Reminiscences of a Stockblogger

Oct 17

Week 279: Cautious on trade(s)

Portfolio Performance

Thoughts and Review

I haven’t written a post since my last portfolio update. Up until this last week I did not add a new stock to my portfolio. I have sold some stocks though. Quite a few stocks really.

I have been cautious all year and this has been painful to my portfolio. While the market has risen my portfolio has lagged. I have lagged even more in my actual portfolio, where I have had index shorts on to hedge my position and those have done miserably until the last couple of weeks. In fact these last couple of weeks are the first in some time where I actually did better than the market.

My concerns this year have been about two headwinds. Quantitative tightening and trade.

Maybe its being a Canadian that has made me particularly nervous about the consequences of Trump’s protectionism. With NAFTA resolved I don’t have to worry as much about the local consequences. But I still worry about how the broad protectionist agenda will evolve.

I continue to think that the trade war between the United States and China will not resolve itself without more pain. The US leadership does not strike me as one open to compromise. Consider the following observations:

Peter Navarro has written 3 books about China. One is called “Death by China”, another is called “Crouching Tiger: What China’s Militarism Means for the World” and the third is called “The Coming China Wars”.

In the Amazon description of Death by China it says: “China’s emboldened military is racing towards head-on confrontation with the U.S”. In the later book, Crouching Tiger, the description says “the book stresses the importance of maintaining US military strength and preparedness and strengthening alliances, while warning against a complacent optimism that relies on economic engagement, negotiations, and nuclear deterrence to ensure peace.”. The Coming China Wars, his earliest book (written in 2008), notes “China’s dramatic military expansion and the rising threat of a “hot war”.

Here’s another example. Mike Pence spoke about China relations last week at the Hudson Institute. Listening to the speech, it appeared to me to be much more about military advances and the military threat that China poses than about trade. The trade issues are discussed in the context of how they have led to China’s rise, with particular emphasis on their military expansion.

John Bolton’s comments on China are always among the most hawkish. Most recently he spoke about China on a radio talk show. Trade was part of what he said, but he focused as much if not more on the Chinese behavior in the South China Sea and how the time is now to stand up to them along those borders.

Honestly when I listen to the rhetoric I have to wonder: Are we sure this is actually about trade?

Is it any coincidence that what the US is asking for is somewhat vague? Reduce the trade deficit. Open up Chinese markets. Less forced technology transfer (ie. theft). Now currency devaluation is part of the discussion.

I hope that this is just a ramp up in rhetoric like what we saw with Canada and Mexico. That the US is trying to assert a negotiating position before going to the table and reaching some sort of benign arrangement. But I’m not convinced that’s all that is going on.

If this has more to do with pushing China to the brink, then that’s not going to be good for stocks.

I can’t see China backing down.

From what I’ve read China can’t possibly reduce the trade deficit by $200 billion as the US wants without creating a major disruption in their economy. Never mind the credibility they would lose in the face of their own population.

Meanwhile quantitative tightening continues, which is a whole other subject that gives me even more pause for concern, especially among the tiny little liquidity driven micro-caps that I like to invest in.

I hope this all ends well. But I just don’t like how this feels to me. I don’t want to own too many stocks right now. And I’m not just saying that because of last week. I have been positioned conservatively for months. It’s hurt my performance. But I don’t feel comfortable changing tact here.

Here’s what I sold, a few comments on what I’ve held, and a mention of the two stocks I bought.

What I sold

I don’t know if I would have sold RumbleOn if I hadn’t been so concerned about the market. I still think that in the medium term the stock does well. But it was $10+, having already shown the propensity to dip dramatically and suddenly (it had fallen from $10 to $8 in September once already), and having noted that Carvana had already rolled over in early September, I decided to bail at least for the time being. Finally there was site inventory turnover, which if you watch daily appeared to have slowed since mid-September. Add all those things up and it just didn’t feel like something I wanted to hold through earnings.

I was late selling Precision Therapeutics because I was on vacation and didn’t actually read the 10-Q until mid-September. That cost me about 20% on the stock. I wrote a little about this in the comment section but here is what has happened in my opinion. On August 14th the company filed its 10-Q. In the 10-Q on page 14 it appears to me to say that note conversion of the Helomics debt will result in 23.7 million shares of Precision stock being issued. This is pretty different than the June 28th press release, where it said that the $7.6 million in Helomics promissory notes would be exchanged with $1 shares. Coincidentally (or not) the stock began to sell off since pretty much that day.

Now I don’t know if I’m just not reading the 10-Q right. Maybe I don’t understand the language. But this spooked me. It didn’t help that I emailed both IR and Carl Schwartz directly and never heard back. So I decided that A. I don’t know what is going here, B. the terms seemed to have changed and C. it’s not for the better. So I’m out.

I decided to sell R1 RCM after digging back into the financial model. I came to the conclusion that this is just not a stock I want to hold through a market downturn. You have to remember there is a lot of convertible stock because of the deal they made with Ascension. After you account for the conversion of the convertible debt and all the warrants outstanding there are about 250 million shares outstanding. At $9.30, where I sold it, that means the EV is about $2.33 billion. When I ran the numbers on their 2020 forecast, assuming $1.25 billion of revenue, 25% gross margins, $100 million SG&A, which is all pretty optimistic, I see EBITDA of $270 million. Their own forecast was $225 – $250 million of EBITDA. That means the stock trades at about 9x EV/EBITDA. That’s not super expensive, but its also not the cheapie it was when I liked the stock at $3 or $4. I have always had some reservations about whether they can actually realize the numbers they are projecting – after all this is a business where they first have to win the business from the hospitals (which they have been very successful at over the last year or so) but then they have to actually turn around the expenses and revenue management at the hospital well enough to be able to make money on it. They weren’t completely-successful at doing that in their prior incarnation. Anyways, I didn’t like the risk, especially in this market so I sold. Note that this is an example of me forgetting to sell a stock in my online tracking portfolio so it still shows that I am holding it in the position list below. I dumped it this week (unfortunately at a lower price!).

I already talked a bit about my struggle and then sale of Aehr Test Systems in the comment section. I didn’t want to be long the stock going into the fourth quarter report. Aehr is pretty transparent. They press release all their big deals. That they hadn’t announced much from July to September and that made it reasonably likely that the quarter would be bad. It was and the stock felll. Now it’s come back. It was actually kind of tempting under $2 but buying semi-equipment in this market makes me a bit nervous so I didn’t bite. Take a look at Ichor and how awful this stock has been. Aehr is a bit different because they are new technology that really isn’t entrenched enough to be in the cycle yet. Nevertheless if they don’t see some orders its not the kind of market that will give them the benefit of the doubt.

BlueLinx. I don’t have a lot to say here. I’m not really sure what I was thinking when I bought this stock in the first place. Owning a building product distributor when it looks like the housing market is rolling over was not one of my finer moments. I sold in late August, then decided to buy it in late September for “an oversold bounce”. Famous last words and I lost a few dollars more. I’m out again, this time for good.

