High Tide Inc V.HITI

hiti will continue delivering superior return

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Article by Acutel @ Seeking Alpha

High Tide Will Continue Delivering Superior Returns

Summary

• Canadian cannabis retailer HITI has returned 272% to investors over the past 1 year, outperforming its competitor Fire & Flower by as much as four times.
• It could continue delivering superior returns in view of the exploding demand for recreational Cannabis in Canada and the fact that it has established early dominance in retail.
• It has been expanding aggressively and now has 87 licensed stores, up from less than 50 barely two years ago. Its long-term plan is to have more than 200 stores.
• Management has cleaned up the balance sheet and is exploring non-dilutive bank financing, which is critical in view of the shareholder dilution that many weed companies are known for.
• The current valuation grossly discounts the company’s potential, making it a good buy and hold stock that is now more widely available to investors thanks to its uplisting to the Nasdaq.

* All currency in CAD unless expressly abbreviated as US$

High Tide Inc. (HITI) is a fast-growing retailer of recreational cannabis products in Canada and had 87 licensed stores operating under the Canna Cabana brand in the provinces of Alberta, Ontario, Saskatchewan, and Manitoba as of June 2021. The company is one of two leading recreational cannabis retailers that have been aggressively vying for market leadership in Canada over the past year through organic growth, single-store buyouts, and takeovers of competitors. The other one is Fire & Flower Holdings Corp. (OTCQX:FFLWF), which had 83 stores as of June 15 when it reported its most recent earnings.

Inner Spirit Holdings (OTCQB:INSHF), another popular retailer in Canada operating under the Spirit Life brand, had a little over 80 stores as at the time of writing with several more in the pipeline. However, most of INSHF’s stores are operated under a franchise model as opposed to direct ownership, making HITI and FFLWF the clear market leaders in terms of number of wholly owned stores and total retail revenue (whether you are selling pot or selling coffee, you generally make more money from wholly owned retail stores than from franchising; benefits such as efficiency and ease of scalability notwithstanding).

Looking back twelve to eighteen months ago, HITI, FFLWF and INSHF each had less than 50 stores. They have expanded rapidly in recent months and are now projecting to each have more than 100 stores by the end of 2021. HITI has a long-term target of more than 200. Expansion is the name of the game and it is not difficult to understand why.

Exploding demand

Although Canada has provided legal access to medicinal marijuana since 1999, it was only in October 2018 that recreational use was legalized in all provinces and territories, making it the first G7 country and the second country in the world after Uruguay to make the landmark decision of legalizing weed for recreational adult-use. Following legalization, retail sales of the popular herb in Canada have exploded and reached a total of $2.62 billion in 2020 compared with $1.18 billion in 2019, according to data from Statista. Sales are expected to grow another 60% this year. The below chart for monthly retail sales since legalization in Canada gives a clear impression of how explosive this growth has been.

Monthly retail sales of legal cannabis stores in Canada from October 2018 to Dec 2021, Source: Statista

To capitalize on this surge in demand, retailers have in the past year focused on aggressive organic growth and big buyouts. HITI, for example, acquired competitor Meta Growth in an all-stock deal in November 2020, adding 32 new stores to its portfolio. FFLWF has also made several single-store buyouts over the past year.

These moves have paid off. HITI posted record revenue of $38.31 million (vs. $13.7 million in previous year) during the quarter ended Jan 31, 2021 (its fiscal Q1) while FFLWF posted revenue of $44.1 million (vs. $23.1 million in previous year) during the quarter ended May 1, 2021 (its fiscal Q1). Contrast these numbers with INSHF’s $8.8 million in the quarter ended March 31, 2021 (despite a roughly similar store count to HITI and FFLWF) and you’ll understand why wholly owned stores are better than franchises from a revenue perspective.

Both HITI and FFLWF each have current pro-forma run rate of more than $150 million for annual revenue. This represents up to $300 million or at least 10% of a retail market that clocked a total turnover of close to $3 billion in 2020.

Generational investment opportunity

HITI and FFLWF both represent exciting investment opportunities given they account for roughly 10% of total recreational cannabis retail sales in Canada. They are the two dominant players in an industry that is still young – just two years old – with many years of growth ahead of it. Investing in dominant cannabis retailers today is like investing in erectile dysfunction drug makers back in 2000 when Pfizer (PFE) commercialized Viagra or investing in smartphone makers and mobile software companies back in 2007 when Apple (AAPL) launched the iPhone. It’s no overstatement to say that HITI and FFLWF both represent a generational investment opportunity.

