Green Thumb Industries: Too Good To Be True

Written by: Christian Stoyanov – Seeking Alpha 

Green Thumb Industries (OTCQX:GTBIF) has been one of the more under-covered companies in the cannabis industry. Since April 10th, 2018, the stock has had an extensive move of +94.75% from CAD 11 to CAD 21.50. So is such a big move justified or is the stock overpriced?

GTI resides in a rapidly growing industry. With the company opening new retail locations alongside growing state legalization, GTI is positioning itself to become a leading company in the growing U.S. cannabis market. But is the company’s price today showing its real underlying value? GTI may become a big player in a trendy industry, but bigger competition may be just around the corner. With Altria (NYSE:MO), the parent company of Marlboro and other American tobacco brands investing $1.8 billion in Cronos Group (CRON), a Canadian company that focuses on rare cannabinoids, big Tobacco finally took the first step towards what some fear will be an eventual takeover of the cannabis market.

Company Background And Overview

Green Thumb Industries is a cannabis consumer packaged goods company and retailer. The company manufactures and sells a well-rounded suite of branded cannabis products including flower, concentrates, edibles, and topicals. GTI also owns and operates a rapidly growing national chain of retail cannabis stores called RISE located in six different states. For 2018, the company reported approximately CAD 62 million in annual revenue, employs just over 500 people and was named Best Workplace 2018 by Crain’s Chicago Business. By acquiring For Success Holding Company (creator of the lifestyle suite of Beboe-branded cannabis products) and Advanced Grow Labs LLC, the company has extended its reach and diversified its revenue streams.

 

As of today, GTI has eleven manufacturing facilities and has licenses for 77retail locations across twelve highly regulated U.S. markets.

*Photo taken directly from GTI’s website

Investment Thesis

In the next 2 years, I expect the company to miss investors’ expectations, with costs offsetting increased revenue from store growth. I expect increased revenue growth and decreasing COGS caused mainly by cost synergies from already made and to be expected acquisitions. I also expect high G&A driven by stock-based compensation to continue for the next 2 years, which will offset future revenue increases. In the graph below, you can see how the company’s operating metrics have performed through the last years:

*Source: Company filings and author’s own estimates

The US Cannabis Market

*Photo taken from Businessinsider

As of 1st of March, 33 states in the U.S. legalized cannabis for medical use and 10 states plus DC legalized recreational use. Within those markets, the consumer cannabis industry is booming as companies find opportunity to feed one of the fastest-growing consumer industries in the country. Even without the nationwide legalization, the U.S. cannabis market is massive. According to a June 2018 report by Arcview Market Research and BDS Analytics, the US market could hit $20.9 billion in 2021, becoming the largest cannabis market in the world by a wide margin. The public has also backed up recreational and medical legalization of marijuana, 66 percent of Americans support nationwide cannabis legalization, and such support could further speed-up the legalization process.

 

Growth Factors

One of the biggest regulatory news throughout 2018 was the U.S. Farm Bill. The bill descheduled some cannabis products from the Controlled Substances Act or in other words this move effectively legalizes non-psychoactive medical cannabis products derived from hemp nationwide.

Another major regulatory factor is the ongoing legalization and regulation of the recreational use of marijuana in the U.S. According to Cowen Research Group, four states in particular look to have ample runway to legalize cannabisas they now have a Democratic Governor and support from either the state’s House and/or Senate, with the biggest one being New York. The state of New York in particular represents a massive market with huge potential and opportunity for cannabis companies.

The other highly debated bill is the bipartisan bill. The idea of this bill is to shield people complying with state marijuana laws from federal intervention, effectively leaving it up to states to decide their own marijuana laws and regulations. President Trump has recently supported the bill saying “I support Senator Gardner,… I know exactly what he’s doing. We’re looking at it.” Right now, 47 states have laws permitting some form of marijuana or marijuana-based products, according to the sponsors, but marijuana remains illegal under federal law.

Forecast And Concerns

Neal Gilmer, research analyst with Haywood Securities, wrote a note projecting that the US cannabis market could be worth between US$15.9 and US$21.7 billion by 2022. The analyst highlighted the most direct approach investors have for gaining exposure to this market: multi-state operators. These companies own and operate assets in legal states, but due to the fractured nature of the market, they have to manage operations separately.

