I’ve been slower in content creation lately due to being on the road, and taking some time for myself. It doesn’t mean I haven’t been busy though: I’ve been wrestling with a few ideas that GoBlue incited by his recent article on Ripple Effects & Moats on the US MSO retail landscape.

I’ve been turning over numbers and assumptions and challenging ‘knowns’. And GoBlue and I have been noodling over the most likely pathing of revenue and income that’ll be generated in the cannabis sector. While sell-side now more often refers to TAM total addressable market rather than the more previously fashionable DCF models – I think its’ relevant to look at the Canadian experience regarding cannabis.

<Random metric from ‘legacy’ states: Thirty-five hundred. That’s the number of population per cannabis store in Seattle, WA, Denver, CO, and Portland, ORE>

In the fall of 2019, we published “Legalization 2.0: Extracting the Numbers” – which laid out a supply/demand scenario based upon declared and planned capacity.

Since then, we’ve seen Rosy Mondin’s World Class ($PUMP) pivot into delivery services (and facilitate an asset arbitrage)….and the whole ‘extraction’ raison d’tete of the company is now a very (very) dim memory. And $13MM dumped on ‘sonic’ extraction IP that didn’t last a year in the pitch decks. At least she’s hustling a lot of weed via that delivery service. Shame it’s only a 27% margin, and producing annualized losses of $2.5MM on $10MM in sales. As is, it’s a dead horse that simply hasn’t fallen over yet. From their latest financials, they haven’t moved an extract/peripheral in more than a year:

The Valens Company ($VLNS)? God, where to start. Weddings, parties, bar-mitzvahs – they aspire to be everything to everybody – and over the past 9 months have presented SKU expansion followed by SKU contraction, a (relatively) massive entry into food products, all while revenue has been declining sequentially. Now they’ve got Sundial ($SNDL) hiding behind a bush in their yard wearing a trench-coat and drinking from a paper bag. $VLNS can probably thank $SNDL for bolstering the stock…..and the halo effect of the February MSO run in helping to raise cash successfully earlier this year.

If there is a viable business in there, they sure as shit haven’t shown it since the good ‘ol days of the initial tolling runs that quickly ran away, never to be seen again. And I can’t escape the thought that – like Supreme – might have an operation in place – but not big enough to support the capital structure bloating it to took to get them to that state.

I think the core of their support stems from the idea that ‘biggest is best’. Which brings us to:

Auxly ($XLY). They join $LABS and $VLNS in pivoting into pre-roll provisioning – having had core operations (like the others) unable to provide sufficient cashflow generation for growth. I mean, $XLY is still being forced into capital markets after some 2 years in, and despite being the leader in 2.0. And this includes some good gains in sales (occasionally), yet GoBlue and I both see dark clouds on their horizon amid a metastasizing share count.

Their throughput and brands are number 1 nationally. Yet. Given their balance sheet and sector profitability – is there something in here that won’t require a half dozen more capital structure re-jigs and another $100MM+ to get them to a target operating state?

That ‘target operating state’ in extraction is really, really simple to derive. I don’t say that flippantly. It doesn’t matter to me which product platforms are being produced……it all comes down to capacity utilization. Something this segment is awash in – arguably moreso than cultivation.

Radient Technologies ($RTI). Whatever.

Medipharm ($LABS?). I haven’t taken a serious look at them since late last year. And I sure as hell can’t say I take them seriously at all. In my opinion, their forward product swaps are the poster child of bad actors in the legal cannabis sector. Sure, there’s ‘funded capacity’ and hidden grow ops, and the side hustles by iAnthus management one can point to. While these are all less than tasteful (and perhaps illegal, criminal charges pending in at least one of them) – nothing says ‘sleaze’ to me more than juicing revenue. Worldcom, Nortel, Waste Management, Enron…..this kind of activity is a stain on the world of formal commerce, and anything greasy I’ve ever come across personally in my career has been around revenue recognition.

I can’t claim $LABS has falsely reported revenue (and won’t), but readers of TheCannalysts will be aware of our research and analysis on reported numbers from financial statements. Res ipsa loquitor, we only present and stand behind our numbers and analysis and opinion.

Heritage Cannabis ($CANN)? Ugh. This outfit is perennially ‘two-quarters out’ – having acclimatized shareholders into thinking ‘great things are just around the corner’ for more than 3 years now. Next quarter, I expect they’ll report ~=$3MM in sales, a +$200k to negative gross margin, and claim to be profitable by end of 2021. You know, 2 quarters out. They’ve got it down to an art form. And the market has them nailed – and pinned to a dime. They’ll pull a reverse split sometime during this fiscal year, pump the shit out of a bland (and likely non-accretive) move into a US brand, and…. make promises then of great things to happen….in just a couple of quarters.

Nextleaf Solutions ($OILS) presents a capable crew and a good asset array. I like small companies, particularly ones with talent. I know several in this outfit who have it. What they don’t have is consistent (and growing) revenue. They’d probably settle for either at this point.

Neptune Wellness ($NEPT) hasn’t put out a set of financials since mid-February – and filed for an exemption for the year-end deadline due to: “delay is due primarily to additional information, arising from two transactions with new customers, necessary in order to determine the appropriate accounting treatment“. Yeah, ok.

We’d looked at them in early 2020 – and saw a whack of promises – and a whack of whoopee-shit too. They’ve shown some share price resilience through 2020 – and in looking at their share price, man – was February a magnification point for them:

Needless to say – I just had a look at that last reported quarter of theirs (Q3 F2020) – and I’ll just leave the top of their income statement here as comment. That COGS is something else. Oh, and add SBC of $10MM YTD:

Le woof, woof.

The only thing that’s holding this thing together is their cash balance (at $32MM) and $19MM in receivables (which I can’t verify). And….boy, could they use a pivot. Oh, wait just a second…..interestingly, instead of psilocybin, these guys have just executed a $28MMUSD purchase of ‘Sprout’, an “organic plant-based baby food and toddler snack company”. Well then.

Now THAT is a pivot folks.

There’s an oft heard refrain – that ‘the US isn’t Canada’. As I see it, it certainly is in the case of extraction.

I see the business model itself – that of capacity utilization – to be paramount. The business model is also relatively flexible, with output able to be scaled relatively quickly and incrementally (once learning curves are acquired). I think that – unlike hydrocarbon refineries (which are typically clustered) – distributed production supports timely delivery and smaller orders. Through this lens, the ban on interstate commerce has seen extraction remain largely demand matching in scale and distributed interstate. Unlike Canada – where folks sought to centralize with scale – it appears that capacity utilization is relatively high in the US. And will likely remain so, with capacity presumeably increased to meet demand incrementally.

In terms of cultivation – I think that’s a different issue. So does Boris Johnson. And Mercer Park. And I tend to believe that many verticals in the US could be facing the over-production and islanded inventory issues similar to Canada. But that topic is for another day.

Regarding centralized extraction at scale….I can’t see a path forward in Canada at this point. It just isn’t that big of a room. It looks to be between $XLY and $VLNS at this point to ‘CPG’ their asses out of the fire – which – is as speculative a position as they were prior to start – with much cleaner balance sheets.

It’s going to be a rough year ahead for the extraction segment.

The preceding is the opinion of the author, and is in no way intended to be a recommendation to buy or sell any security or derivative. The author holds no position in any of the companies mentioned.