When I bought Overstock back in July I knew I was going to A. keep the position very small and B. have it on a very short leash. I stuck with it when it broke $30 but when it got down to $28 I wasn’t going to hang around. Look, the thing here is that who really knows? Maybe its on the verge of something great? Maybe its a big hoax? Who knows? More than anything else what I liked when I bought it was that it was on the lower end of what was being priced in and the investment from GSR showed some confidence. But with nothing really tangible since then it’s hard to argue with crappy price action in a market that I thought was going to get crappier. So I took my loss and sold.

Thus ends my long and tumultuous relationship with Radcom. I had sold some Radcom in mid-August before my last update primarily because I didn’t like that the stock could never seem to move up and also because I was worried about the second quarter comments and what would happen to the AT&T contract in 2019. I kept the rest but I wish I would have sold it all. In retrospect the stocks behavior was the biggest warning sign. The fact that it couldn’t rise while all cloud/SAAS/networking stocks were having a great time of it was the canary in the coal mine. As soon as the company announced that they were seeing order deferral I sold the rest. I was really quite lucky that for some reason the stock actually went back up above $13 after the news (having fallen some $4-$5 the day before mind you), which let me get out with a somewhat smaller loss. The lesson here is that network equipment providers to telcos are crummy stocks to own.

Finally, I sold Smith Micro. This is a second example where I actually didn’t sell this in the online portfolio until Monday because I didn’t realize I had forgotten to sell it until I put together the portfolio update. But it’s gone now. I wrote a little about this one in the comment section as well. The thing that has nagged me is that the second quarter results weren’t really driven by the Safe & Found app. It was the other products that drove things. That worries me. Again if it wasn’t such a crappy market I’d be more inclined to hold this into earnings and see what they have to say. They could blow everyone away. The stock has actually held up pretty well, which might be saying that. Anyways I’ll wait till the quarter and if it looks super rosy I’ll consider getting back in even if it is at a higher price.

What I held

So I wrote this update Monday and Vicor was supposed to report Thursday. Vicor surprised me (and the market I think) by reporting last night. I’m not going to re-write this, so consider these comments in light of the earnings release.

One stock I want to talk about here is Vicor, which I actually added to in the last few weeks. Vicor has just been terrible since late August. The stock is down 40%. I had a lot of gains wiped out. Nevertheless this is one I’m holding onto.

I listened to the second quarter conference call a couple of more times. It was really quite bullish. In this note from Stifel they mention that Intel Xeon processor shipments were up significantly in the first 4 weeks of the third quarter compared to the second quarter. They also mention automotive, AI, cloud data centers and edge computing as secular trends that are babies being thrown out with the bath. These are the areas where Vicor is growing right now (Vicor described their core areas on the last call as being: “AI applications including cloud computing, autonomous driving, 5G mobility, and robots”).

Vicor just started shipping their MCM solutions for power on package applications with high ampere GPUs in the second quarter. They had record volume for some of their 48V to point of load products that go to 48V data center build outs and a broader acceptance by data center players to embrace a 48V data center. There’s an emerging area of AC-DC conversion from an AC source to a 48V bus. John Dillon, who is a bit of a guru on Vicor, wrote a SeekingAlpha piece on them today.

I know the stock isn’t particularly cheap on backward looking measures. But its not that expensive if the recent growth can be extrapolated. I’m on the mind it can. Vicor reports on Thursday. So I’ll know soon enough.

The second stock I added to was Liqtech. I’ve done a lot of work on the IMO 2020 regulation change and I think Liqtech is extremely well positioned for it. When the company announced that they had secured a framework agreement with another large scrubber manufacturers and the stock subsequently sold off to the $1.50s, I added to my position.

I’m confident that the new agreement they signed was with Wartsila. Apart from Wartsila being the largest scrubber manufacturer, what makes this agreement particularly bullish is that Wartsila makes its own centrifuges. Centrifuges are the competition to Liqtech’s silicon carbide filter. If Wartsila is willing to hitch their wagon to Liqtech, it tells me that CEO Sune Matheson is not just tooting his horn when he says that Liqtech has the superior product. I’ve already gone through the numbers of what the potential is for Liqtech in this post. The deal with Wartsila only makes it more likely that they hit or even exceed these expectations.

Last Thought

I took tiny positions in three stocks. One is a small electric motor and compressor manufacturer called UQM Technologies. The second is a shipping company called Grindrod (there is a SeekingAlpha article on them here). The third is Advantage Oil and Gas. All of these positions are extremely small (<1%). If I decide to stick with any of them I will write more details later.

Portfolio Composition

Click here for the last seven weeks of trades.

Sep 1

20 Comments

Week 372: Stealth Correction (also updates on Mission Ready, Blue Ridge and Empire Industries)

Portfolio Performance

Thoughts and Review

First off, the portfolio updates in this post are as of August 24th. I’m a little slow getting this out. So the numbers don’t include what has happened in this last week.

I really got it handed to me in August. The portfolio was cruising to new highs in July but those were short lived. Top to bottom I saw a 6% pullback in a little over a month before finally bouncing a couple weeks ago. Fortunately that bounce has continued this last week so things aren’t as dire any more.

What was funny about the move is that it didn’t feel like things were going that badly. Usually when I lose 5-6% in a month (this seems to be an annual occurrence for me) I’m tearing my hair out, contemplating throwing the towel in, and generally in a state of disrepair.

Not so this time. I have been surprisingly unconcerned by the move.

Why have I taken it in stride this time? Here are a few reasons I can think of.

1. I lost on stocks that I still have conviction in. Take for example Gran Colombia Gold (which is one of my larger positions). I’m just not that worried about the move, as painful as it has been. I’m still up on my position, and it remains cheap with no operating concerns. I don’t feel like it warrants my worry. RumbleOn was another (another large position), touching back into the $5’s at various points over that time. We know what transpired there this last week.

2. I was getting beat up almost entirely by my Canadian stock positions. Its probably irrational but I don’t worry as much when its my Canadian stocks that are going down.

3. Earnings for most of my positions were pretty good, even if those results weren’t reflected in the stock price. Vicor was great. Gran Colombia was stellar. RumbleOn was fine. R1 RCM was another stand-out, as was Air Canada. No complaints.

Anyways it is what it is. Things have gone better this week. In the rest of the post I want to talk about 3 stocks in particular and these have turned into rather long excursions. So I’ll leave any further portfolio comments for another time.

Mission Ready Solutions

Mission Ready has been halted since July 18th. Nine times out of ten if a stock is on a 6 week halt it wouldn’t be a good thing. Yet I’m pretty sanguine about the company’s prospects. The news so far has been pretty good.

The big news happened on July 31st, when Mission Ready signed an LOI to acquire Unifire Inc. They followed this up with an update on the foreign military agreement on August 2nd. Then there was another news release August 7th that gave more detail on the foreign military agreement and more detail about the acquisition. Finally they followed all of this up with a conference call to investors on August 15th.

Having spent some time reviewing Unifire and the deal, I am of the mind that it is a good one. I am also cautiously optimistic that it will close. On the conference call the CEO of Unifire was in attendance and spoke at it. While that doesn’t mean it’s a done deal, his attendance and all the detail provided by Mission Ready points to it being well along.

Here’s the deal. Mission Ready acquires Unifire for $9 million USD. The purchase price is comprised of $4 million in cash and 26 million shares (priced at 25c CAD. They are also taking on at least $6 million of debt (I say at least because Mission Ready didn’t specifically say what Unifire’s total debt was, only that they would be paying back $6 million USD of debt upon close). With 129 million shares outstanding at $0.25c, $15 million works out to about 50% of the Mission Ready enterprise value.

