Sunday, April 27, 2014

Vapor ( Nasdaq - VPCO ) -- Smokin' Hot or Up in Smoke ?

Vapor (VPCO $6.50) is a leading manufacturer of electric cigarettes.  The new smoking technology actually eliminates the carcinogenic smoke that causes cancer in conventional cigarettes.  Instead, the devices employ a battery and an electronic control system to vaporize liquid nicotine that's stored in a plastic cylinder.  The vapor is inhaled, delivering the nicotine along with some flavoring.  The amount of nicotine can be varied.   Electric cigarettes are sold both in disposable and reusable formats.  The latter is becoming more popular because it costs less, and consumers can fill their units with custom blends that are unique to them.  The technology is believed to be safer than conventional cigarettes due to the absence of tar and other cancer causing chemicals.  It also doesn't generate second hand smoke.  Opponents are trying to prevent e-cigarettes from gaining widespread adoption.  Some fear the new format will provide a gateway to regular tobacco use.  Others don't like the way they look.  The more serious want to slow down the market's growth until more scientific evidence becomes available.

Vapor was an industry pioneer.  It entered the business more than five years ago.  Manufacturing relationships were established in China, where the technology was invented.  Brand names were created.  Distribution channels were opened up.  A series of snafus impacted performance in 2011-12, though, just as the industry began to roll.  Several major tobacco companies entered the industry via acquisitions as the same time.  Those companies used their marketing muscle to capitalize on the industry's 100% annual growth rate, leaving the company behind.  At present Vapor's sales are approximately 10% of those generated by the industry leaders.

Vapor is attempting to mount a comeback in 2014.  Costs were brought back under control last year.  Operations were streamlined.  The products themselves were upgraded.  And a windfall distribution partnership was established with a Hollywood mogul (Ryan Kavanaugh) with big plans to make Vapor a success.  Kavanaugh is a self-made billionaire who has made a significant impact on the movie industry by focusing almost entirely on statistical and financial variables.  His productions consistently make money.  His company has developed a broad range of retail relationships to promote products that are connected with his movies.  The company also has connections with high profile celebrities, who might be recruited to promote Vapor's "Krave" brand on Twitter and other social media outlets.  Kavanaugh is committed to promote the company's products through a detailed contractual relationship.  It's thought he wants the effort to work as a matter of pride, as well.

Vapor has little chance of competing with the major cigarette companies without Kavanaugh's help.  But the fact of the matter is, he is on board.  (He's on the company's board of directors, in fact.)  Financial performance is likely to be unspectacular during the transition phase.  First quarter results probably will demonstrate little improvement on a sequential basis.  But sales and earnings could accelerate in the June period as new retail relationships go into effect.  Reinforcement on the social media front could provide additional impetus.  Overall industry sales are continuing to expand at a 100% rate, moreover.  Those gains actually could pick up speed as a result of recent publicity surrounding e-cigarette technology.


F.D.A. regulations could hamstring performance over the long haul.  A recent proposal contained little in the way of bite.  But the smoking vigilantes are likely to push for more stringent controls as time goes on.  State and local taxes could be applied, as well.  The technology currently costs more than tobacco cigarettes to produce but it enjoys a retail price advantage due to the absence of excise taxes.  If those are implemented demand could suffer.  Another long term factor is the possibility that e-cigarettes might veer in a completely non-corporate direction.  At this time a majority of e-cigarette revenue is produced by selling disposable units in conventional "packs" at conventional retail locations.  There has been a surge in small "vape" shops over the past year, though.  Customers go there and buy custom blends designed especially for them, which are used in reusable units.

Vapor is small enough that it might be able to take advantage of a development like that.  We think there is a good chance the industry could take on an anti-Big Tobacco flavor.  That sort of thing could happen in the marijuana industry, too, if that's ever legalized.  Imagine the head shops knocking off the Marlboro Man.

These shares trade at a high valuation.  Vapor competes with more established companies that already have greater market shares.  The government is on its tail.  And the industry remains in an early stage of development.  Things could go in any number of directions, with or without the company.  Our advice is to avoid the stock until a lower starting price emerges or the picture comes into better focus.  It's an interesting story, though.  Vapor deserves keeping an eye on.

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