TheCannalysts have looked at retailer Inner Spirit Holdings ($ISH) in depth. Take a look at the earliest posts for backstory on the WatchIt! franchise that predated the ‘Inner Spirit’ one.

We’ve had a good look at them not because they present as a potential investment (not to me anyway). Nor is it because of the quality of their financial reporting (it actually sucks. GoBlue won’t sully his hands unwinding their plugs. And completely understandable). It’s not because of their CEO’s last foray in franchising was a success (it wasn’t. It failed. Twice). And it’s not because of the superior returns generated through a franchising business model (franchising generally boils down to being a profit share: two parties, reduced risk, margin splitting).

Nope. The reason why we’ve spent time on them is to look for insights into retail. I’d forsworn these guys at one point too, but I can also use a much needed break from US MSOs right now.

Let’s have a look at $ISH’s latest quarter, and see what they accrued (burn! ).

To the financials!

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• Retail revenue up to $5.7MM (from $3.6MM prior). Royalties up 30% to $1.2MM. Total revenue $8MM, gross margin at 47%.
• OPEX up $400k to $3MM. Given an incremental 25 (!) stores came online during the quarter, that’s impressive.
• I’m getting a COGS value for the Corporate store sales that shows a gross margin of 30%. More below.
• Cash is lean. Up $2.2MM due to a 28MM share private placement by someone in the UK. Another $720k was also raised in a private placement during this fiscal year, for a total of $3MM against 30MM shares. The share price here hasn’t suffered like others raising below market.
• Hmm. They have an $8MM liability booked for gift cards. It was only $1.8MM at the beginning of the year. Interesting look into consumer purchasing habits, and it appears gift cards are an option some folks want. The amount translates to $12k in sales of gift-cards per month per store. That’s a pretty good number.
• Sales & Marketing at a lean $200k, or about $800k for this year (comparatively: $FAF is ~=$1MM/yr, $HITI ~=$500k/yr)
• 320MM shares fully diluted. 85MM in options and warrants (50% of them are at a $0.25 strike, expiring 2022).
• There’s a $10MM convertible laying around, but doesn’t mature until June 2022. It’s accruing interest at around $400k/q.
• This is $300k/q more per quarter than interest expense attributed to ‘accretion’ within leases. I have no idea what that is, but there’s $530k in interest expense related to them, with $408k in ‘finance income’ offset against it. There’s been $850k booked in that ‘income’ YTD.
• Not necessarily material (nor a suggestion of nefariousness). I simply can’t figure out Note 7 (where this all comes from), nor the economics of what the bookings are intended to represent.
• It looks like the CEO was up late one night on the internet back in 2018, when $ISH ended up spending $110k USD for a prepaid subscription of High Times equity. Their IPO has been the main star of a Mexican Soap Opera for quite awhile now. Of the initial $150k investment, it’s been written down to $75k on the books. Probably won’t survive year end.

Ok. I’m reaching a bit here. There’s nothing material in these that hasn’t been noted previously.

$ISH uses a phrase – ‘system-wide’ – to provide a sales number for the entire 58 stores in their fleet. They report this as $31MM, implying total monthly per store revenue of ~=$180k, or $5.3k/day. This is a lower run rate to numbers reported by $HITI ($6.5k/day) and $FAF ($6.3k/day). Interestingly, $ISH’s 12 corporately owned stores (~=20% of the fleet) report a similar run rate of $5.2k/d, at a 30% margin.

That 30% margin I derived is different from the 47% margin they report. I took reported COGS, eliminated inter-company and franchise sales, and deducted that from Corporate store revenue. I got a 30% margin. The 47% they tout in the quarter includes royalties and ‘advertising’ revenue from franchisees. There’s no ability to attribute cost against these streams with what’s presented. I point this out to note that the ‘47%’ margin and positive EBITDA they report are values that don’t have much utility to investors (in a word: meaningless). If one wanted to be deliberately vague about reporting store performance, this is one way to do it.

‘SpiritLeaf Macleod’ is a store that $ISH owns a 50.1% stake, and thus need to split out the non-controlling interest (NCI) in reporting. To me, the store is essentially a flagship for the chain: it’s on one of the highest volume streets in Calgary across from a massive retail complex. How’d it do last quarter? It lost money, albeit at a slower rate than 2019:

All retail chains probably have a few marginal stores in their fleets, and its the same across other sectors. We’ve seen Fire & Flower and High Tide and Tweed ‘realign’ some of their storefronts in terms of closures and openings around specific locations. As to the quality of $ISH’s fleet, $ISH does have a strong interest in seeing franchises succeed: it doesn’t serve them to lose a franchisee….nor being forced into assuming operations in the case of of low performing outlet.