Unifire is bringing a lot to the table.

As per the first press release Unifire’s “trailing revenue for the 6-month period ending June 30, 2018 was approximately USD$18.3 million”. Their net income was $750,000 USD. That’s a lot more than what Mission Ready has (as per the second quarter financials, Mission Ready is running at about $1 million of revenue a quarter).

More importantly, in the second press release (the one where they expanded on the details) Mission Ready pointed out that Unifire was the following:

A Department of Defense Prime Vendor.
A contract holder for the Defense Logistics Agency (“DLA”) Special Operational Equipment (“SOE”) Tailored Logistic Support (“TLS”) and Fire & Emergency Services Equipment (“FESE”) programs.
held “multiple General Services Administration (“GSA”) schedules, blanket purchase agreements and contracts with organizations such as the Department of Homeland Security, the U.S. Army Corps of Engineers, West Point United States Military Academy, Idaho National Laboratories, Hanford Nuclear Facilities, United States Air Force, United States Marines, United States National Guard, United States Navy, and many others”

I dug into this a little bit further. Turns out that Unifire is actually 1 of only 6 participating vendors from the DLA Troop Support program (from this original Customer Guidelines document issued by the TLS). Here’s a short list of the types of equipment offered by this program:

What does being a vendor of this program mean? It means that if, as a government organization, you want to order one of the 9,000 items covered by the Troop Support Program, you can (I don’t believe the program has mandatory participation but I’m not sure about that) do it through one of these 6 vendors via this program and get subsidized product.

So who would order through the program? According to ADS, “authorized Department of Defense, Federal Government and other approved Federally-funded agency customers”.

The overall amounts of product involved are significant. According to this article:

With both being small-business set-asides, and continuations of prior contracts, the first contract will be used to procure special operations equipment (SOE) worth $1 billion per year, and the second will allow for the purchase of a total $985 million in fire & emergency services equipment (F&ESE).

These are big numbers. So when Mission Ready stated the following in the August 7th news release with respect to Unifire’s justification for entering into the merger, they weren’t kidding:

Unifire has been limited in its ability to secure the initial capital required to facilitate many of the larger solicitations. Mission Ready has identified sources of capital that will enable Unifire to pursue TLS solicitation opportunities on a much larger scale than they have been able to at any point in their 30-year history, thereby creating immediate and significant growth potential.

Unifire has been getting maybe $30-$40 million a year in total revenue. But its sitting in the enviable position of being 1 of 6 companies participating in a $2 billion program. The lost opportunity is significant.

That said, Unifire is a significant vendor for the Department of Defense. Here is Unifire’s revenue from contracts over the past few years (from Govtribe.com). It seems to mesh up fairly well with Mission Ready’s stated revenue numbers for Unifire:

In fact Unifire appears to be the 15th biggest Construction and Equipment vendor with the DOD.

What Mission Ready is apparently bringing to the table is availability of capital. They are going to raise $15 million USD at 25c [note: it was just pointed out to me that the 25c number wasn’t communicated and there was no pricing specified for the PP. I could swear I read or heard that number somewhere but maybe I’m getting this mixed up with the Unifire shares. I’ll have to dig into this]. They are also going to enter into a credit facility of a minimum $20 million USD amount. The idea is that with the capital, Unifire will have a higher “solicitation readiness” and be able to bid on much more than the $2 million per month that they can right now.

Of course the other thing Mission Ready has is a suite of products that will fit nicely with what Unifire offers, and to which Unifire’s manufacturing capacity can be utilized. And they also have this massive $400 million LOI with a foreign military that we continue to wait on.

On that matter of the foreign military distribution agreement, it appears the wait will continue. In the August 2nd press release they explained what we already knew. They had expected to receive orders by now but that this hasn’t happened and while they expect to still receive orders this year, they really don’t know what to expect any more.

They had more comments on the August 7th news release, which was more upbeat, if not cryptic. With respect to the foreign military purchase order they said the following:

The Company is working diligently to finalize the Licensing Agreement in advance of the initial purchase order(s) (“Purchase Order” or “Purchase Orders”) and expect to complete the agreement for consideration by all parties no later than August 24, 2018.

You could read into it that they expect of some sort of purchase order soon that they need to get this new agreement in place for? Maybe? Bueller? But who really knows.

Here’s what I do know. I know that if the LOI for Unifire falls through and no PO comes from the foreign military then this thing is going to be a zero (or at least a “5 center, which is effectively the same thing).

But I also know that if the Unifire deal closes, if Mission Ready closes a $15 million financing and a credit facility of $20 million, if Unifire secures the $100 million of business in the next 18 months that is mentioned as a minimum requirement in the terms of the facility, and if the foreign military PO comes through, this stock is going to have a significantly higher capitalization then the current $25 million (CAD).

Honestly, when I review all the details above, I think the odds are on the latter scenario.

Blue Ridge Mountain

Oh Blue Ridge. This stock has turned out to be a bit of a disaster. I bought it at $9 and then at $7 thinking that it could be worth maybe $15 in a relatively short time as they sold the company at a premium. With the news this week that they are merging with Eclipse Resources that value is likely to be realized over a much longer time period.

I still like the stock and plan to hold my new shares of Eclipse. But I also recognize that this is a broken thesis.

I think what happened here is two-fold. First, part of the value in Blue Ridge was in their stake in Eureka midstream, which seemed like it could be valued at $200 million or more itself. In fact when the company announced the deal to divest their stake in Eureka (back last August), they said that the transaction was valued at between $238 million and $308 million (I’m not going to post the slide that breaks down that value because it has confidential written all over it for some reason).

Well presumably, given that the stock was trading at at $225 million enterprise value before the merger, the market didn’t agree. The problem was that much of the “value” in the Eureka sale was in the form of fee reductions and the removal of minimum volume commitments (which I don’t believe are going to bring any cash in, though I’m still not sure on this). So it was different than receiving tangible cash.

The second thing is something I missed originally. As I wrote about in my original article on Blue Ridge last year, they have a lot of acreage prospective for the Marcellus and Utica. What I didn’t understand well enough at the time was that much of the acreage in Southern Washington county and northern Pleasant county was outside of what is considered to be the “core” of these plays. While the step-outs Blue Ridge has had so far have actually been pretty good, there is a lot more work to be done before the acreage gets the sort of value that acres in Monroe, Wetzel or Marshall county get.

I kinda figured this out earlier this year, but by then the stock was in the $6’s, which seemed to more than reflect my new understanding, and honestly even if I wanted to sell it at that level I couldn’t have given the illiquidity.

Well now with the Eclipse merger there is liquidity. I think what you saw in the subsequent days was a lot of the bond funds that had picked up the stock in bankruptcy and who were now stuck with equity (which could very well be outside of their mandate) selling Eclipse in order to neutralize their Blue Ridge position and effectively get out of the stock.

That this seems to have waned on Friday, in particular given a pretty rough Stifel report on Eclipse, is likely a good sign.

