Looking back at our last Structure on Harvest Health ($HARV) reminded me of how little I enjoyed doing it. And how difficult the financials are to approach.

Seemingly locked in continual litigation……and packing a capital structure that resembles an inverted pyramid……there wasn’t much to like in $HARV’s last year end. Retail strategies announced just 6 months earlier were abandoned days after those financials were (finally) published. While GoBlue has kept up with $HARV via his Quarter in Pictures series, let’s roll up the sleeves, put on a hazmat suit, and see if and how the deals and capital structure have evolved over the past 6 months.

To the financials!

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• No segmentation provided. More below.
• $HARV’s abandoned an entry into Michigan. A PENN asset (CannaPharmacy) mentioned last time, had its’ contractual wrinkles ironed out, and a deal for a cultivation site and processing permit closed. Nice to see them close a deal that wasn’t prescribed by a judge. More on their legal travails below.
• I’ve heard PENN is supply constrained. The site that $HARV bought is 48,000 ft². For that grow-op and a processing permit, they paid $45MM in cash and stock. That’s $957/ft², compared to a new indoor build at around $200-$250/sqft. Such is the premium attached to having a permit in a limited license area, which imputes to being valued at about $36MM.
• I’d expect similar or higher values to emerge as other MSO’s continue to expand. The eastern seaboard in the US has revealed intense asset valuation if they’re linked to cannabis.
• Cash is north of $65MM. Good, they’ll be able to use it.
• 368MM shares out, they took a $10MM charge on re-issuing options earlier this year, and have pushed out 600k at-the-money RSU’s as well. Total SBC for the year so far: $18.6MM. That’s pricey given performance.
• The $100MM in financing back in May 2019 was not cheap ($7MM in discount alone), and it’s odd now to see subordinate shares at a conversion rate of $13/share, a reflection of how far $HARV’s fallen since those halcyon days. Mentioned because if the next few quarters aren’t kind to $HARV, a reprice and roll of that debt (due May 2022) would be ridiculously expensive for shareholders.
• You may notice I said 368MM shares outstanding, but theres only 132MM subordinates. Well, this is an MSO, and, multiple voting shares abound. More below.
• There’s deltas between their press released financials and the actual financials. Brutal. I see Blue spotted it as well. If I was an investor, I’d be livid. Seriously. Hey $HARV: you guys gonna book a true up from your press release to actual financial results?

I really don’t like companies that press release ‘earnings’ in advance of financial statements.

Regarding the multiple voting shares, a picture shows exactly what they mean. $HARV has also issued 55k warrants this year convertible into multiples, which translates into an incremental 5.5MM subordinates. An additional 70MM shares are sitting in options and warrants too. Fully diluted, $HARV’s got 450MM shares.:

There’s no better way to describe the capital structure than that.

I mentioned the lack of segmented revenues in these financials. Most MSO’s are generally poor around disclosure in this, and it’s understandable given context. Margin and market share and dispensary run rates and product sales are information that competitors would love to have for comparatives. In the varied regulatory environments and regional topologies MSO’s compete within, this information is as commercially sensitive as it is desirable.

In a pretty frank statement from the MD&A, $HARV seems to recognize that their historical approach to business formation might have not been the best way to do it. Instead, they’re declaring competency around operational execution, will streamline where they can, and will eschew ‘big’ acquisitions to focusing on growing weed competitively:

That there is a straight-up Mea Culpa.

With respect to litigation, it’s something $HARV seems to attract.

$HARV’s entry into Washington State – also mentioned last time – has blossomed into multi-faceted legal action, and currently resides in arbitration which has been extended until next February. From what I can gather, it looks like a middle man (ICG) had acquired some sort of options on 6 Washington State dispensaries, bundled them up…..and sold a separate service agreement on their behalf to $HARV. The dispensaries were offside with that, so, they sued the middle-man, the middle-man sued $HARV, and $HARV’s sued everyone they could serve papers to. No matter the outcome, it’s a look into a mature (and somewhat marginal) cannabis market that has – for several reasons – resisted consolidation. Some of those dispensaries were perhaps never onside, as it appears there’s non-controlling interests (NIC’s) all over the place (NICs are frequently be the source of friction within business, and it can become acute when big numbers start popping up).

Which begs the question: Does Washington state provide a glimpse into what full legalization will ultimately look like across the US? If so, it implies that growth and consolidation by MSO’s will be challenged in areas where limited licenses and moats don’t exist. I mean, look at Colorado and California as well. The three longest standing wide-open recreational jurisdictions might as well have been kryptonite so far to the US MSO’s (an exception here may be seen in Origin House but the asset is unproven). One reason is that those states don’t have the profitability MSO’s require to drop in and scale up. Another reason might be that some licensing and regulatory approaches innately resist consolidation….and deny broader commercial deployment.