Moreover, HITI and FFLWF are likely to grow more dominant as industry growth charges ahead in coming years and the government cedes greater control of distribution, including e-commerce, to private players. Cannabis distribution in Canada is still heavily controlled by the State. There are also significant regulatory barriers to entry. For example, Licensed Producers are allowed a maximum of 25% ownership in retail. The licenses, registrations, permits, authorizations and industry connections required to start a new retail chain also means HITI and FFLWF are unlikely to lose their crown as the market leaders (barring a takeover of either of them or the takeover of a significant competitor by a third party).

Importantly, both HITI and FFLWF have started reporting EBITDA positive numbers. HITI had positive adjusted EBITDA of $4.6 million (vs. adjusted EBITDA loss of $821K a year earlier) in the quarter ended Jan 31, 2021. FFLWF, by contrast, reported positive adjusted EBITDA of $2.3 million (vs. adjusted EBITDA loss of $1.4 million) for the quarter ended May 1, 2021.

Both companies have a path to profitability and are likely to make progress towards this important goal in view of the high gross margins they enjoy. HITI had gross margins of 41% in its last reported quarter while FFLWF had gross margins of 36%. These are also both undervalued. HITI trades at 3.3x EV/Sales and EV/EBITDA assuming $150M run-rate revenue and $18M EBITDA. In comparison, FFLWF trades at 1.9x EV/Sales and 26.44x EV/EBITDA (all Fwd). These valuations have significant room to go higher considering the average EV/EBITDA for all retailers (cannabis and non-cannabis) worldwide was 18.5x over the past two years. Recreational cannabis is in a hyper-growth phase and valuations could grow well past the retail industry’s average. The upside potential is simply phenomenal.

So, which between HITI and FFLWF is a better investment? Both are fast growing undervalued companies in a fast-growing industry. HITI has, however, delivered superior returns, netting a mouth-watering 272% over the past year compared with FFLWF’s impressive but lower 61%. If you took the guesswork inherent in stock picking out and decided to buy the AdvisorShares Pure Cannabis ETF (MSOS), you’d get a 52% return over the same period.

1-year return profile of HITI and FFLWF vs. the S&P 500 and Advisor Shares Pure Cannabis ETF, MSOS

While we are long both HITI and FFLWF, we favor HITI owing to the returns seen over the past year (more than 4 times FFLWF) and its strong outperformance of the sector, which we feel will accelerate as the company and industry continue growing. Our rule of thumb when picking a sector or industry winner is that it needs to significantly outperform the sector ETF to justify the risk of buying and holding the individual stock over the ETF, which is generally safer due to diversification. This explains why FFLWF, while a good investment, does not occupy the same position in our portfolio as HITI.

HITI also has a stronger profile in the capital markets than FFLWF owing to its successful listing on the Nasdaq in late May. Most Canadian weed stocks, including FFLWF, typically list on the TSX and trade over the counter in the US. This limits the size of investors who can get involved, particularly institutional investors who allocate more weighting to stocks listed on major US exchanges vs. smaller exchanges outside the US.

While FFLWF plans to list on the Nasdaq as well, there can be no assurances that this will be successful (if you’ve bought stocks over the counter you know many stocks that plan to up list usually fail). Even if FFLWF were successful, which we hope is the case, it will still have to play second fiddle to HITI, which as the first major recreational cannabis retailer to list on a major U.S. exchange has a first mover advantage as far as securing inflows from a wider base of U.S. and global institutional investors is concerned.

It’s worth noting that HITI had to implement a 15 to 1 reverse split to meet the minimum share price requirements of the Nasdaq. While share consolidation is always a sticky subject for investors, a reverse split for an up list is not nearly as bad as a reverse split to avoid a delist. Also, the number of outstanding shares is now around 45 million following the consolidation. From a pure supply and demand standpoint, the odds are high that the share price could rise substantially on higher demand for a relatively fewer number of shares. From this perspective, the share consolidation works in favor of the bulls.