My take is that the combined entity is not expensive. Here is a little table I put together of what the individual parts and the new Eclipse looks like (my $6.64 for Blue Ridge is based on the conversion of Eclipse at $1.50 per share):

If you look at the comps, the combined Eclipse doesn’t stack up too badly. 5x EBITDA for a company anticipated to grow 20% in 2019 is probably a little cheap compared to peers.

Peer comparisons are hard though because there aren’t a lot of smaller, all natural gas, players in the Marcellus/Utica. From what I can see its dominated by big companies like Range, Southwestern and EQT. These companies are 10x the size or more. They generally trade at higher multiples but that isn’t necessarily instructive. The smaller “peers” are more oil weighted and in other basins.

So what do I conclude? I’m going to stick with Blue Ridge/Eclipse because A. it’s not expensive, B. the Blue Ridge management team is leading the combined entity has done a good job operationally with Blue Ridge, C. There is a lot of undeveloped acres between the two companies and if they can prove up even a fraction of them the stock price should reflect that, and D. this is a nice way to play the upside option on natural gas.

But it didn’t turn out the way I expected.

Empire Industries

Empire announced second quarter results on August 27th. It was another “meh” quarter. But patiently I wait.

The reality is that Empire has been a perpetual “just wait till next quarter” story since last September when they announced the co-venture partnerships. They have an incredible backlog of business. Contract backlog as of June 30, 2018 was $280 million. The co-ventures have a tonne of promise. But neither the backlog or the co-ventures have translated into results yet.

They continue to struggle to turn the backlog into profits. In the second quarter gross margins reversed (again) to 16.7% from 19.6% in the first quarter. Remember that the magic number the company has said they should be able to achieve is 25%.

The problem has been the continued work through of three first generation rides that are being built at very little margin. In fact the company said on the conference call that these contracts contributed no margin in the second quarter. I had hoped that by the second quarter we would see the impact of these essentially unprofitable contracts abate. But that wasn’t the case.

I talked with investor relations about this and it appears that in the third quarter we should see less of an impact. But whether this means 22% margins or 18% margins is anyone’s guess.

Management also seem to recognize that their cost structure just isn’t low enough right now. Part of the problem appears to be that they operate much of their manufacturing out of Vancouver. They hinted that there are going to be changes in this regard in the next few months.

One of the key opportunities was how rapidly the growth — the market was growing, but with this growth came an increasingly apparent need to improve our cost competitiveness to capitalize on this growth. As a result, Empire has undertaken an aggressive action plan to reduce its cost structure, as described in detail on previous calls by Hao Wang, President and Chief Operating Officer of Dynamic Attractions, a wholly owned subsidiary and the primary business unit for Empire…The organization-wide cost-reduction initiative is well underway, reducing our headcount and fixed costs. Furthermore, we’ve identified and implemented design, procurement and production efficiencies that can improve our execution capabilities and our financial results.

They went on to say that “margin expansion is a top priority”. This is a good thing because it’s crazy to be letting this backlog pass without making any money from it.

The other piece is expansion. Again they touched on this (“we’re actively looking at innovative ways to increase our production capacity”) in the second quarter call. It’s clear that right now they are capacity constrained. For instance, the backlog has essentially doubled over the last year and a half and yet the quarterly revenue is pretty much the same. Its nice to have a backlog that extends out 3 years but it would be nicer if they could grow revenue a bit.

And then there is the co-ventures. Nothing to announce but still on-track to be announced this year.

Just to recap the co-ventures, last August Empire announced the creation of two co-venture attractions companies. The intent of these companies were to partner with “tourist-based locations” to co-own and operate Flying Theatre rides. One of the companies, called Dynamic Entertainment Group (DEGL), would partner with US locations, while the other, called Dynamic Technology Shanghai (DTHK), would partner in Asia (China most likely).

It was a complicated structure with a rights offering (at 50c) and a private placement to their Shanghai partner Excellence Raise Overseas (EROL) also at 50c.

In total Empire invested $12 million in the ventures. They own 62.5% of DEGL and (I think) 22% of DTHK. The ownership in DTHK is via DEGL, which is makes things complicated. The other 28% of DEGL and 78% of DTHK is owned by their partner EROL. EROL and Empire invested at the same valuation. Got that?

This somewhat ridiculously complicated ownership structure can be summed up with the following graphic (from the September 2017 presentation):

At the end of the day Empire gets to own 63% of a venture that will build and operate attractions in the United States and about 20% of a venture that will do the same in China. Empire also gets to build the attractions that these ventures market. Originally this was going to be at a low margin of 15% but given the recent results that margin is looking to be pretty much right in line <rolls eyes>.

Way back when the venture opportunity was finalized I was able to dig up more information on the economics of the attractions business. First, I found information on the economics of what appears to be a fairly similar existing ride called FlyOver Canada. The attraction is part of Canada place in Vancouver. Flyover Canada is a virtual flight ride experience. Its also owned by a public company named Viad, so unlike every other attraction I read about, there is actually publicly available information about its performance. Here is a quick summary from the 2016 Viad 10-K:

Flyover Canada showcases some of Canada’s most awe-inspiring scenery from coast to coast. The state-of-the-art, multi-sensory experience combines motion seating, spectacular media, and special effects including wind, scents, and mist, to provide a true flying experience for guests. FlyOver Canada is ideally located in downtown Vancouver, Canada. FlyOver Canada is rated by Trip Advisor as the #1 “Fun & Games in Vancouver” and has been awarded with the Trip Advisor Certificate of Excellence.

Flyover Canada is essentially a flying theater, which is the exact same attraction that Empire is looking to co-venture. Empire has built numerous flying theaters in the past and references a number of them on their website’s Flying Theatre description. It doesn’t appear that Empire built Flyover Canada (it was a competitor Brogent) but they did build Flyover Italy, Soaring over California, and Soaring, a Florida attraction.

Viad purchased Flyover Canada from Fort Capital at the end of 2016. According to the Fort Capital press release at the time of the sale, the purchase prices was $69 million Canadian (remember if all goes well Empire and its ~$50 million market capitalization is going to own 63% of one of these in the US and 20% of another in China). Flyover Canada had 600,000 guests and generated $11 million in 2016, so it’s a $20 a pop ride. In their 2016 10-K Viad gave the following 2017 forecast for FlyOver Canada:

FlyOver Canada is expected to contribute incremental revenue of $9 million to $10 million with Adjusted Segment EBITDA of $5 million to $5.5 million.

The numbers are in US dollars. Flyover Canada ended up doing $10 million of revenue in 2017, and though there was no EBITDA breakdown I have to assume it was close to expectations. So it’s margins of 50%+

At the time I talked to IR about the opportunity. The information I got was that depending on the size of the ride, revenue would be around $8-$14 million USD per year depending on the size. Margins on the ride would be around 50%. A smaller ride would cost $10 million to $12 million to build, while a larger attraction would cost $18 million. So these numbers are all pretty much inline with Flyover Canada.

The idea was (and is) that net to Empire’s 60% ownership, and assuming a split with a landowner, they should get somewhere between $3 million to $4 million of recurring EBITDA (CAD) out of the US deal. I didn’t get any information on the Chinese opportunity.

Empire (via Dynamic Entertainment Group) would partner on the attraction with a landowner in a tourist destination. The deal would be structured so that Empire got a preferential return until the cost of the ride is paid off. Empire would make 10-15% margins on the design and construction of the attraction as per their contract with DEGL. There is also a $3 million subsidy for developing creative content in Canada which would reduce the overall manufacturing cost to $7-$9 million.

