We’ve chronicled Inner Spirit’s journey into the world of selling dope for awhile now. Our last structure detailed that despite the store count, the outfit isn’t exactly rocking it.

Recent housekeeping saw CEO Darren Bondar setting his sights on no less than 6 corporate stores in Ontario, yet disavowing any intent to stray from the franchise model, which he views as the bread and butter of the Inner Spirit way. I have no view on it per se, I have no position nor disposition towards the outfit aside from what’s been said before. I do see it as an interesting business story, but am suspect in the ultimate business model underlying it all.

Sure, franchising is and can be extremely successful for some, but as I’ve mentioned, it can easily become a straight-jacketed Income Trust Death Trap. $ISH seems to be trying to walk a line between both worlds, which appears similar to the results demonstrated in their roots as a company that stiffed suppliers for millions and left franchisees hung out to dry…not only once, but twice with the declaration of bankruptcy of the WatchIt! franchise at year end.

Let’s turn our eyes to a 46(!) store chain of a semi-kinda-sorta-ish-like retailer, and see how a year in build has turned out for them.

To the financials!

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• Cash is anemic. Perfectly aligned within the Retail slot in the value chain. $2 MILLION DOLLARS! Cue Dr. Evil music. Another $1.2MM in ST deposits held.
• They’ve gotten 2 raises off since the financials. They’re going to need it.
• They lost $11MM on $8MM in sales, that were sporting a gross margin of 46%. How they did that is anyone’s guess. More below.
• From inventory (Note 6), we do find out that the millwork that had provided so much margin in earlier quarters had revenues of $1.9MM over the year, but inventory of $1.8MM was expensed against it.
• We also find out that cannabis revenues were $3.2MM, but inventory expensed was $2.4MM, giving a margin of only 25%. That’s low when set against peers, and having 9 corporate stores in operation as of September’s financials.
• That’s revenue of around $110k/mo for corporate stores, so at an average per sale value in Alberta, that’s about 5 transactions per hour.
• Inventory at year end a lean and crisp $1.4MM. Franchisees carry their own working capital after all.
• WatchIt! became a discontinued operation, and wrapping it up cost $ISH some $800k, as well as a $3.5MM write-off of goodwill/intangibles. It declared bankruptcy at the end of last year, with trademark & such sold to a franchisee (who owned 2 stores) for what I see as about $600k, but it’s complex to follow, and the disclosure isn’t good.
• $ISH had dumped $2.6MM cash into that same WatchIt! hole the year before they finally threw dirt on it.
• Somehow, $500k in leasehold improvements and furniture was also impaired during the year. Hmm.
• They’ve lost $700k on $1.3MM in investments with LP’s. Sector performance after all.
• Note 16 (Share Capital) is an absolute dog’s breakfast. It should be renamed ‘Ipecac syrup’. Seriously. It’s one of the ugliest capital notes I’ve seen. More on this below.
• 200MM shares in the float as of year end, another 71MM in options and warrants.

Ok. This thing is just pissing me off right now.

There is no linearity in narrative in the financials, and trying to divine information in here is no fun at all. The MD&A is crap.

One of the complexities of trying to find risk in a hybrid business model is exemplified in the subleases, which were taken on by corporate, offloaded to franchisees, and booked as an asset. But credit risk is backstopped by $ISH, who’ve made a $300k provision for losses on $2.7MM of these sleeved ‘assets’:

Another complexity is in their revenue mix, which is an amalgam of streams that are variable and often contingent. The word ‘segment’ doesn’t appear in their MD&A, yet the breadth of business ‘lines’ is indecipherable without it:

Spirit Leaf Macleod is a subsidiary that holds one corporate store, but $ISH only owns half of it. It provides us with a rare glimpse into operations at that store though because of this though. It lost $570k operating in 2019 (!) and has net assets of $250k. Wow.

Note 16 (Ipecac Syrup Share Capital) gives us insight on an agreement done with an Ontario lottery winner – who was given 5MM shares plus $500k in cash to come under the $ISH banner to ‘bring the partner into the Spiritleaf system under a retail operating agreement and to earn royalties‘.

Ok. The entire amount of $1.3MM was then booked as an intangible, and will be amortized, but due to the discounting of the Note Receivable, it came in at $1.1MM. Presto!

A share issuance to buy a fucking royalty. Seriously. The cash part was booked as a ‘loan’ to the franchisee but interest free, and discounted at 12% on the books as well (Note 8, Note 9, & Note 16(b)(xviii)). Yes, there’s a Note 16(b)(xviii) in there.

Look. I’m not trying to start a war with the concept of franchising. It’s a proven and viable business model, and there’s many examples of success out there.

Auxly’s and Tilray’s and Hexo’s position in $ISH is obvious: being a manufacturer of end-user product….hey, let’s find a friendly. Positioning and facings. You know. From a Licensed Producer’s perspective…..any road that leads to Rome is a road that should be taken.

From my perspective – that of an investor looking for returns – $ISH is complete and utter dog-shit. For many reasons.

The business model relies upon a mixture of millwork, royalties, franchise fees, and where possible, corporate revenues. The other side is that of the franchisee, who is intent on making primary returns on retail sales, with payments being made to be part of a larger network. That value that network (in theory) provides is sales support, data, advertising under some form of brand umbrella, and whatever else a brand can bring.

Ok.

For an investor, you do not gain exposure to cannabis sales in 75% of their fleet. Instead, one relies on whatever percentages and fees negotiated and tied to franchisees – with other one offs thrown in (recall, ‘Spirit Leaf Macleod’ is a subsidiary that holds one corporate store, but $ISH only owns half of it). Without velocity in the underlying brand, returns are going to be static. As well, returns on that stream are clipped by corporate overhead – which serves the company and management first and foremost.

Corporate owned stores ostensibly compete with franchisees as well. It can be a complex business to manage, and the history of franchising is littered with tension and litigation. A franchisee’s assets can become corporate in the event of financial distress, or simply shuttered if undesirable. Poor corporate performance (via inefficiency or weak operations) can become franchisees problems in escalating fees or diminishing lines of support.

Sure, bad things could happen anywhere. Why does this matter to an investor?

Because a franchise mechanism diffuses both financial exposure and management’s accountability to the core underlying business. In my thinking, the entire model serves the Franchisor above all, and makes assessing the business extremely complex, and challenging to evaluate.

In the past, I’ve dumped on companies I believe are crap. I want to see where decisions by management directly impact the cost of capital and how they run their shop. In this model, this is often impossible.

Ignoring all of that – the most important reason I dislike $ISH for an investor: In a highly regulated, rate of return constrained sector, franchising is utterly useless.

For a large volume, uniform, strongly branded and product differentiated sector (fast food, clothing, consumer durables), it makes complete sense. Taco Bell. Canadian Tire. KFC. Coca-Cola. Mattress City.

It doesn’t make any sense in dope, with resellers tabling un-unique product offerings. Just like booze.

This thing’s a waste of time for anyone except those aspiring to own their own store, the CEO, or for an LP looking for facings. If you aren’t one of those, you should walk right on by, and never look back.

If you’re interested in Retail cannabis exposure: buy a retailer. $ISH isn’t one. All I see is a complex money losing mess, and I can see this becoming a ‘WatchIt! Part 2’ in no time at all.

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 $ISH and has a hard time imagining ever having one.