This Fast-Growing 'Cigarette Killer' Has 30% Upside

Although over-the-counter (OTC) stocks are growing in popularity, most investors avoid them because of their reputation for extreme risk.

Among the most common dangers of OTC stocks are poor transparency (since the underlying companies don't have to file with the SEC), the inability to meet minimum financial and other requirements for listing on a major exchange, and increased susceptibility to "pump and dump" scams. What's more, OTC stocks often display absolutely sickening price volatility.

So once an OTC stock gets to where it can uplist to a major exchange like the Nasdaq or NYSE, many investors may get the impression the stock is now "safe." And this could be the case with one small stock that's right in the thick of what may be the Next Big Thing -- electronic cigarettes.

After trading on the "pink sheets" for years, this tiny e-cigarette maker with a $92 million market capitalization has been trading on the Nasdaq since May 30. Its stock price is up 25% since the uplisting was announced on May 28. So to many investors, the company could be looking more and more like a legitimate and reasonably safe entry point into the emerging e-cigarette industry, especially since it's really the only pure play around.

And though there are reasons why the company -- Vapor Corp. (Nasdaq: VPCO ) -- is worthy of investors' consideration, there are also reasons to exercise extreme caution, despite the greater credibility that comes with a Nasdaq listing.

There's certainly no arguing with Vapor's success so far. With an increasingly familiar stable of brands such as Krave, Alternacig and EZ Smoker, as well as a large retail presence consisting of nearly 60,000 online and retail outlets in the U.S. and Canada, the company has tripled sales since 2009, to $24 million.

That may only be 1.6% of the $1.5 billion e-cigarette market -- but even if Vapor merely maintains this share of the market, it could still mean awesome growth. Assuming industrywide revenues hit $24 billion in 2023 as Wells Fargo analysts project, a 1.6% slice would translate to annual sales north of $380 million for Vapor about a decade from now.

That's nearly 16 times current revenues. And at that level of performance, I doubt the company would have much trouble generating strong per-share profits.

However, it's not there yet. Indeed, Vapor hasn't even achieved consistent profitability, though it's a good sign that earnings have been positive in three of the past six years.

In the meantime, the company faces a lot of uncertainty because its operations are small next to those of big tobacco companies beginning to muscle in on the e-cigarette action. For instance, Lorillard (NYSE: LO ) , the third-largest tobacco maker in the U.S., has been especially aggressive about pursuing growth in the e-cigarette space and already generates annual sales of more than $200 million with its Blu and Skycig brands.

The second-largest U.S. tobacco maker, Reynolds American (NYSE: RAI ) is also establishing a presence in e-cigarettes, with its new Vuse brand. Plus, the firm is in talks to acquire Lorillard, a deal that would give it three e-cigarette brands with far larger sales than Vapor's.

Thus, there appear to be several possible outcomes for Vapor. One is to keep operating independently with a relatively small but potentially very profitable piece of the e-cigarette pie. This could eventually lead to a buyout by one of the big tobacco companies such as Altria (NYSE: MO ) , the maker of Marlboro, since that company has been slowest to adopt e-cigarettes and may need to play catch up. Or Vapor could be overwhelmed by its much bigger competitors and go out under.

As with any speculative investment, it's tough to say what's going to happen with Vapor. Although the new Nasdaq listing indicates important strides have been made, this is still a young company in an emerging industry with an uncertain future. So those interested in Vapor as a potentially fast-growing pure play or buyout candidate should consider only establishing a small position in the stock.

They should certainly expect to continue seeing excessive volatility -- shares commonly fluctuate by double digits on any given day and have ranged in price from $3 to $10 during the past 12 months -- and be aware they could lose their whole investment in the worst-case scenario.

Risks to Consider: Besides intense competition, Vapor faces the risk of much heavier regulation since the federal government is authorized to treat e-cigarettes the same as regular tobacco products. Compliance costs could place more financial strain on Vapor than it can bear.

Action to Take --> Despite its promise, I think Vapor could be more than 30% undervalued. Specifically, investors have historically been willing to pay 13 times book value for the stock. Applying that multiple to the current per-share book value of $0.66 suggests shares are worth $8.58 apiece. Yet they're only trading at around $5.80.

Valuing the stock is admittedly a bit tricky, though, since Vapor is in its infancy and there's currently covered by only one analyst, who projects earnings per share ( EPS ) of $0.34 in 2015, suggesting a reasonable forward price-to-earnings (P/E) ratio of 17. Investors willing to take a risk have a good entry point right now.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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