The expectation was that the EBITDA should get a multiple of 10x. Viad bought FlyOver Canada for about that multiple. Again, if Empire got a 10x multiple on $3 million of EBITDA, that would eat up much of the current capitalization right there.

Overall, it’s always seemed like a decent venture for Empire once it gets off the ground. The company invested $12.1 million via $8 million in equity and $4 million in debt. In return they would eventually get the $2-$4 million of recurring EBITDA from the US venture, add two near-term attractions to their construction backlog (one for the US and one for China), and get some additional EBITDA (I don’t know how much) from the Chinese venture.

Of course like everything else with Empire this is a waiting game. On the call they said “Before the end of the year, we expect to announce our first co-venture location. We expect to have an opening sometime in 2019”. Hopefully we get an announcement soon.

Portfolio Composition

Click here for the last six weeks of trades. Note that this is August 24th, so I’m a week behind here.

Aug 27

33 Comments

Liqtech: Getting a Boost from IMO 2020

I owe this idea to @teamonfuego. He brought it up to me a couple weeks ago. Unfortunately, I was on vacation and I was slow to the punch. As it was I ended up picking up the stock at $1.10 on average.

Liqtech has been your typical little energy technology company. They have an interesting technology but have struggled to sell it into established markets that aren’t all that interested in new ideas.

The consequence is that the stock has spent years bouncing around with no real upward momentum, every year losing money and raising capital.

What they sell

Liqtech sells a suite of silicon carbide filter products. They’ve tried to break into oil and gas, into mining, even into pools and spas. But they’ve only had moderate luck. They have a small but fairly steady business selling diesel particulate filters (around $8 million a year of revenue). Beyond that they sell a few filter systems a year but never enough to break-even on a consistent basis.

From what I can gather, their lack of success is not because of the product. The silicon carbide filter is a better product for many industrial waste/purification applications than what is used right now. But that doesn’t always guarantee a win.

The problem has been getting a foot in the door. This article, from way back in 2014 with CEO Sune Mathiesen, describes the problem that the company has had in the past:

My initial, and most important focus point was to turn the Company around from being a supplier of membranes into a supplier of complete water treatment systems. Since LiqTech started commercializing its membranes in 2009, it has proven very difficult to convince system integrators to invest time and money in developing systems around our membrane technology. The reason is simple, most engineers know how to build a system around sand filters, polymer membranes or other well-known technologies, but they don’t know how to handle our silicon carbide products.

Beginning in 2015 Mathiesen made the transition from selling membranes to selling filter systems. They began to research and invest in building a full filter assembly so they could by-pass the system integrators.

Three years has passed and the stock hasn’t exactly lit the world on fire. But they’ve been slowly built out a product line of filter systems for various applications. And now one of those applications appears about to take off.

IMO 2020

IMO 2020 refers to new regulations from the International Marine Organization that come into effect in 2020. These regulations change the pollutant requirements of bunker fuel, reducing the maximum SO2 concentration in marine fuel exhaust from 3.5% to 0.5%.

About 60-70% of the shipping fleet uses a bunker fuel that has >0.5% SO2. The most common bunker fuel has SO2 of about 2.7%. The ships that use this fuel will have to do something about that by 2020.

The ship owners don’t have many choices. They can either switch to a more expensive low sulphur fuel or install scrubbers that clean out the SO2 from the high-sulphur bunker fuel.

The economics around fuel switching versus scrubbers is in favor of the scrubbers. Here’s a quote from Rudy Kassinger, consultant at Veritas Petroleum Services, from this article:

The cost of installing scrubbers is somewhere between $3 million and $6 million depending on the ship (though I have seen estimates that use a high-end number as much as $10 million). The payback on scrubbers can be 1-3 years. Most of the articles I’ve read peg the number at 2 years, which is not too bad.

So how does this impact Liqtech?

Liqtech filters are installed as part of the scrubber assembly.

Scrubbers can operate in open loop, closed loop or hybrid configurations. When a scrubber operates in an open-loop, sea water is used to remove pollutant from the exhaust stream. The sea water is then discharged back into the ocean.

But in harbors and in some regulated waters seawater discharge is not possible. In these areas a closed loop or hybrid system needs to be used where no polluted water is discharged.

The closed loop requires that the effluent water be filtered for re-use. This is where Liqtech filter systems come in. The silicon carbide filter is ideal for the application (in terms of durability, temperature resistance, corrosion and operating performance).

The opportunity for Liqtech is large. Each scrubber installation needs a filter. Ships require on average 1.6 scrubbers (so some need 1, some need 2). The shipping fleet is about 70,000 vessels. Some percentage of those ships will be retrofitted for filters. As well more new builds will include scrubbers going forward.

According to Goldman Sachs less than 500 ships have scrubbers installed today. Goldman estimates that by 2025 we should expect to see over 5,000 ships equipped with scrubbers. Other estimates are even higher. The IMO put out its own estimate (quoted in this WSJ article) forecasting 4,000 ships with scrubbers by the end of 2020. Liqtech said on their second quarter call that:

Analysts believe that by 2025 roughly 14,000 vessels are roughly 20% of the global fleet with have a scrubber.

Whatever the number, its meaningful to Liqtech. Liqtech sells the marine scrubber filters for about $450,000 a unit. At 1 scrubber per ship, the total addressable market is somewhere between $1.8 billion and $6.3 billion.

Liqtech has 72.7 million shares outstanding and no debt. So even after the latest run, its only a $87 million market capitalization company. The addressable market is truly multiples of the capitalization.

The obvious question is what sort of market share can they capture? Things look pretty good so far.

In March they announced a framework agreement with “one of the world‘s largest manufacturers of marine scrubbers” for “an initial term for 2018 and 2019 and provides that more than 95 systems are estimated to be delivered”
In April they announced a second framework agreement for “a minimum of 35 systems are estimated to be delivered during the initial term” of 2018 and 2019.
Also in April they announced a letter of intent with “one of the world’s largest marine scrubber manufacturers”. This was extended in July. On the second quarter call they said the LOI was for 95+ systems.

On the first quarter call Liqtech said they were working with five or six of the largest scrubber manufacturers. They said on the second quarter call that they are expecting to see orders coming from other sources as well:

we believe that we see a lot of the orders in the future come directly from the shipyard operators. It doesn’t necessarily mean that — or it doesn’t mean that we’ll not see orders coming from scrubber manufacturers, it just means that I have told to several sources for orders in the future.

I’d make a guess that the 95 system framework agreement is with Yara, which is a large scrubber manufacturer. Liqtech has previously disclosed they have been working with Yara. A look at this Yara video shows a filter that looks pretty much the same as what Liqtech shows in their own presentation.

I’m not sure who the other 35 systems or the LOI are with. The list of scrubber manufacturers includes: Alfa Laval, Wartsila, Saacke, Yara, Puyier, DuPont, and Feen Marine. Liqtech has said there are 10 major manufacturers in total.

So what kind of impact is this going to have on the bottom line?

I think its going to be significant. Here are a few points to consider.