I suspect both of those hold some truth at the moment.

An Arizona acquisition (6 dispensaries in the state) – written in February of 2019 and supplemented with closing documents in August of the same year – will be heading for arbitration if $HARV gets its’ way. The seller is looking to hold $HARV accountable to a separate ‘merger’ agreement that was apparently made, and has sued for damages.

Pennsylvania is off to a litigious start (natch). It began with $HARV buying a cultivator in May of last year, which, was denied a renewal of its’ cultivation permit in July due to multiple violations by the state regulator. This is different than the 48k ft² deal mentioned above. $HARV is suing these guys for damages, as they claim permit violations were occurring before they bought the thing, and that the company was sold to them under false pretence. An appeal of the permit’s revocation by the state has been made by the cultivator…..all litigation is on hold until that gets sorted.

California is being litigated as well. Besides Falcon (a complete cluster-f***), there’s also reference to a deal called ‘Rainbow Lease and Real Estate’. We again see mention of ‘ICG’ – the company is named as defendants along with $HARV – with the claim that ICG induced a third party to buy three dispensaries from them, who sold those back to ICG, who then sold them to $HARV. It’s similar in theme to the Washington State acquisition. Both of these stories centre around a guy named Ryan Kunkel, who was an early entrant in cannabis, and one of the owners of ICG.

In March of this year, $HARV had dropped some $45MM to ‘merge’ with ICG/Ryan Kunkel, which, brought the Washington State and California dispensaries forward for $HARV to purchase. At least that’s what the plan looked like. It also looking like Kunkel didn’t have his act together. It can be said (with some confidence) that the dispensaries he tried to sell didn’t think he had his act together. Nor did $HARV……according to their court filings.

$HARV states they are pretty confident that the legal actions won’t result in material negative outcomes. The biggest single claim comes from Falcon (for $50MM), who demands treble damages and similar for related costs. Now, litigation can be unpredictable. Whether anything here has merit (or is material), the lawyers would be the ones to ask. That said, there is a qualifier within the financials I hadn’t yet seen in cannabis, north or south of the border:

Acquisitions for the fiscal year have been updated. We get a much clearer picture of the related assets in Note 10, which shows that of the $143MM in acquisitions made during 2020, $141MM was booked to goodwill and intangibles. Such is the state of the US cannabis sector right now. The reader might feel something vaguely familiar within the recent run of MSO’s leading up to the presidential election.

To me, it’s reminiscent of the Canadian sector’s trajectory at points during 2017 and 2018. Higher share prices at the time brought deals with high values in exchange for equally high priced paper. It may suggest to some – in the absence of US federal legalization and banking reform and allowance for inter-state commerce – that much of the intangibles being loaded into MSO’s now won’t be able to be crystallized:

That might sound histrionic. But. As a thought exercise, try and value a $CURA or a $GTII without US federal legality being brought in. Note that the largest chain of cannabis stores in Colorado is at 8, and, that its’ privately held. That without Fortress Florida, $TRUL is completely naked.

While rhetorical, this is intended to get you thinking about how much current US MSO valuation is based upon full legalization. And what those valuations might be in the absence of it. In other words: how much is worth losing if the US decides not to go ahead with legalization? What’s a 5 year ‘delay’ mean to share price? What about 10 years?

At this point, you might be thinking I’ve been drinking my bathwater (I’m not).

Much of my professional life has been spent in Risk Management, and thinking about all potential outcomes (good and bad) is what analysts aspire to be really good at. I strongly encourage the investor to try and think that way as well. Far too often I’ve seen investors substitute faith for reason and put trust in places that have earned none. In any event, the extrinsic value of a permit ranges from virtually $nil (WASH/CO), to adding 1000% to the price of a $4.5MM asset (PENN/NJ/MI). In the event a state remove license restrictions, those values vanish.

Regarding $HARV, they’ve got a business that’s selling weed. They’re mired in litigation over 4 attempted expansions across 3 states (add a divestiture to that list). They are are looking to focus in the immediate term on making what they do have profitable. Their stock has risen during the MSO run, but in comparison to other MSO’s, this is one the market forgot about. It’s not terribly hard to see why.

Despite improving operational metrics, they’ve yet to achieve the mass that’ll support their infrastructure. If they can keep organic growth trending, it’ll help. Given their acquisitions (both successful and those in litigation), I see $HARV’s cost of capital running about 400 basis points higher than $GTII or $CURA.

The next several quarters ahead of them are going to be challenging..

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 $HARV