I recently referred to Supreme ($FIRE) as a ‘canary in the mid-tier coal mine‘. As mid-tiers go, they’ve cleaned up their balance sheet and remodelled themselves as a CPG outfit, hiring leadership from the CPG space, and going boldly forward in chasing the broader (read ‘not the chronics’) consumer market for cannabinoids. Which….is still a relatively undiscovered country.

This is despite the promises of the wonders of weed that activists have been promoting for years. From hemp dislodging cotton for fibres and corn as biofuel, to its’ ability to masticate hardpack and re-invigorating soil….cannabis also holds the promise of effective cancer treatments and psychological applications….even into the use of TCH-V as weight-loss aid.

Seniors and soccer moms not typically indulgent to the ‘Devil’s Lettuce’ haven’t materialized in force. Yet. Topicals and analgesics and bath bombs, use of specific chemovars for relaxation and motivation, rapid/delayed onset of effects, micro-dosing….you already know it.

That CPG path is the one that Supreme (among others) is following. And I go on about it here because in many respects, so is The Valens Company ($VLNS).

We’ve been following them from the start. Late 2019/early 2020 saw the two primary extraction shops (Medipharm($LABS)/$VLNS) begin to expand into in-house product creation, after expanding into white-label a couple of quarters previously. $LABS was almost 3 quarters later in developing their own SKUs. Perhaps they hung up on the idea that kicking revenue forward by ostensibly inflating sales was a long-term business model. Yeah, I’m being facetious, but not much. Valens did a forward product swap with Village Farms ($VFF), the difference though is that it was disclosed. Which, is all the difference in the world.

So, $VLNS has been active of late, announcing that a long-awaited Toronto facility (Pommies) is finally seeing the end of the tunnel, they just bought a kitchen, and subsequently closed a bought deal to pay for it. $VLNS also took a punch on some extract that the market has been pricing down over time. I think that move was prudent, even if the announcement was driven to clear the decks for the raise.

To the financials!

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• Cash at $20MM/AR at $27MM/Prepaids $12MM as of financials. Between the recent raise, costs coming in from the LYF acquisition, SKU expansion, and Pommies activating, they’re gonna have use of it.
• Revenue down $2MM QoQ. Most notable is YoY quarterly drop, attributed to tolling revenue backing up. It accounts for about $1MM of the drop in sales this specific quarter.
• They refused to put any segmentation to their revenue splits as to co-packing/white-label/in-house product sales. From revenue, of the $16.6MM reported, it was comprised of tolling ($1MM), testing services ($420k), and the remainder in product sales ($14.5MM). So. they went backwards, but we can’t see where.
• They attribute the gross margin dump to “price compression & shift to manufacturing platform.” They went on at length about becoming exclusively a CPG manufacturing company in a year. More below.
• They reported a $16MM loss this quarter, it included a $9MM additional inventory allowance. Whether this will capture the inventory blowout in early January, they didn’t say. Inventory now down to $14MM, which is more manageable than previous given sales rates.
• Still, even if their buys are more closely matching throughput, they’re still experiencing inventory losses that I thumbnail around $3MM/Q. This implies that price compression was continuing through late 2020, or, that they’ve mismatched supply with demand. Either is possible. Will look to see if this has stabilized next quarter.
• Their lab testing is pulling in a little over $400k/quarter, probably a relatively stable run rate from here. Also, one of the few spots where they highlight QoQ comparisons. They seem to provide that only when convenient.

• My prediction that SBC would see a hard increase in 2020 v 2019 didn’t bear out. Share price declines are probably part of this as warrants and such went out of the money. Compensation is largely flat YoY. More below.
• Goodwill and Intangibles a relatively modest 21% of total assets, although this will probably double with the LYF buy. Which, brings us to another large part of their pivot. More below.
• Wages and salaries doubled in this quarter ($2MM to $4MM). G&A consistent QoQ ($700k/q). Advertising and promotion relatively low heat and similar consistency at about $500k/q.
• Travel and business development a rounding error in terms of materiality. Like advertising and promotion. For a company trying to build brands and facings, seems low.

Ok. Much is orderly here, and good disclosure (where it’s something they want to). $VLNS (like many others), lean heavily on YoY comparisons. Somewhat irritating for myself, but this is not exclusive to them. Still, TheCannalysts like fulsome disclosure. Operations here are somewhat opaque in the financials.