The company says their break-even is $16-$18 million of revenue, on the sale of about ~20 filters systems for marine scrubbers
On the second quarter call they said incremental systems sold should expect 70-75% gross margins and they have also said they expect 65% contribution margin from incremental sales
The current expense run rate is $1.25 million per quarter
There are $14 million of NOLs in the US and another $6 million in Denmark

I’m assuming they need to sell about 20 systems in 2019 to hit a break-even point at current run-rates. If the two framework agreements come to fruition they will sell 130 systems, heavily weighted to 2019. Let’s say they sell a total of 80, so 60 that are incremental to the break-even number.

I’m throwing in the 21% tax rate even though they shouldn’t be taxed through most if not all of 2019. Un-taxed EPS is over 23c with these assumptions.

Conclusion

One downside is that sales of filters to the existing marine scrubber fleet is not going to last forever. There are limits on ship-yard capacity which will extend the retrofits out to 2025. But probably some time around then (maybe sooner, maybe later depending on how things play out) the installs will taper off.

There will be continued sales from new-builds after 2025. There are 70,000 ships globally. It seems like for most markets (containerships, dry bulkers, tankers) at least 3% of the fleet is added every year. So that’s ~2,000 ships a year. On the first quarter call Liqtech said they expect to see a further uptick on the 30-40% of new-builds that are currently being built equipped with scrubbers. So the opportunity is not insignificant.

Also, by the time the retrofit opportunity is exhausted, and assuming everything plays out positively, Liqtech will have an install base numbering into the 100’s of ships.

I would expect it will be a lot easier to hock their product to big oil producers, power producers, miners, and municipal water suppliers with a resume that includes a major vertical that has accepted their filters in an extreme environment.

But that’s a long way off. For now, its enough to say that the stock is cheap if they can secure the expected number of deals from the existing framework agreements and have those agreements project forward, and it is very cheap if they can capture even more market share from other scrubber manufacturers and shipyards.

A second risk is that they start to see price pressure. They are the only provider of a silicon carbide filter but there is competition by way of centrifugal filters. Liqtech has said before they are the cheaper and better option. But as the higher volumes are borne out you have to expect competition. The margins I’m showing in the table above are admittedly very high, and unlikely to be sustainable in the long run.

A third risk is that IMO 2020 gets delayed. From everything I’ve read I don’t see this happening. But you never know.

The bigger upside is that they capture a larger share of the market. I’m assuming about 80 filters a year. The opportunity size is significantly larger (as much as 14,000 installs according to Liqtech) next 5 years.

The other upside is that I have to think it will be easier to sell into other verticals once they can come to these customers with a portfolio of installs throughout the marine scrubber industry.

Anyways, it seems like a pretty tiny capitalization for such a big opportunity. Worth a portfolio spot in my opinion.

Aug 22

21 Comments

Buying into US Cannabis legalization with C21 Investments

I missed out on the rise of Canadian cannabis stocks. It was my own fault. I didn’t do the research, didn’t really understand the valuations, and the stocks moved so fast that I was always scared I would be catching the top.

But it made me watchful. When I saw companies listing on the junior Canadian exchanges with expanding operations in the US I was immediately interested.

I was introduced to C21 Investments (CXXI) by a friend who mentioned it to me when it was doing a private placement back in March.

The stock started trading in June. I’ve been watching it since. It started off above $2 and traded almost to $3 at one point before recently collapsing back to a little over a $1. It’s been crazy volatile.

My guess is that the move down has been precipitated by anticipation and the subsequent end of the lock-up period of the March private placement, which ended on July 27^th. There are also probably sellers from the reverse takeover shell (called Curlew Lake) that C21 inherited.

C21 raised $33 million in March through the issue of 33 million shares. The price was $1, which is not far off from where we are now. They raised another $5 million in July at much higher prices.

I’ve taken a position at this level.

Why am I buying?

Well the first reason is that it looks pretty cheap compared to its peers.

Before I give that peer comparison, let me give this caveat. The one conclusion that I’ve drawn in researching the US cannabis sector that there are a lot of projections, but not a lot of operating history. This goes for C21 as well as every other cannabis company on my list. This is a reason to be at least somewhat cautious with all of these names.

There are two reasons for the lack of history:

Apart from a few small states (Oregon, Washington and Colorado), recreational cannabis has only been legalized in most states recently
Most these names have gone public in the last year to raise capital and consolidate existing, smaller businesses that were previously private and that therefore did not report publicly

C21 is no different. They have made 6 major acquisitions. All those acquisitions were done in the last 6 or so months. While the company has actually provided more trailing revenue numbers then most, a valuation still has to be based on their future projections for these businesses.

Below is a comparison using 2019 projections for each company. For the other companies in the list I’ve found brokerage coverage (in most cases Canaccord but also GMP and Beacon Securities) for the revenue and EBITDA estimates. C21 is my own estimate which is primarily based off of the company’s own projections.

I’ll get into how I came up with the market capitalization, enterprise value, revenue and EBITDA estimates for C21 shortly, but first let’s talk a bit about the US cannabis market.

US Cannabis Market

The US Cannabis business is a different beast than Canada. US cannabis is legal at the state level but not the federal level. This means that you can’t have an operation across multiple states or if you do, each needs to be separate, as cannabis cannot cross state lines.

It makes the business inefficient, but it also provides the opportunity for small players. The lack of federal legalization keeps larger players from entering the business. There is still the threat (though this might be receding with soon to come legislation) that company management could go to jail for selling something that is a crime federally.

Each state is an island, with their own laws, their own implementation and probably most importantly, their own licensing structure.

Therefore, it’s important to evaluate the specific states that a US cannabis company is operating in.

C21 is operating in two states: Nevada and Oregon.

These two markets could not be more different from each other.

C21 has made 6 investments in Oregon and another in Nevada. But the Nevada acquisition is larger then all the Oregon investments combined, and probably the bigger generator of value in the short term, so lets talk about that one first.

Cannabis in Nevada

Nevada passed the legalization of cannabis as part of a referendum on the 2016 election ballot. Recreational sales began in July 2017.

Nevada is not the largest state to legalize cannabis. That honor goes to California.

However, Nevada has a significant number of tourists visit the state. There are over 40 million tourists a year that come to Nevada. So, the market is much larger than the population implies.

Nevada, like other states that have only recently legalized cannabis, has been more cautious in their licensing approach than earlier adopters such as Oregon, Washington and Colorado. These early adopting states flooded the market with licenses. The table below compares licenses per population for various states.

Nevada looks middle of the pack, but after considering the much high tourism, the licensing looks conservative. The consequence is that Nevada is considered by many to have one of the best potential cannabis markets.

The limited number of licenses have kept wholesale prices at reasonable level so far.

The Nevada market is growing. Total sales of recreational and medical cannabis in the first year were $500 million. Sales have been trending upward. The last available data point I see is for May, where sales were $48 million, which is up from the prior peak of $41 million in March.

Existing medical cannabis license holders have an advantage in the Nevada market. The state has limited new license applications to open to existing holders.

Nevada is in the process of accepting applications for another round of license approvals right now. Existing holders will be able to apply for licenses from a pool of 44 cultivation, 23 processing, three retail and one lab license.

Perhaps the only downside to Nevada is taxes. Cultivators pay a 15 percent excise tax on wholesale cannabis sales. Retail stores pay a 10 percent excise tax on each sale to a retail customer.

