an estimated $2.5 billion as of September 2014, the overall vapor category grew 23% in 2014 compared to 2013, driven by open system devices, which are now growing at about twice the rate of the overall vapor category, according to Wells Fargo.

Company Shifts Focus to VMTs and Growing Retail Presence

As the market has shifted, so too has VPCO’s business model. The company has coupled its e-cigarette strategy with a focus on vaporizers. Moreover, not only is the market transitioning to VMTs, but the retail channel is also moving towards specialty vape stores. In the past year, brick and mortar sales of e-cigarettes and vaporizers have passed online domestic sales in the market. Reflecting this change, Vapor Corp. is focused on growing its retail distribution reach by opening new retail stores and kiosks, entering into franchise agreements and forging distribution agreements with large and established value added resellers. According to management, an estimated 33% of 2014 domestic retail purchases were through the vape shop retail channel, which represents an ongoing shift from c-store, food, drug and mass retail channels, as noted.

Vaporin Acquisition Underscores New Strategy

The Vaporin acquisition was an important step forward in the company’s revised strategy. Vapor Corp. acquired Vaporin in March of 2015 for 13.6 million shares, which equated to $14.96 million on VPCO’s share price at the time. Reflecting ongoing consolidation in the rapidly expanding$900 million vape retail space, Vaporin itself acquired The Vape Store in August 2014, adding vape stores in Florida and $2.6 million in revenue. Unlike Vapor Corp., Vaporin had a strong year in 2014, with pro forma revenue of $3.2 million for the first nine months of 2014 compared to $28,463 for the same period of 2013. Even without the Vape Store acquisition, Vaporin’s 2014revenue was $1.4 million in the 2014 period, fueled by the rapid growth of VTMs. 

Vaporin Grew While VPCO Sales Contracted

Vaporin’s focus on VTM’s and e-liquids rather than e-cigarettes made it an attractive merger partner to Vapor Corp., we believe. Vapor Corp.’s own 2014 net sales of $15,279,860 were down 41.2% from $25,990,227 in 2013, on lower volume sales mirroring growing competition amongst e-cigarette brands and from vaporizers and other vapor products. VPCO’s gross margins decreased to 5.1% from 37.3% and the company reported a net loss of ($13,852,249) compared to net income of $801,352 in 2013. 

Vapor Corp. was not alone in experiencing weaker 2014 e-cigarette results. Lorillard also saw pressure on its e-cigarette business. After its 2012 purchase of blu, the company promoted the brand aggressively and achieved sales of $230 million for its e-cigarettes segment in 2013, up from $61 million for 2012. However, in 2014, sales fell to $165 million and the e-cigarette segment gross profit fell to $38 million versus $70 million, while its gross margin declined to 23.0% compared to 30.4% in 2013. Results in the U.S. were negatively impacted by a decline in unit volumes. As competition increased with the entrance of other big tobacco e-cigarette brands, blu also lost market share. According to Nielsen ScanTrack Database, blu’s domestic all-outlet dollar market share of e-cigarettes was 33.4% for 2014, down from 42.1% in 2013.

With the Vaporin stores as an initial toehold, Vapor Corp. intends to expand its retail presence. As of November 2014, Vaporin operated five Vape stores and has expanded its retail footprint with the opening of new stores and re-branding of acquired locations. Vapor Corp. currently operates ten stores in Florida and targets doubling that to about 20 by year-end 2015. Management believes its retail strategy is particularly important, as the traditional venues including convenience stores and the grocery channel are seeing a slowdown. According to market research firm IRI, U.S. multi-outlet sales of electronic smoking devices of approximately $144.7 million for the 52 weeks ended January 25 declined 20.2% compared to the same period of 2014. Unit sales were down nearly 12% to just over 13 million.

On April 13, 2015, the company’s CEO Jeffrey Holman issued a letter to shareholders describing the company’s “three prong strategy for growth and return to profitability,” which includes the:

– Regional expansion of proprietary and franchised stores

– Development of e-commerce sales channel

– Build-out of a wholesale distribution channel 

Similar to the Starbucks (SBUX) model, management believes people likely will visit the stores not only to make purchases, but to linger and socialize with other vape users. The company expects the stores to help VPCO “achieve sustainable category leadership” and is leveraging social media marketing, as well as in-store and online promotions to build brand awareness. The stores operate at high margins, according to management, which expects the expansion to contribute to a return to profitability. Vapor Corp. intends to sell its own brands and other leading products in its stores, as well as to launch a franchise strategy to accelerate retail expansion.

In a recent SEC filing related to the sale of shares by selling shareholders, management noted that proceeds from any shares issued upon exercise of warrants “will be used for working capital and general corporate purposes,” presumably including the expansion of its retail network. The company has also recently restructured its management team and inventory strategy to align with the greater focus on VMTs. New members to VPCO’s executive team include Gregory Brauser, President and Director, and James Martin, the company’s CFO. 

Further Opportunities in the Electronic Market?

As the market evolves, management believes industry transitions create opportunities. Even cautious players do not appear to be backing away from the sector. For example, in an investor call last month, Vector Group (VGR) noted that, “Uncertainties regarding e-cigarettes are significantly greater today than they were a year ago…Disposable e-cigarettes that dominated the market as recently as 2013, are in significant and rapid decline…Meanwhile, open-system vapor products that feature refillable tanks and use low-cost flavored liquids are demonstrating mixed results.” Nevertheless, Vector Group does not appear to be abandoning its e-cigarette business – nor, apparently, are Lorillard, Reynolds or Altria.

We believe many companies see continued opportunities as new users enter the market, including people who view these alternatives as smoke reduction aids. The CDC reports that about 18% of U.S. adults smoke and about 21% of that group had used e-cigarettes in 2011, up from about 10% in 2010. The NIH (National Institutes of Health) and the FDA joint study has found that 28% of adults say they use a tobacco product and 40% of that group say they use two products including electronic cigarettes. If electronic cigarette usages grows as smokers substitute these products or use them in conjunction with combustible cigarettes, it might suggest further growth opportunities, in our view. The electronic market pales in comparison to the $90 billion traditional tobacco market.

Proposed Regulatory Changes Still Unclear

Until now, electronic cigarettes have generally been less regulated than traditional cigarettes but there are potential regulatory changes pending. On April 24, 2014, the FDA released proposed rules that would extend its regulatory authority to e-cigarettes. Among other things, proposed new rules would require that electronic cigarette manufacturers submit their products for FDA review, include a health warning and only sell e-cigarettes through vending machines in venues where young people do not have access. Some local U.S. entities have already banned the use of vaporizers and e-cigarettes. 

Youth Market

Seemingly, a key consideration for regulators is the potential impact of electronic devices on the youth market, with surveys noting a significant increase in the number of middle and high school students using e-cigarettes. Their numbers increased from 79,000 in 2011 to 250,000 in 2013. In all, over 263,000 teenagers who have never used a tobacco cigarette are reported to be using e-cigarettes. This trend is alarming to regulators because: 1) long-term impacts of e-cigarette usage are not documented at this early point and 2) there is the potential that usage of e-cigarettes could eventually lead to smoking of traditional cigarettes. At the same time, marketing of e-cigarettes to teens is up 321%, according to TIME.

VCPO believes it has a technology to address the young adult issue. The company has a patent pending for a biometric fingerprint lock sensor that can be used in vaporizers and which would allow the device owner to lock it, with only authorized users then able to unlock it using a fingerprint scan. The company introduced the biometric fingerprint at CES 2014 and expects to launch it commercially in 2015. While the electronic market is highly dynamic and there are potential challenges, VPCO management believes it has a proactive strategy to resume growth.