With all the good news surrounding this market, there are some concerns to watch out for. One of the biggest causes for concerns is overvaluation. With the pro-cannabis movement gaining traction, Canada completely legalizing marijuana and the U.S. going on the same path, marijuana stocks are on fire. But some professionals are skeptical, Canopy Growth (OTC:CGC) CEO Bruce Linton said, “It’s entirely true that cannabis has become frothy and I’m not saying that necessarily specifically about our [stock]. But you could list 85 or 90 names that are probably publicly listed that I as the operator of one of the first and most dominant [companies] have never heard of those companies”

 

Other experts are worrying that investors haven’t factored in that, not all illegal operations have shifted to legal and that the illegal part of the business still competes with the legal one The managing director at Brightfield Group had this to say “Another full third of consumers who are not purchasing through the retail market yet have cited pricing as one of their key concerns… that pricing differential between the recreational market and the black market… the market is really missing those mid to lower income cannabis consumers which are a significant portion of that population.”

Another sceptic Jon Najarian, the co-founder of Investitute, voiced his concerns September last year, “This is just stupid. I can’t believe the valuations at this stage.”

Recent Quarter Results

*Photo from company’s Q4 presentation

GTI recorded Q4 18 revenue of CAD 21,197 million, representing a yearly decline of 237%. Operating income was CAD (-15.6) million, representing a year-to-year decline of 632% and quarterly decline of 191%. Net loss for Q4 18 was CAD 3.1 million, representing a yearly decline of 7% and quarterly decline of 5%.

The decrease in operating profits for Q4 were mainly driven by CAD 12.6 million of stock-based compensation for the fourth quarter and an increase in headcount to support the Company’s growing consumer products and retail businesses.

The increase in the net income numbers in the Q4 report, was mainly due to the increase of CAD 8.1 million in the “other income” section, driven by an increase in asset value in strategic investments. Gross profit margins have also increased recently, as you can see in the chart below.

With all the new acquisitions, we can see the company stabilizing its gross profit margins and growing its revenue, but also sharply increasing their G&A, thus offsetting EBIT growth.

 

Source: Company filings and author’s own estimates

Acquisitions And Expansions

At the end of 2018, GTI has made two acquisitions in order to increase its market share:

Beboe

*Photo taken from 360.Advertisingweek

Beboe is known for its thoughtful design aesthetics from product to packaging. There are more than 125 California and Colorado retail locations, with available home delivery. Beboe has already forged partnerships with Dirty LemonGoop, and Daniela Villegas. Via distribution in select GTI markets, Beboe products will be able to expand beyond California and Colorado. GTI founder and CEO Ben Kovler said, “We believe authentic brands distributed at scale is the key to winning in this industry and we’ve built the national infrastr­ucture to produce and distribute high-quality products across the country.”

With such an innovative pipeline, Beboe’s acquisition will expand GTI’s customer reach and diversify its revenue streams.

Advanced Grow Labs

*Photo taken from Advanced Grow Labs

On January 7th 2019, GTI signed a definitive agreement to acquire Advanced Grow Labs LLC (AGL) and enter the Connecticut market. By acquiring AGL, the company now operates one of only four cultivation and processing facilities in Connecticut with a 41,000 square foot facility in West Haven. Such an acquisition will greatly support the company’s revenue growth by tapping in a new market, meeting the state’s growing demand.

 

In addition, AGL has a 46 percent ownership of a recently-awarded dispensary that will be located in Westport which makes it the only vertically licensed company in the state. AGL produces and distributes a wide range of cannabis products to every operating store in the state. The Connecticut medical marijuana program currently has 33,788 patients and 1,093 registered physicians. Right now, there are 9 medical marijuana dispensary facilities in the state, none of which are RISE locations.

The transaction is valued at approximately $80 million which includes $15 million to be paid in cash and 7.0 million Subordinate Voting Shares of GTI. The purchase agreement also includes additional consideration based on performance targets and up to an additional 1 million Subordinate Voting Shares of GTI subject to pricing conditions prior to closing.