Silver State Relief Nevada Operations

C21 Investments added Nevada to their footprint with their purchase of Silver State Relief. The purchase price was $20 million USD of cash, $14 million USD of 3% interest bearing debentures convertible at $3.50 per share and 2 million shares.

The purchase price was for the business and associated licenses of Silver State. There is a separate option to purchase the real estate (the cultivation land and Sparks, Nevada dispensary location) for an additional $14 million (payable in shares). There is a separate option to purchase the real estate of a Fernley dispensary for $750,000. I don’t believe that they have exercised these options.

Silver State Relief has been around in Nevada since the legalization of medical cannabis. They were one of the first two companies to receive licenses in Nevada and the first company to sell an ounce of cannabis in the state.

Silver State Relief owns and operates a 125,000 square feet cultivation and processing facility in Sparks Nevada, which is part of Reno. This facility, which is 20% utilized, is producing 5,500 lb/month of cannabis flower.

Silver State also owns a large dispensary in Sparks. They describe this facility as a cannabis superstore:

The second dispensary is in Fernley, about 30 miles east of Reno. It is under construction and scheduled to open later this year.

Here’s what gives me comfort with C21. The Nevada operations has tangible trailing revenue that allows some confidence in a valuation of C21. Silver State did $17 million of revenue in 2017 (in a half year of recreational sales) and is expected to do $28 million this year. This article says that sales in the first half of 2018 were $15 million.

Revenue is expected to jump again in 2019 once the Fernley location is open and further expansion is finished.

Silver State margins are quite good. In 2017 Silver State had $7 million of pre-tax profit, or about 40% operating margins. Assuming similar margins in 2018 Silver State pre-tax income should exceed $11 million in 2018 and $15 million in 2019.

We can’t be sure how the Nevada market will evolve. It’s possible more licenses will saturate the market. So far that hasn’t proved to be the case though I have read a few anecdotes that wholesale prices in Nevada are starting to fall. As I mentioned Nevada is opening additional licenses to existing holders only, so C21 and Silver State should be able to participate in that expansion.

Perhaps the biggest negative about Silver State is that, at least so far, they are not operating in Las Vegas. Nevertheless they have the 3^rd biggest store in the state and Reno is a tourist destination in its own right.

I don’t think there is any doubt that Silver State Relief is the crown jewel of the portfolio so far. But C21 has made a number of other interesting acquisitions outside of Nevada as well.

Oregon Market

Oregon was one of the first states to legalize recreational cannabis in 2014.

As with other earlier implementers of recreational cannabis laws (Washington and Colorado are the others) Oregon flooded the market by giving out licenses to anyone with a dream, and is now experiencing an over-supply of product.

Oregon put very few limits on licenses when they legalized cannabis. It’s been easy to get a license and as a result far too many licenses have been granted. By some counts Oregon has over 2,000 producer licenses and 550 retail licenses (I believe the data from the GMP table I posted above is somewhat out of date and thus the higher numbers mentioned here).

Compare that to Nevada, which about one-tenth of the production licenses with a larger population and way more tourism. You can imagine what transpired.

Last year Oregon consumed somewhere around 400,000-500,00 pounds of cannabis. By some estimates (here and here) Oregon has been 1 million and 1.4 million pounds of product stockpiled.

With such massive inventory it is not surprising that wholesale cannabis prices have tumbled. Last year cannabis was selling for more than $1,500 per pound. This year it’s closer to $400 per pound and there are some accounts of product being sold for as low as $200 per pound.

Those are prices that can only be profitable for the most efficient producers and those with a brand that gives them leverage to hold firm. The mom and pop businesses are failing en masse. I’ve seen estimates that up to 150 dispensaries could close in Oregon in the next year, and that 30-40% of cultivation acreage have gone unplanted this year.

So Oregon is not a great market for commodity unbranded cannabis.

C21’s strategy appears to be:

picking up established brands in Oregon
focusing on organic, indoor, high quality cannabis cultivation that receives a premium in the market and is not over-supplied
acquiring operations that allow them to produce value-added products like vape, edibles, CBD products, etc.
Creating a vertically integrated chain of production

In total C21 has made 5 investments in Oregon so far:

Eco Firma Farms
Phantom Farms
Swell Companies
Gron Chocolates
7 Leaf/Pure Green dispensaries

These investments are complimentary of one another. Phantom Farms and Eco Firma are well-known and high quality producers of flower and rolled products. Swell Companies is an extraction and processing company, producing oils and consumer packaged goods. Gron has a focus on chocolates, and with 80% of the edibles market in Oregon. And 7 Leaf/Pure Green give C21 their first 3 dispensaries.

Together the acquisitions represent the entire supply chain, from production to retail sales. They give C21 a suite of 50+ SKUs to offer dispensaries. I think the weakest link is on the dispensary side. I wouldn’t be surprised to see more dispensaries added in the near future.

Let’s dig into each acquisition a bit more.

Phantom Farms

C21 bought Phantom Farms for $15.5 million. As with most of the Oregon acquisitions C21 purchased the company using in large part a non-interest convertible notes that have a conversion at a much higher price ($3.50).

Just a quick thought about the convertible and the Oregon acquisitions. C21 has been using non-interest-bearing convertibles for their Oregon acquisitions. In recent cases the conversion price was $3.50, which is well above the current share price. In the case of their two biggest Oregon acquisitions, Phantom Farms and Swell Companies, the convertible is structured to have a cash value much lower than the share conversion value ($8 million for Phantom Farms and $5 million for Swell Companies). This seems like a smart way of providing upside to these companies but protecting their own investment at the same time.

Each of these Oregon acquisitions also has a fairly significant earn-out if they can hit targets on EBITDA. So the structure does mean there could be further dilution in the future, but only if the company is succeeding. I’m okay with that.

Anyways back to Phantom Farms. They have 80,000 sqft of outdoor cultivation and another 5,000 sqft indoor facility, including a lab and warehouse space. I believe they are adding indoor grow space this year. Phantom is producing 5,200 pounds of cannabis annually. They have historically sold cannabis flower and pre-rolls (apparently they have very good pre-rolls).

The Phantom Farms brand is well recognized and highly rated. They’ve been around for 10 years. They sell their pre-rolls and flower into 175 dispensaries. They expect to sell oils by the fourth quarter.

Revenue is expected to grow significantly next year as C21 adds an extraction facility and another 40,000 sqft of (indoor?) cultivation.

Swell Companies

Swell sells a number of processed THC and CBD brands into the Oregon market. They sell products via their Dab Society, Hood Oil, Quill and Swell brands.

Swell is extraction and processing company. While I believe they have some of their own growing capacity, the primary business is on processing THC and CBD extracts and manufacturing of the resulting oils into vape cartridges, capsules and tinctures. Their website gives some information about the specific products available in each brand.

Swell delivers 50 distinct SKUs and has products available 275 retail locations. They shipped 500,000 product units into the market in 2017.

According to C21’s presentation Swell had $6.5 million of sales in 6 months of operation in 2017. C21 says monthly revenue from Swell is $1 million.

While it’s impossible to know the composition of their sales, I did dig a little into what some of the more popular product lines sell for. Dab Society products go for $25 to $50 per gram. Hood Oil sells for $20 per gram.