Understanding the risks

Investing in HITI is, however, not without its risks. Although the company is EBITDA positive, it is still deep in the red owing to the high capital costs in the legal cannabis sector. Also, like any fledgling industry in the early innings of the hyper-growth phase, retail of recreational cannabis in Canada continues to attract new smaller entrants who compete on price. According to Brightfield Group, reductions in price was a major theme in 2020 that is expected to continue as the price of legal weed gets more competitive compared to illicit weed. Price reductions could affect HITI’s margins and future profitability if it is unable to grow volume sales or create more meaningful experiences for customers to entice them to buy more per trip to the store.

Despite positive adjusted EBITDA, HITI is still deep in the red if you factor in capital costs, data Source: HITI earnings releases

There is also the risk that newly acquired businesses could introduce inefficiencies and lower margins. The projected synergies that are touted when signing a term sheet and the actual results of operations from a newly acquired business can differ materially.

The company also operates in an industry that is undergoing massive consolidation, meaning a larger player could challenge its current dominance through a series of acquisitions. The company therefore needs massive amounts of capital to continue expanding at the current pace, including for potential acquisitions in future. This introduces the risk of shareholder dilution, something weed companies are notorious for (some weed companies sell more common stock than actual products).

What we’re watching out for in HITI’s upcoming earnings

In view of these risks, and the fact that HITI will be announcing earnings for the quarter ended April 30 on June 28 (a week from now), we will be watching out for the following factors, which we believe are integral to the business’s continued growth and the stock’s continued outperformance relative to peers and the sector.

• Focus on quality growth

HITI must continue driving quality growth, particularly after the Meta Growth acquisition. Quality growth to us does not end at strong year-on-year revenue growth or positive EBITDA, important as these are. Trends in same-store sales are a more reliable indicator of how effectively a retailer is utilizing its stores so we will be looking out for this in the earnings call. The company had 21 cannabis stores in the quarter ended January 31, 2021, that had been operational for at least a year. For these 21, same-store sales increased 14% from the prior quarter.

Continued downward pressure on cannabis prices in Canada also means HITI will need to create more stickiness between itself and its users to extract more sales per customer interaction. A good indicator for investors to watch will be the growth of the Cabana Club loyalty plan, which offers members instant discounts at checkout, and promotions direct to their phone.

Over 50% of store revenue comes from club members. Loyalty clubs are important in driving repeat sales, which can help a retailer grow in an environment of declining prices and slimming margins. Brands such as Nike (NYSE:NKE), Amazon (NASDAQ:AMZN) and Starbucks (NASDAQ:SBUX) have grown on the back of loyalty programs, with members spending in some cases double what non-members spend and accounting for significant share of sales in both volume and value.

• Continued strengthening of the balance sheet

As per its latest investor presentation, HITI notes that its cash balance increased from approx. $21 million to $33 million following two recent equity financings. The company also cut debt by more than half from $72 million to $32 million with minimal near-term maturities. CEO Raj Grover in a recent press release also said that: “we feel we are a prime candidate to obtain traditional non-dilutive bank debt, and we are in late-stage discussions with a leading bank on that front.” An update on this will be important for investors during the earnings call as the biggest drawback for HITI and many weed stocks remains shareholder dilution.

• Diversification of revenue

HITI is not only focused on brick-and-mortar stores. It also has online sales channels through which it sells cannabis consumption accessories such as bongs as well as CBD products (CBD is the non-psychedelic compound in cannabis believed to have medicinal qualities). HITI also manufactures and sells consumption accessories on a wholesale basis. Below is a snapshot of its different lines of business.

Despite the seemingly diversified structure, more than 90% of HITI’s revenue still comes from its retail stores in Canada as seen below.

Investors will be keen to see more diversified revenues, particularly revenue from the U.S. where legalization is also on the horizon and the target addressable market is significantly larger than Canada.

Takeaway

HITI remains the best bet in Canada’s recreational cannabis retail sector. It is strengthening its balance sheet and has raised its profile among investors following the Nasdaq uplist. It has also established some dominance in the Canadian cannabis marketplace thanks to its growing store count and visible brand. The company is well-positioned to benefit from the surging demand for recreational adult-use of cannabis.

We are confident that in the coming months the stock will catch higher bids if management continues executing its retail expansion plan at the current pace, diversifies revenues to capitalize on opportunities outside retail and outside Canada, and pays close attention to the quality of growth and the health of the balance sheet. The current valuation grossly discounts the company’s potential, making it a good buy and hold stock with lots of upside potential despite the 270% run over the past year.

Disclosure: I am/we are long HITI, FFLWF, MSOS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.