Supreme Cannabis: Seeing The Profits Of Premium Weed – The Supreme Cannabis Company, Inc. (OTCMKTS:SPRWF)

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Source: Canadian LP Comparison Chart on The Growth Operation. All dollar totals herein are in Canadian dollars.

Supreme Cannabis (OTCQX:SPRWF) cultivates high-end cannabis for the Canadian medical and consumer markets. This cannabis is sold wholesale to other licensed producers and is also sold under the 7ACRES brand to recreational consumers in eight of Canada’s ten provinces (excluding QC and NFLD).

Expansion: Supreme is expanding their 7ACRES cultivation facility located in Kincardine, ON. When the facility is complete, it will be 440,000 sq. ft. and have a cultivation capacity of 50,000 kilograms per year. In May 2019, Health Canada approved five new flowering rooms, bringing licensed capacity up to 33,580 kilograms/year. This facility is expected to be completed in calendar 2019.

Acquisitions: In May, Supreme acquired Blissco in an all-stock transaction valued at approximately $48 million. The company issued 23.4 million shares and received Blissco’s 12,000 sq. ft. CO2 extraction facility in Langley, BC. The deal closed in July.

In July, Supreme acquired Truverra in an all-stock transaction valued at approximately $20 million. Among other assets, Truverra has a 5,000 sq. ft. facility in Scarborough, ON, which will be used to produce cannabis extracts. The deal closed in August.

Supreme Cannabis has partnered with Wiz Khalifa and KKE.

Source: Supreme Cannabis.

Partnerships: Supreme is preparing for the Canadian legalization of Cannabis 2.0 products, including edibles and vapes, in December. In June, the company announced a partnership with PAX Labs wherein 7ACRES products would be one of four licensed producers to sell cannabis pods for the PAX Era vaporizer in Canada.

Supreme also plans to commercialize a line of extracts and oils under the KKE brand, in partnership with hip hop artist Wiz Khalifa, and to introduce oils and topical products under the Blissco brand.

Financial results

Supreme Cannabis revenue rose 90% sequentially and gross margins are higher than their peers.

Source: Author based on company filings.

Revenue and gross margins: Supreme had strong revenue growth in the June quarter and among the best gross margins in the sector.

Revenue grew to $19 million in the quarter, up 90% sequentially. Revenue growth was driven primarily by increased sales while the price of flower ticked up ~1% sequentially. The company does not disclose price per gram, cannabis quantity sold, nor the retail/wholesale/medical split of their cannabis sales.

Gross margins expanded to 59%, up 16 basis points sequentially and up 27 basis points year over year. These gross margins are among the highest in the Canadian cannabis sector, topping Aurora Cannabis‘ (ACB) recent 56% gross margins. Gross margin expansion was driven by economies of scale as output increased at the 7ACRES cultivation facility.

Supreme Cannabis is EBITDA-profitable for the first time.

Source: Author based on company filings.

Profitability and cash flow: Supreme recorded its first adjusted EBITDA profit, just as they forecast in their guidance last month. This profit was driven by strong revenue growth, great gross margins, and only modestly expanded operating costs.

Supreme reported a $3.2 million adjusted EBITDA profit in the June quarter, its first adjusted EBITDA profit. This was the first quarter where Supreme has reported EBITDA. Their adjusted EBITDA excludes share-based compensation but does not exclude any other one-time costs. Adjusted EBITDA margins were 17% this quarter (or 11% if including share-based compensation), up from -23% last quarter.

Operating cash flow deficit fell to $0.6 million, down from a $3.0 million deficit last quarter. This operating cash flow deficit is partly due to inventory swelling to $19 million, up from $7.1 million last quarter as cannabis production grows.

Free cash flow fell to a $21.6 million deficit, slightly higher than last quarter on increased capital expenditures. The company spent $14.9 million on its 7ACRES site this quarter and $76.9 million for the year. This site is expected to be completed this calendar year, which will reduce the company’s capital expenditures and potentially lead to positive free cash flow.

Balance sheet

Supreme Cannabis shares have fallen from their all-time highs.

Source: TMX Money.

Cash: Supreme ended the quarter with $55 million in cash and carried $79 million in convertible debt on their balance sheet. The company had $20 million less cash than in March 2019, due primarily to their 7ACRES expansion project discussed above.

The company has $100 million in convertible debt arising from an October 2018 offering. This debt carries a 6% interest rate, paid semi-annually, and matures in October 2021. The debt converts to shares at a price of C$2.45/share.

After the quarter ended, Supreme completed the acquisitions of both Blissco and Truverra. Both acquisitions were made using shares rather than cash.

Given Supreme’s free cash flow, their capital may be enough to last them until the end of the year, when they will complete their 7ACRES facility. However, that may leave the company low on cash, so it is probable they will opportunistically raise capital under favorable market conditions when possible. The company will seek to use non-dilutive financing through debt with tier one banks and lenders, although its current expansion projects are already fully funded.