Pommies – the drink company $VLNS bought for $8.7MM (initial calculation due to share price declines. $7.4MM of the initial estimate of $7.5MM price was intangibles). True ups see about $900k of the price for actual hard assets. Interesting to see that the entire PP&E was ascribed $600k in value. The final numbers see the Pommies acquisition had $0 in net assets (Note 18).

$VLNS has budgeted $6MM to get that plant retrofitted and in operation. They’ve spent a million so far, rest is supposed to be spent by June (with $3MM in equipment. Wow). Operation is contingent on a Health Canada application being approved and the plant’s commissioning. The plant wasn’t fallow though in 2020, and did generate $2.2MM in sales over the year (reporting a net loss of $542k).

The wind up of their debt facility is said to be around $VLNS ‘rapid acceleration’ from tolling into finished goods provision. I’ll put up the entire paragraph its’ given in the MD&A, although the last sentence probably says all that needs to. To me, this has the feel of a margin call. I’m not going to hunt it though:

Related party transactions total some $10MM this year, which I think is pretty steep given where they’re at. That’s for an 11 headcount, but 4 of those are independent directors, and they pull in about $80k/yr each. That leaves the rest at a million per year in salaries and SBC (40/60 split). They’re still in build – relatively speaking – yet to myself, compensation is being made as if there’s a profitable core business being built upon. To me, that’s not apparent.

Throughput looks like it’s stabilizing, although I wouldn’t place much confidence in it without more data points. Competition – particularly on hydrocarbon and alkane pulls is increasing. While 2.0 is finding its’ footing, the urge to splinter product offerings to find customers will increase costs. Good disclosure here. Note the SKU count held up as operational metric:

We recently saw our first use of an ‘onerous contract’ provision in Indiva’s financials. $VLNS gives us a second, recording an $800k liability after writing off a $1MM deposit and renegotiating the rest of the fixed off-take. I’m having a hard time finding the counter-party at the moment. I don’t think it has anything to do with Emblem (which is noted as fee for service). It’s still a pretty good haircut, reflective of the state of over supply. Thus, they’ve taken both ends of the price compression stick in both oil and biomass.

The one thing Blue noted that struck us both as being not terribly ‘cricket’. It was in $VLNS adjusted EBITDA calculation – where they ascribe inventory impairments/alignments as negatively impacting adjusted EBITDA. From their press release:

Problem is, they have always removed cost based inventory impairments from adjusted EBITDA. How can that impact something it’s always been reversed from? Note the $4.895MM reversed in their calculation, along with losses on bulk oil. They don’t disclose if any of the deep discounted oil is in there:

From the conference call:

• They announced ambitions to get into the USA (not an ‘if’, but a ‘when’, health and wellness, get into every province, chasing EU-GMP. Launching prerolls/flower/edibles, very focused on increasing ‘total addressable market’. <yep, like everyone else at the moment>.
• LYF relationships with big box touted as ‘synergies’ <I am unsure how, I don’t believe drug kitchens are switchable back to non-drug use. Confirming>. Vegan/low sugar/no sugar/peanut butter cups/coconut/cinnamon plus industry relationships – food expertise….they’re putting a big sell on for the LYF acquisition.
• Edibles will make up 10%. They see little differentiation in the market currently, and LYF will fix that. Shipments expected in the next couple of weeks(?). <I think that was a misstatement>.
• 16.4% margin. Tout positive ADJ EBITDA during 2020 despite all the hardships. <Umm, more below>.
• ‘Second half of 2021 is really gonna see things happening. <Long time readers will know our disdain for things that are ”two quarters out’. While the industry is still in development – and there is some expectation around this – using this ‘go-to’ more than a couple of times signals to me a business plan that hasn’t gone as expected, and being in the middle of a pivot. $VLNS acknowledges they are in ‘transformation’, but, it doesn’t appear they can manage the current business they had designed. Might be a bit of overstatement. Still.>
• ‘One stop shopping’. Flower and preroll (60% of market) entry by $VLNS will drive people to the brand. <‘Weddings parties, bar-mitzvahs.’. You want it, we got it. Not the first (nor last) operation that’ll expand services.>

There’s several inconsistencies that pop up between the company’s narrative, and financial reality. One is that COVID has impacted inbound shipments, so there’s less to do. This is discordant with increasing system-wide legal cannabis sales. They also touted the LYF acquisition hard on the conference call, that it’ll be great to have an actual food maker put out edibles, while also acknowledging that gummies are 70% of the market. Another tout $VLNS has is that – as buyer with no production – they can pick and choose from the market at lowest cost. Unlike ‘peers’, they aren’t beholden to their own grow (take that Auxly!), and they are purchasing for terpene profiles and beyond. $VLNS also states they’ll be releasing minor cannabinoid products in the second half of this year.