<An aside, Auxly sold the flagship Kolab store to Delta-9 recently. Delta-9 has been increasing their retail outlet count lately, and they seem to want to exist supplying smaller markets, focusing on Manitoba/Saskatchewan. To myself, the Kolab Delta-9 store is sexy – despite being in a relatively rural setting. Delta-9 picked it up for $875k, primarily in stock. One mans’ trash and all. Lloydminster also saw the permanent closure of a $HITI store during this year (for which they wrote off $250k). I’m guessing there was little commercial interest around that particular site>

Regarding $ISH’s franchise fees, I’ve been pessimistic whether the amounts offset related corporate overhead. $ISH charges franchisees an upfront fee (comprised of refundable and non-refundable deposits) on initiation, and then collects ongoing ‘royalties’ and advertising revenue. The ‘advertising’ likely sleeves online and website promotion/expenses to franchisees, and perhaps attaches little or no margin. I don’t have much visibility.

Royalties and advertising revenue for the quarter was $1.5MM, or alternatively a direct cost to franchisees of about $10k/month. It adds up for $ISH, but the total revenue is only 20% of their corporate store sales. It’s logical to assume a chunk of the corporate overhead exists to service franchisees, but it’s indiscernible. As to the ‘margin’ that the franchises generate as a segment for $ISH – even assuming say a 50% ‘margin’ – would only contribute some ~=$2MM/yr against $12MM/yr in total OPEX. It strikes me as low in support of a 48 store system.

And, that brings us to the main point I have about $ISH.

Where are returns going to come from?

$ISH has shown adroitness in collecting and putting franchises into production. It’s no small feat to get 25 stores up in a quarter, even if the franchises are doing most of the work. Of that total, 5 were corporate stores themselves (!). But initial franchise fees and ongoing royalties seem low in terms of contribution margin given absolute value. I can’t offer much in terms of relative pricing of franchises (I know some large chains like A&W & Taco Time charge franchise fees based upon a percentage of gross sales, but those brands are a world apart from retailing legal cannabis, and likely not a good fit as comparative). I know $HITI booked $872k in franchise fees last quarter from just 2 of the Ontario stores they did a deal with…….but……..I can’t see the whole of the transaction, and, these were related to purchases in large part, and could be interim in nature. The point is that its’ little use as comparative either.

If we exclude the franchise stuff …….we’re left with corporate store sales. They’re at the lower end of monthly per store revenue figures with peers ($YSS reports the lowest revenue numbers of the chains we’ve looked at, running around $3.7k/day/store), the $5.7MM $ISH report generates $1.7MM in gross margin to support $4.7MM/q in expense. To break even, that implies a $3MM gap per quarter – or about $9MM/Q in incremental cannabis sales. That translates to an incremental 17 corporate stores required to generate those $14MM in quarterly sales.

(I’m going to exclude ‘millwork’ revenue here as well…it’s a support service that builds furniture and displays to furnish stores with. As part of the agreement, franchisees are required to buy store materials/displays from $ISH. This business ‘segment’ reported losing money last fiscal after year-end true-ups plugs. This quarter reports accrues 50% margin on $400k in sales).

With a relatively small bank account, there could be a ‘quick’ add of a couple of corporate stores, but I can’t see $ISH as they are being able to add more than a few per quarter.

Readers will note I’ve been dour on the idea of franchising – at least within a highly regulated industry with relatively low-value reseller brands attached. To myself, it also details $ISH’s prospects.

If these financials do anything, they support much of our analysis so far. Like other retailers, $ISH needs more stores online to support their infrastructure and generate returns. Despite having 12 corporate stores and 48 franchises, $ISH is not generating meaningful EBITDA, and the $HITI’s and $FAF’s and $WEEDs and $YSS’ and $DN’s of the world are adding stores, as are independents. They need to be in position prior to saturation, and so the path forward for $ISH is pretty much the same in needing to open incremental corporate stores…….absent the backing that an $ACT or an $STZ can provide. Or from positive cashflow that’s beginning to emerge in $HITI.

The relative pricing of cannabis retail chains in Canada is a mess at the moment, and this thing demonstrates just that by running as hot as it does for the potential these assets represent. I’ll keep watching them. But like the past several sets of financial statements $ISH has released, in these……there’s nothing to see. At a market cap that’s one third of $ISH, $YSS sports 18 locations without the bother of having to deal with 46 different owners.

One might be tempted to compare $ISH to a $META and see it as a possible M&A target. I wouldn’t. There’s 46 stores that are in the hands of individuals and small businesses – the only assets $ISH really has is 12 retail stores centred in Alberta.

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 $ISH, $ACT, $XLY, or $FAF, and holds position in $HITI