Inner Spirit Holdings ($ISH) holds some fascination for me. I’ve got a fair bit of research into these guys (yeah, I know, it’s probably *too* much of a fascination for the market cap and business model they sport). But I was really interested in retail over the year or so when the chains ($FAF/$HITI/$ISH/$YSS/$META) were in formation. I didn’t know much about this segment of the value chain, and I ran pretty hard given reign.

About a year ago, GoBlue pushed back from the table and walked away from $ISH when he found errors in the financials. Me? I’m not the sort to linger and stare at accident scenes, but, I can’t help feel there’s going to be one here, and it’s more of a ‘how’ than a ‘when’.

Why? Because I’ve seen constrained margins – uneven from province to province; the creation of a ‘no-go’ zone in our second most populous province (QUE); and a deliberately planned ‘slow-go’ zone in the third (BC). Both BC and QUE proven to be more interested in grabbing revenue and building State empires…..than enabling an economy for all citizens to participate in equally.

This is a challenging environment for any business to survive in. For a public company: the road to success means sizing up. For a capital thin packing a business model built on offering non-exclusive products and collecting franchise fees….I think its’ even more challenging.

Let’s get to the numbers, and see what’s happening.

To the financials!

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• Cash flat QoQ at $4.6MM. A/R, same ($1.4MM). Inventory, up slightly ($1.7MM). A/P matches A/R.
• Balance sheet overall can be described as ‘tiny town’. Largest asset they report ($9.5MM) is ‘Investment in Leases’ where they’ve used their credit rating to secure leases, then flow them through to franchisees. They have a net lease liability of $4MM, which probably attaches directly to corporate stores.
• I can’t be bothered to check if $ISH is making any money backstopping franchisees. Theoretically, they should. The ‘asset’ number is up $3MM QoQ. More below.
• Overall – $ISH reports a 46% ‘margin’ across system
• Revenue was $18.3MM on the year for corporate (~=$1MM/store). Another $10MM in the year for everything else (royalties/millwork/franchise fees….). So, about 65% of all revenue is generated by corporate. $12.3MM in COGS on that, or a 32% margin. Lowest of our retail peerset.
• Another 63 franchised stores generated the other $10MM. Millwork is meaningless in terms of margin (5% margin), so that leaves $6.3MM in revenue, from royalties ($4.2MM), ‘advertising’ (net $0), and franchise fees ($850k).
• There’s also $900k of revenue in something called ‘Supply’ – which I’ll assume is wholesale smoke related goods.
• So….of $12.6MM in gross margin across system, with $10.5MM in expenses adjusting for depreciation/amortization/SBC/impairments. It all adds up to about $2MM generated by operations for the year.
• Interest expense of $3MM.
• Ok. I’ve laid this out, because what I see is that they’re losing about $500k/q. I can’t separate corporate from franchise cost, but I can see that across 63 franchised stores, that’s a net contribution margin of about $85k/store per year. (This is a very imperfect number mind you, due to timing of openings and such).
• Tell me how many franchisees a public company – with a $27MM cumulative deficit in capital and 235MM shares outstanding – needs to have to get to break even operations? More below.
• $ISH claims to have another 27 franchises in the works, and 8 more corporate stores pending. Their cash balance *should* get them most of those corporates up.
• The good news is that overall operations generated some $2MM in positive cashflow for the year.
• There’s about 35MM in warrants and options out there at $0.15. Their recent share price run is likely very welcomed by debt holders and management.

Ok. Now I’m just bored.

Regarding $ISH’s subletting to franchisees. A franchisor’s value is in offering a ready made brand, millwork, levering existing advertising, and offering support in data. That last one is probably as valuable to a franchisee as anything else – no trial and error in finding what sells (presumably).

$ISH’s ‘Investments in Leases’ has doubled over the past 2 quarters, as franchisees without the credit rating or capital to qualify for a commercial lease lean on $ISH to help out. Hey, that’s what franchisors are there for right? $ISH’s lease liabilities have grown from $8MM to $13MM over that same period, and now exceeds their convertible debenture debt. So?

As $ISH takes up more room on their balance sheet in sleeving the liability, it leaves less room for other things. Like more debt. Or, a dilutive capital raise. It means the risk of a franchise failure comes right back and lands in their liabilities. There might be claims and personal guarantees – but dissolution is inelegant, and fees and process are costly.

My point being – it’s a different facet of business exposure than simply selling weed. It’s unremarkable in most cases, but here, it’s both the single largest asset – and single largest liability – on the balance sheet.

Meh. This thing is tiny town anyway. I’m usually not dismissive of small business – unless its’ poorly run or used as a loot-box. Neither of those strike me hard here (although look for SBC next quarter to blow out). But no matter which way I turn this around, it looks exactly the same as WatchIt!, the previous franchising attempt that CEO Darren Bondar didn’t succeed at.

Unlike that one – which never had scale – there is a business in here. Yet my dismissiveness of $ISH centres around it being a public company. For something with as much heft and size in appearance (store counts and ‘system’ revenues), the whole thing weighs an ounce. It would probably be fine as a private company – provided it hadn’t taken $27MM to get it to this point. Long term rates of return on retail assets are typically around 5%, so $ISH can get there assuming they add their planned corporate stores, as well as another 48 franchises.

I’d often asked how many stores would it take for CEO Fencott of $FAF or CEO Grover of $HITI to be profitable. With those, it was never really clear. $ISH has allowed us to get to an actual number (thank you!).

But ‘normal’ retail returns won’t support the cost of capital (nor current debt levels) it’s taken to get $ISH into position. Their current share price is in the low $0.30’s. From what I derive – that predicts operating 45+ corporate stores and ~=190+ franchises. That’s as is, and assumes no franchise failures nor competitive pressure. Nor a limit on how many stores are actually feasible.

I’ve got no axe to grind with $ISH. But it’s equity thin, and I just don’t see the math. Now, or anytime soon. Above all, I see little reason for this to be a public company.

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