Retail

* Photo taken from Cannabis Business Times

GTI’s direct to consumer operations are conducted through their RISE dispensary network. In just six months following their RTO in June and in the beginning of 2019, the company has expanded the infrastructure of their consumer products and retail businesses to now include 13 production facilities and the ability to open 88 retail locations across 12 states including pending acquisitions. The total consolidated retail revenue included contributions from 14 open stores, driven by seven new store openings during the year: two in Maryland, four in Pennsylvania, and one in Massachusetts. With more than five new store openings being planned for the second quarter of 2019 across Ohio, Pennsylvania and Florida, the company is positioning itself well to serve a rapidly growing market. GTI plans to open 15-20 new stores in 2019.

 

Company Information

Income Statement Breakdown

As we can see from the income statement below, revenue has grown steadily through the years with a CAGR of 7.6%. In 2018, we see a definitive increase in revenue growth, driven mainly by store expansions.

Source: Company filings and author’s own estimates

COGS

As we can see for the last three years, COGS as a % of Rev. has declined, this is mainly boosted by operation optimization and the cost synergies from acquisitions. For the future, with better business practices and tech investments, the numbers should improve.

G&A, S&M And D&A

G&A has grown rapidly in the last year. This was driven by new retail headcount to support new store growth and non-cash expenses related to stock-based compensation of $16.2 million for the year. In the next 5 years, I expect G&A as a % of revenue to decrease with synergies between stores increasing and operations stabilizing. This will be offset by the increase in S&M which I expect to more than double in the coming years with more store openings and more competition entering the market.

I expect D&A as a % of revenue to increase in the coming years in numbers closer to GTI’s peers. For comparisons, I have used the numbers of Medmen Enterprises (OTCQB:MMNFF) 11.6% and Hexo (NYSEMKT:HEXO) 15.6%.

Gross Profit Margin

We can see gross profit margins increasing steadily through the years. This is supported by additional operating scale which I expect to continue for the next 5 years.

Catalysts

Catalysts in the next 12-24 months for the price to increase include:

State Legalization

Several U.S. states are right now pushing hard for legalization and have recently been in the news.

Wisconsin is debating legalizing cannabis, but hurdles remain. The big movement for legalizing cannabis in Wisconsin started in 2002 when a longtime medical marijuana advocate, suffering from glaucoma, named Gary Storck has been pushing the state Legislature to legalize his medicine. But until now, Wisconsin’s laws on marijuana have stayed largely the same — and federal law continues to ban use and sales, but bordering states (Illinois, Michigan and Minnesota) have all legalized marijuana. Now Democratic Gov. Tony Evers has announced proposals to fully legalize marijuana in Wisconsinand would support a statewide referendum on the issue.

 

On the 3rd of April 2019 Illinois also OK-ed a pot legalization bill. There are no details filed yet, but the State Senate Executive Committee did vote on the measure on Wednesday. State Sen. Heather Steans said, “Hopefully we’re going to file it by the end of April and we’re going to have plenty of time to hear it and debate it.” According to governor J.B. Pritzker’s proposed fiscal year 2020 budget contains $170 million in projected revenue from legalization. His office said that the projection is based entirely on licensing fees. If those revenue projections are to be realized, fees for cultivation centers and dispensaries would have to be exponentially larger than those in the medicinal program.

As this trend continues some experts predict that by 2021-23 the entire United States will legalize marijuana. This is great news for GTI since the company is growing along with legalization procedures. This could mean that in the next 4 years, we could see rapid growth in revenue and CAPEX.

Federal Law

The Federal law still prohibits the use of marijuana, but it seems that’s about to change soon. With prо-marijuana bills introduced to Congress being largely symbolic, it seems that’s about to change soon. The most recent evidence of this was the third proposed marijuana bill numbered H.R. 420. The new bill filed in the House on Wednesday by Rep. Earl Blumenauer (D-OR) is titled the Regulate Marijuana Like Alcohol Act. If the bill passes, it would remove cannabis from the federal Controlled Substances Act. The proposal basically represents a wholesale reimagining of how marijuana is treated nationwide. It would put marijuana under the Bureau of Alcohol, Tobacco, Firearms and Explosives, and not the Drug Enforcement Agency. It would also allow marijuana businesses to access the banking system and allow research on the plant to go forward without any constraints currently imposed on cannabis by the federal prohibition that currently views marijuana as the same as heroin.

Even if I doubt that this bill will pass, it again shows the determination from the cannabis community and how marijuana is viewed as something different from people and the Congress alike. Sen. Cory Booker said, “We are going to win this. It’s not a matter of if, it’s a matter of when.”