And….of course….what would a pivot transformation be without CEO Tyler Robinson ending the call….coming back to an earlier reference to $VLNS future plans around the US market. His words? $VLNS entry to the USA is [paraphrase] ‘a matter of when, not if, and we’ll be going in as ally‘.

Well then. Perhaps he’s assuming there’s nobody there with established brands and extraction and edible capability already. There wasn’t any kind of colour on the flag planted (except maybe white – in acknowledgement of Canada’s market potential).

I don’t know. From their presentation, this is a company in progress of a full and complete pivot/transformation, promising to be the one-stop’ manufacturer of anything a company would want to do with cannabis. Pre-rolls, whole flower, extracts in C02/hydrocarbon/alkanes, edibles, beverages, co-packing, but less tolling. It has the feel of a shop trying to increase asset utilization by being willing to do it all. Fair enough. I like that they are indeed ahead of the curve in terms of re-triangulating. Delays at Pommies has likely been difficult.

But if the pivot is live, the margin question pops up. As in, what will margins ultimately land at with such an array of services, particularly if bespoke and ‘custom’ becomes the primary throughput channel?

Another important question as to this transformation – where and when does in-house branding lock in? $VLNS is relatively small in this regard. Presumably, the brand is where folks will come to in experiencing CPG, and $VLNS is entering a competitive space in pre-rolls as an entrant unknown for flower. They claim strength in flexibility in sourcing, and presumeably they’re banking on quality and hitting a bullseye on consumer preferences. Still, one should think about the ability for them to DIY brand and lever that very thing, at least out of caution. And…really, I wonder how much the LYF acquisition will actually be (even if they pound out a Coq au Vin equivalent of a gummy) in the absence of Health Canada changing packaging and potency rules around edibles.

Their decline in sales is at the bottom of the challenges they face. They’re losing ground in what should be their wheelhouse: extraction and formulation. I said last time: “should sales generally remain at these levels…….look for a restructure or re-org in the next quarter or two”.

Notwithstanding my prediction quality (ugh!), what $VLNS is in right now is a full and complete ‘transformation’ away from being an extractor, to manufacturer. This is aligned with much of industry thinking – that as the industry matures, it’ll formalize the concepts found in CPG. It is also at some odds with another line of thinking – that many companies went too big and tried to do too much – that there was not enough focus on being successful within specific segments of the value chain before trying to do them all.

The extraction segment has borne out to be facing the most challenges of all in legal weed. A well-trod sector (familiar to anyone familiar with refining or molecular isolation) that is predicated on capacity throughput – got a first and single wave go through it. And it now stares capacity surplus right in the face. $VLNS appears to be banking on organically building up capacity themselves.

They claim they can deliver. I’d counter that over the past three quarters (since the launch of their own products)….they largely haven’t. $VLNS has a good handle on capital (for the most part) and a relatively well funded balance sheet. Business risk and results now lay several quarters out, in a landscape that’s evolving crazily, and one that isn’t a competitive vacuum.

I referred to Supreme at the start. Unlike them though, $VLNS isn’t refining their business model, they’re changing it, and they’re doing so on a base that’s not showing much traction. The risk here is not only within execution, it’s whether or not they can achieve enough capacity utilization to make the whole thing sing. And that is the same question they have been facing for the past 2 years. Now, we’re at ‘two quarters away’, and a year from seeing results.

It is an ‘exciting’ story as business stories go. But I can’t help but think of the risk comes along with it.

In the interim, what’s vital for $VLNS is to actually increase sales on their products and said they were going to do. That hasn’t been demonstrated at the cash register. And if they can’t do that….I’m not sure what weight to put on their latest promises of execution.

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 $VLNS.