High Tide: Potentially A Rare Winner In This Space

Survival of the fittest

A prime illustration of how investors can occasionally misjudge opportunities is the cannabis sector. There was an expectation that this industry would yield rewards for patient investors, yet even five years after Canada's legalization, this hasn't materialized. Many also anticipated that a global wave of legalization would similarly benefit patient investors but with the current pace of progress and the realities of the current economic environment, it is doubtful many companies would even be present till that reality plays out.

This is a problem most new industries would face. Investors often assume that a new industry presents an opportunity for wealth. The reality is a lot more humbling. Frequently, we overlook the historical pattern that has been unkind to emerging industries. In their early stages, a multitude of companies sprouted, driven by the initial enthusiasm and the influx of capital into the sector. Nevertheless, as the industry matures, only a mere handful of these enterprises survive.

A notable illustration lies in the American automotive industry, where approximately 2,000 car manufacturers thrived between 1900 and 1920. However, by the 1930s, this number had dramatically dwindled to just a few dozen, and with the passage of time, it continued to decline.

In recent memory, I would say it's the internet boom. Nearly 50% of these companies closed shop post the bubble burst and many failed to recapture the heights they had attained during that period (Cisco (CSCO) would be a famous example)

Circling back to the marijuana industry, how do we invest in this sector when we are already seeing the Darwinian phenomenon play out in real time? I guess we can quote Warren Buffett and say we need to be greedy when others are fearful but where to be greedy?

In a general sense, we can say that the industry conditions do not look favorable now but hope that it will eventually change (Initial seeds were sown in Canada). So the key here is checking if the company has the capability to survive till the good times roll.

Key differentiators

High Tide's (NASDAQ:HITI) business model is characterized by its comprehensive approach to the cannabis industry, encompassing both retail and ancillary product offerings but staying away from growing cannabis. This diversification allows the company to benefit from evolving market dynamics and save itself from the problems currently plaguing pure-play cannabis growers.

Retail Operations: High Tide owns and operates a network of retail cannabis stores under the brand name Canna Cabana across different provinces in Canada (A total of 156 stores)

E-Commerce: High Tide has an online platform that allows customers to purchase cannabis products and accessories conveniently. Owns the two most popular consumption accessory e-commerce platforms in the world.

Brands and Products: Owns NewLeaf a Cannabinoid company that manufactures ground-breaking cannabinoid formulations sold through its websites and brick-and-mortar stores. Also owns Fast CBD and Bless CBD which focuses on CBD products in the US and UK.

Wholesale and Distribution: High Tide engages in the wholesale and distribution of cannabis-related products to other retailers, further expanding its reach within the industry. This aspect of the business involves supplying products to licensed cannabis retailers in Canada and internationally.

It has to be mentioned that we are only talking about established or mature operations at this point. The company is continuously innovating and coming up with new offerings. A good example is Fastendr, a unique and fully automated technology that integrates retail kiosks and smart lockers. As their implementation is completed they plan to license the technology to other retailers.

Most players in the cannabis industry do not have the type of diversification and depth of offerings that High Tide has which has allowed them to leapfrog their peers in the industry.

Relentless Growth and Narrowing Losses

At a time when many cannabis companies are seeing declining revenues and widening losses, High Tide Remains the Highest Revenue Generating Cannabis Company and is the fastest-growing retailer in its primary markets of the US and Canada. The growth up to this point has been aided through a combination of organic growth and acquisitions.

What is best about this growth is the fact the company is not sacrificing its bottom line for this growth (which is uncommon in the cannabis industry). Its gross margins have been between 26 - 28% and it showed a positive operating margin for the first time in many quarters.

Another rare win for the company is its positive operating cash flows. Even after accounting for SBC, the company's cash flow has remained positive for the last twelve months and has been able to maintain an uptrend in the past several years, which suggests less reliance on macro and industry conditions.

There are many factors that are occurring in their underlying business that have helped propel the company to this stage.

1. Cost-saving measures implemented by the Company resulted in a decrease in general and administrative expenses as a percentage of revenue. Salaries, wages, and benefits as a percent of revenue also went down from last year because of increasing operational efficiencies partly attributed to the implementation of Fastendr technology in their stores.

2. The company's loyalty membership program is seeing increased success and has seen an increase of 39% in members since the last quarter

3. Canna Cabana same-store sales have more than doubled since the end of FY 2021. The average Canna Cabana store nationally was on a $2.8M annual revenue run rate in June vs. $1.2M for peers outside Quebec. This has enabled them to increase their market share which is at 9.5% currently

Survivability

As I mentioned in my thesis, the macro and industry will turn around when it turns around but the key is survivability. Their operating metrics so far have proved that their unique approach to this industry is a well-oiled machine so the next step is to how well they are maintaining their balance sheet which would enable them to go after more candidates that would be accretive to their growth.

1. Even with its current unprofitability they have sufficient cash runway for more than 3 years if it maintains its current positive free cash flow level

2. Its debt is well covered by its liquidity and its long-term debt has been steadily coming down in the last several quarters

3. Its debt-to-equity ratio is quite low at 0.24

All their balance sheet metrics indicate that the company is healthy and there are no concerns about its survivability.

Highly undervalued considering the potential

If the winner-takes-all effect holds in this industry (highly likely based on how capital-intensive this business is) and if we say High Tide is the leader based on their performance so far, I would say the market is undervaluing the potential provided by this company. On an EV/Sales metric, the company trades at 0.44x, and on a Price to Sales metric at 0.33x. I have identified some comparables in the industry based on just a retailing perspective and also other bigger players in the industry not just focused on downstream.

From the above table, it is clear that none of the companies come close to High Tide in terms of valuation and therefore the company takes the crown here. It also has to be mentioned that none of the companies are profitable and these metrics are the only fair way to compare all of them.

How low can it go?

With its rapid revenue growth, how low can the valuation metrics go? The company mentioned in its earnings release that it has already hit its revenue run rate target for the year. With its history of high revenue growth rates, I would say it would be easier to evaluate its forward metrics under a range of scenarios.

Comparable LTM revenues have grown 50% and it would be difficult to have the same level of growth going forward. So the range of values for Price to Sales would vary from 0.22x to 0.33x(assuming no growth in revenues). Similarly, EV/Sales would fall to 0.3x in the best-case scenario where the growth maintains at 50% for the next year and would stay at 0.43x provided no growth in sales. This means any growth in sales would continue to make the company more attractive.

Key Risk from Bigger Players

One risk that would threaten this company would be bigger players finding success with their cannabis investment. Most big players know that their time in the tobacco industry, however lucrative, could be quite limited going forward. As such, they have been making increasing investments in cannabis-related companies. I believe the U.S. legalization is the spark these companies are waiting for to make headline-defining moves. The proposed changes could be a double-edged sword. On one hand, it could provide the industry with much-needed tailwinds and end up greatly benefiting some of the incumbents. On the other hand, it would welcome the deep-pocket tobacco players who may or may not partner with the incumbents. Should a deep-pocket tobacco player end up competing directly against High Tide it would definitely threaten the wonderful moat that they have been working on so far.

Wrapping up

There are many names in the industry and we have been able to demonstrate that High Tide has been managed wonderfully despite all the challenges facing the industry. From a fundamentals perspective alone this stock looks undervalued and looking at its growth strategy the upside looks quite high. Currently, its market cap is at $121M in a multi-billion dollar industry that is highly fragmented and expected to reach more than $100B in revenues by 2030. If the winner-takes-all effect holds true, this company has a lot more room to grow. I rate this company as a Strong Buy.

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