 

Risks

Black Market

Can the legal market actually compete against the black market? With cannabis still not legal on the federal level in the U.S. and only a few states legalizing its medical use and fewer its recreational use, the black market is still a monopoly. Even in some U.S. states where marijuana is legal, the illegal market remains a tenacious competitor. In California, for example, the underground market can be divided into two broad categories: the illegal or “black” market (everyone growing and manufacturing products for export out of state) and the “gray-market” (companies that continue to operate in California even though they don’t have the required licenses) California’s gray market presents a really big problem.

Since these companies do not adhere to any regulations, they undersell everyone by up to 50% according to Bryce Berryessa, the president of the licensed California cannabis company La Vida Verde. With gray-market companies operating in plain sight, customers can easily get confused whether a store is legal or not. According to a December article in the Coloradoan,since Colorado legalized recreational use in 2014, the illegal black market became a larger problem.

With undercutting prices, the black market could present a growing concern for GTI and the company could stand to lose millions.

Big Competition

According to cannabis industry experts, it’s very likely that the country’s largest tobacco companies will get into the marijuana business and considering the big cash flow they have it’s very possible that these companies get a huge head start in the race. As mentioned above, Altria Group already made its leap into the marijuana industry, investing $1.8 billion into Ontario cannabis producer Cronos, with whom they’re exclusively partnering for international distribution and development of new products and projects. The major part of this investment is going to be allocated in things like genetics, technical assistance, taking back the product and ultimately processing it, formulating it, branding it and distributing it.

 

In August, Constellation Brands (NYSE:STZ), which owns Corona and other beers, paid $4 billion for a major stake in Canopy Growth, another Canadian marijuana company. This actually raises Corona’s stake in the Canadian cannabis producer to 38% from 9%. As beer sales fall such acquisitions are expected to build momentum for alcohol companies.

Again, in August 2018, Molson Coors Canada (NYSE:TAP) and HEXO announced a joint venture agreement Focused on Non-Alcoholic, Cannabis-Infused Beverages for the Canadian Market. Molson Coors Canada will have a 57.5% controlling interest in the JV, with HEXO having the remaining ownership interest. The new company will combine the proven beverage experience of Canada’s leading brewer with a recognized innovator in the fast-growing cannabis sector to explore the highly anticipated consumable cannabis market, which is expected to be legally permissible in Canada in 2019.

The arrival of such corporations could cause major disruptions in the market. With billions of dollars in cash on hand poured into product development, marketing and manufacturing, these companies will be looking to create big brands with the market share to match. I expect such occurrences only to increase in the coming years, significantly damaging GTI’s market share.

Overvaluation Concerns

As discussed above and one of my main concerns is overvaluation of the whole cannabis market and have found two companies tremendously overvalued.

Aurora Cannabis (OTC:ACB) is one of these companies. Although Aurora currently produces around 500,000 kg/year and made a recent acquisition of South America ICC labs which could push the company’s production it is heavily diluted. Aurora has been trying to finance itself by diluting shares and by overdoing this they have almost killed shareholder value. Since 2016 the company’s share count has jumped from 129 million to 732 diluted shares outstanding.

According to GMP analyst Martin Landry, Cronos is another overvalued pick and I couldn’t agree more. Since the beginning of 2019 in just a 4-month time frame, Cronos has made a tremendous upside move of 60%. Landry argues this run-up in share price has been on no material news. Altria’s announcement of a $1.8 billion investment in Cronos happened way back in December, and it’s been basically crickets ever since.

 

Here are Landry’s concerns with the stock:

Cronos’s failure to penetrate further into the Canadian recreational market — its home turf. Cronos’s apparent lack of sufficient inventory to supply the Canadian recreational market. Cronos’s need to make more progress deploying capital in the US market — which could be complicated by a lack of opportunities to legally deploy such capital in the U.S. Cronos’s “limited revenues in relation to its sizeable market cap.”

Considering all this information, I would approach an investment in GTI carefully. Although the company shows much promise, careful examination of underlying value should be taken into consideration.

Key Takeaways

In considering all catalysts and risks, I do see big growth in the market, but also many risks accompanying it. With uncertain legislation periods, federal law lagging behind state legislation and big tobacco’s growing interest, we could see GTI continuing to struggle in bringing greater value to its investors.