Shares: After its summer acquisitions, Supreme has about 353 million shares outstanding plus another 101 million shares through options, warrants, and convertible debt. The company trades at a market cap and an enterprise value of approximately $550 million, including the value of this dilution and the convertible debt.

Looking Forward

Supreme Cannabis is guiding towards $150 and $180 million in revenue in fiscal 2020.

Source: Estimates based on analysts, guidance, and company filings.

Guidance: Supreme is guiding toward revenue of $150 million to $180 million in their next fiscal year, ending June 30, 2020. The company is also guiding towards positive adjusted EBITDA over the course of the year.

Supreme plans to transition its 7ACRES cannabis brand from a wholesale business to a premium consumer brand by the third quarter of 2020 (Mar/20 quarter), including in-house packaging for flower products.

Analysts: Analysts expect Supreme to hit around the midpoint of its revenue guidance with about $163 million in revenue. Given current EBITDA margins and plausible operating cost increases, the company may generate about $50 million in adjusted EBITDA profits in fiscal 2020. Forward EBITDA estimates may vary substantially from actual results.

On a forward basis, Supreme trades at about 3.5x forward sales and about 11x forward EBITDA. This is significantly cheaper than large-cap Canadian peers like Tilray (TLRY) or Cronos (CRON) but in line with smaller Canadian producers like Aphria (APHA), Hexo (HEXO), and OrganiGram (OGI).

Risks

There are a few potential risks to Supreme Cannabis, past the risk of investing in a very volatile sector.

Lack of transparency: Supreme’s results are the least transparent in the sector, as I’ve noted in my previous coverage of the company. They are the only Canadian producer that does not provide price per gram, sales in kilograms, a breakdown in revenue between retail, wholesale, and medical cannabis, or even host an earnings call. This limits investors’ ability to forecast future results as the Canadian cannabis market continues growing.

Supreme Cannabis expects to see price compression in wholesale sales.

Source: Supreme Cannabis annual report.

Reliance on wholesale sales: It is likely that a significant portion of Supreme’s sales are wholesale sales to other licensed producers. These sales may be more volatile than sales to consumers: Cannabis producers are expanding their cultivation capacity and may be less reliant on purchasing third-party cannabis once their expansions are complete.

Among other deals, the company has deals to supply $12 million of cannabis Tilray before October 1, 2019, and had a deal to supply $6 million of cannabis to Namaste (OTCQB:NXTTF) at $6/gram in 2018. Unless it was extended, the latter deal has been completed and it is unclear how much of this quarter’s sales were under the former deal, potentially at prices agreed to in 2018. This may have contributed to Supreme’s strong gross margins. Supreme’s filings suggest the company also has other wholesale sales which are not contractually obligated.

The prices used by Supreme Cannabis to estimate biological asset value and intangible assets have fallen.

Source: Author based on company filings.

Price erosion: There are some signs Supreme’s prices are eroding. Their revenue per gram rose approximately 1% this quarter, but their filings suggest future prices will be lower:

  • Supreme reduced its estimate of selling prices for premium flower by $0.15/gram to $6.13/gram “to account for greater expected volatility in the wholesale market for the portion that is not contractually obligated.” This was the second consecutive quarter where Supreme lowered this estimated future price. This estimate is used to value Supreme’s biological assets.
  • In another section, Supreme dropped its “average selling price per gram” used to value intangible assets by 15%, from $6.30/gram to $5.35/gram. This estimate is used to value Supreme’s intangible assets.

It is unclear how these prices relate to Supreme’s revenue per gram. However, these amended estimates may suggest management expects future price compression which could hurt margins.

Supreme recently had a large number of in-the-money warrants cashed in. This increases downward pressure on share prices.

Source: Supreme Cannabis annual report.

In-the-money options and warrants: Supreme has a relatively large number of in-the-money stock options and warrants. These financial instruments can potentially limit near-term upside for investors. As of June 30th, there were 24.4 million in-the-money options and warrants outstanding.

Most notably, there were 14.3 million stock warrants which expired on August 30th, 2019, with an exercise price of $0.50/share. It is likely that most of these warrants were converted to shares (13.8 million warrants were converted after the quarterly filings). These new shareholders may be less likely to hold shares long term, potentially increasing liquidity and volatility.

Conclusion

Supreme had a very strong quarter, featuring a significant increase in revenue and the strongest gross margins in the sector. This is their first profitable quarter by EBITDA, and it is likely they will generate positive cash flow in the coming quarters as revenue rises.

Despite strong results, I will stay on the sidelines due primarily to Supreme’s lack of transparency. I suspect the company will continue to perform well and I admire their recent profitability and their guidance of $150 to $180 million of revenue and continued adjusted EBITDA profitability. However, given limited available information about the company, I prefer to invest elsewhere.

Happy investing!

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Disclosure: I am/we are long HEXO, OGI. 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.



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