Some news the other day about Fitch downgrading Canopy Growth’s credit risk……landed on their equity with a dull ‘thud’, adding another layer of weight onto the wider sector.

Profitability remains elusive across the value chain, almost 4 full years after recreational use was legalized in Canada.

It’s not been fun at times documenting the how and why so many are struggling. Yet here we are – and have got what we have.

Heritage Cannabis ($CANN) has kept afloat. An acquisition of an extractor called ‘Premium 5’ in early 2021 likely saved both companies from insolvency. A raise to buy equipment and biomass was pricy…but it was done. Fast forward a year (and more debt and dilution), and the company is still here.

Our last look at them ended in a yawn. So long as margins remain variable….and operations keep consuming cashflow….it’s a slow circle around the drain.

This’ll be brief. I’ll be putting up content over the next week or two, along with the 2nd part of our look at the ‘The Road Ahead’ for legal cannabis companies in North America.

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• Revenues up $900k QoQ to $7.5MM. Gross margin up to 42% this Q – up from 28% Q prior. Sounds like improvement.
• The nature of their revenue has changed over time. More below.
• That additional revenue was helped by SG&A declining by almost $1MM QoQ as well. While operations lost some ~$2.8MM last Q, this one saw only $750k spent on operations.
• Which, is a little odd on its’ face. Why? An improvement of |$2MM| (cost reduction + revenue increase) reduced operational cash burn by exactly an equivalent amount. Yet this quarter was accompanied by an absolute increase in gross margin of 14%.
• That kind of result implies a shift in product mix. More below.

Ok. Not much point in going further, as the sight-line on this outfit’s viability has become pretty clear.

Regarding that product mix: if one takes a high level view up front, you’ll see why I suspect product mix might be having an impact. To wit:

Gross margin up $1.3MM, plus an additional $1MM in lower SG&A……ultimately led to a higher loss? Hmm.

Looking at revenue makeup, the excise tax remits are flat this quarter relative to sales levels:

One of the early ideas (before 2.0 landed in 2019) was that extracts and processed goods would be good for the sector….that additional value add and higher product pricing would attract higher gross margins. In most cases, much of that real estate has been taken over by various levels of government. An inelastic excise tax structure (and accompanying provincial taxes) has consumed much of those expected margins….as consumers appear to balk purchasing goods outside of certain levels.

Add in producers dropping price to gain market share….here we are.

I’d mused last time about a category split that $CANN included in their MD&A, and whether it’d remain. It has, perhaps it’ll be useful in tracking the numbers:

Hmm. ‘Vapes and Concentrates’ up marginally, ‘Flower’ showing relatively strong improvement. Not terribly ‘positive’ to myself in the overall, inasmuch as their growth engine (2.0) seems to have stalled this quarter (the flat excise tax remits above confirms). But this still doesn’t really explain why net income went in reverse.

Net interest cost has gone up $~100k….but largely negligible. How about inventory? Did some product flow through?

Nope. There was growth in almost every line item, with finished goods growing $1.1MM.

How about Accounts Payable? Well, they’ve been rising by some $1.7MM/Q for the past 4 quarters. Sequentially, it looks like this:

Prior to that, it appears to have been turned over/satiated every 6 months or so.

$CANN reports a net working capital (WC) number currently at some $7.8MM, and holds cash of $5MM. Remember that WC value includes $17MM of inventory….and I’d say it’s doubtful 100% of it will be able to be turned into cash. As well, a bridge financing they did last fall has now landed in ‘Current Liabilities’ – which brings total cash needs (aside from operations) in the next 3 quarters to $23MM:

I don’t know from where that $1.7MM/Q is accumulating in their payables. Perhaps it’s from deferred management compensation(?), perhaps some sort of amortization. Net cash (outside of $1MM in remaining GICs) increased $300k QoQ to $4MM…..but this was achieved by drawing down an additional $2MM in debt:

There’s a hole in this bucket. Somewhere. The professional fees we noticed last time have dropped to $90k (after 3 steady quarters at $280k).

I’ve gone through these items to help the reader understand my thought process, and how I approach looking around financials. A shareholder would be well-served to inquire about this: a direct answer would sort instantly. I’m not ascribing nefarious intent anywhere….but the leakage begs several questions to myself.

Rather than go on, I’m stopping here. I’ve little use for $CANN outside of using it for examples – and this one has provided plenty.

Ultimately, they’re either going to need to raise against or re-finance that $23MM. They have improved cash burn….but a burn it remains. They are nearly at the top of available credit, and relatively ‘good’ increases in sales aren’t being matched by cost reductions. $CANN is releasing SKUs pretty aggressively….which will work against gross margin stability.

I’m sure $CANN will tell you they’re ‘only 2 quarters out’.

$CANN’s near-death experience in the first quarter of 2021 demonstrates how <ahem> ‘flexible’ counterparties with aligned interests can be when facing a dark alley. I’m sure the next few quarters in the sector will demonstrate flexibility in other company’s deals as well.

As to this outfit…..getting on top of product/mix/yield in maximizing gross margin is a relatively complicated activity, heavily dependent on talent. $CANN’s not demonstrated it’s got any (outside of the Premium 5 folks they brought in). And while the Premium 5 folks seem to be capable of pulling gear…..it doesn’t look like they’re terribly adroit at linear programming to optimize profitability.

While sales and margin are improving, this company continues to lose ground.

The preceding is in the opinion of the author, and is not intended to be a recommendation to buy or sell any security or derivative. The author holds no position in $CANN