Those are interesting price points because they illustrate the value add of branding and processing. I mentioned earlier that commodity flower is $200-$400/lb. The processed products from Swell sell at an order of magnitude higher price.

Eco Firma Farms

The first acquisition made by C21, which coincided with the reverse takeover and initial stock offering, was Eco Firma Farms. They purchased Eco Firma Farms for a little over $4 million, again payable via convertibles.

Eco Firma produces about 2,500 lb of cannabis per year from 23,000 sq ft of grow and processing space in Canby Oregon. I believe much if not all of this space is indoor.

If you google Eco Firma and their owner Jesse Peters you will find a lot of articles, videos and interviews with the company. They are well-known in Oregon for their organic and environmental production practices.

They are also one of the lowest cost producers in the state. According to this article “it costs Eco Firma $189 to produce one pound of cannabis. (That comes out to $11.81 per ounce, or $0.43 per gram.)”

Eco Firma sells the flower and a rolled cigar-like smoke that they call Pachecos. They list 41 dispensaries across Oregon on their website and have been selling the 19 strains they grow since 2012. Eco Firma has won a number of awards for their strains:

Part of the acquisition stipulated a $5 million investment in Eco Firma. So there are significant expansion plans.

Like Phantom Farms and Swell, Eco Firma products appear to command a premium price. Here are a couple of sales ads I found for Eco Firma product.

Even on sale, we are looking at prices that translate to $1,300-$3,200 per lb. Much higher than the commodity wholesale prices quoted in the articles I’ve read.

C21 is projecting $12-$16 million of revenue from Eco Firma in 2019. This is probably the revenue estimate that I find most uncertain. I’m not entirely sure how they get to such a big number. In the presentation they point to the $5 million investment in retail and indoor grow operations. So there is a lot of growth expected.

Nevertheless, it seems that in the past Eco Firma had relatively modest revenue. So I’m taking their estimates with a grain of salt for now.

Gron Chocolates

Gron Chocolates was the latest acquisition of C21, being acquired a little over a week ago. The purchase price was $6.8 million with an additional $4.4 million potential earn-out. The price was paid via cash and convertible but I’m not sure about the weighting of each.

There wasn’t a lot of information available about Gron so I called the company and asked a few questions. Gron has 80% of the edibles market in Oregon and, according to the website, are in 400 dispensaries in Oregon (there are ~500 dispensaries in total in Oregon). They are expected to deliver $4-$5 million in revenue this year, and that is expected to increase to $8 million in 2019. In 2019 they will be expanding the brand to Nevada, where it presumably be available in the Silver State dispensaries.

One other point is that Gron makes both THC and CBD products. The CBD products are interesting because they are considered “non-hemp” and do not have the same state constrained laws. A Gron CBD chocolate can be sold nationally, which gives it more potential. I don’t totally understand how big this opportunity is but it is interesting. When I talked to the company they seemed to be pretty excited about the CBD angle. So we’ll see.

Capitalization

C21 has about 51 million shares outstanding. I say about because there are so many transactions and so many convertibles that it’s a bit of a rat’s nest to come up with the final tally.

Here is how I came up with it. As of the date of the July 10th MD&A there were 42.8 million shares outstanding. There are another 4 million shares issuable to Eco Firma as part of that acquisition that are part of in the money convertibles (these are in-the-money), and another 2 million issuable to Silver State. Another 2.1 million shares were offered as part of the July capital raise. There may be shares issuable to Gron but I don’t know if they are priced in-the-money or at a higher price so I just included that $6.8 million purchase price as additional debt.

There is about $33.7 million of debt if I add up the cash redemption value of all of the convertible debentures and the Gron acquisition on top of that. Like I said earlier the cash value of the debentures issued to Phantom Farms and Swell Companies is less than the share conversion value. Only if the share price gets above $3.50 do I need to consider dilution of the convertible from these acquisitions.

I think there is also roughly $5 million USD of cash remaining on the balance sheet. The cash number is also tricky to estimate, but I know that they had $27 million CAD of cash at the end of April and that their acquisitions (Silver State Relief) included a $20 million USD cash payment. They received $4 million USD from the July raise. So that’s how I’m coming up with the $5 million number for cash and as a result the $29 million of net debt (all in the form of the convertibles).

Conclusion

Below are the combined 2018 and 2019 projections for each of the acquired companies.

Apart from the dispensary revenue from 7 Leaf and Pure Green and the Eco Firma revenue, all of the estimates I used are from the company’s own presentation.

In the case of the 3 dispensaries, I used the purchase price of each and assumed a 1x revenue multiple (this is about the going rate of a dispensary acquisition in Oregon) to come up with a revenue estimate.

For Eco Firma, I wasn’t sure how the revenue estimates from the company could be so high, so I took them down to be conservative. I took the latest production estimate (2,400 lb per year) and assumed they can sell that for on average $1,000 per pound. Maybe I am being too conservative but I need more information to be comfortable with the Eco Firma projections. For 2018 I doubled revenue to $5 million, which is far less than the $12-$16 million the company has pegged in the presentation.

EBITDA Margins are tougher to peg. I know that Silver State operating margins have been in the 40% range. I don’t know what the margins on any of the Oregon operations should look like. I basically made a simple guess – I used 40% EBITDA margin for Silver State and 20% for each of the Oregon operations (20% is on the low side of what Canaccord and GMP have been using for the companies they cover), which gives the blended 29% margin that I showed in my original comp table.

Getting back to the comp table, if the numbers and my assumptions are okay, its clear that C21 Investments is at a pretty significant discount to the other companies in the list.

Why is that? Honestly my best guess is that each of the other companies is covered by Canaccord, GMP and/or some other brokerage. I think that investors are familiar with these other names but not C21.

Its also possible that some discount could be attributable to having some of the operations in Oregon. But both Golden Leaf and Cannex are in Oregon so that doesn’t totally ring true.

At any rate, from what I can tell C21 has acquired a good operation in Nevada and some pretty solid brands in Oregon that should be able to survive the headwinds and likely come out the other end stronger. What’s more, they’ve put together a very complimentary suite of assets that allows them to produce, process, and manufacture a wide range of THC and CBD products. Some of these brands can be expanded into Nevada, which you are already seeing with both Phantom Farms and Gron.

Anyways, based on my research so far I don’t see anything wrong with the businesses acquired. I think its more likely a supply/demand problem with the shares. You take the lack of promotion and exposure, you add to it holders from the original shell that are probably happy to get out at this price and maybe some holders from the original private placement that don’t like the price action so far.

If I’m right, maybe the biggest negative with the stock is how long this overhang lasts.

The other possibility is that I am missing something here. Which can never be ruled out.

Another risk has got to be further dilution. I suspect that C21 isn’t done with the acquisitions. At the very least it would make sense to add more dispensaries in Oregon to fill out the vertical chain. How this plays out and whether stock is offered at these lower prices is a fair question.

Nevertheless, if my numbers are accurate then the stock is reasonable at these levels. I’m used to waiting for something to work. So I’ll be patient. I’m keeping my position on the smaller side simply because, as I mentioned earlier, everything right now is a projection and so this feels like a risky position even for me. But as we get firmer numbers and especially if the stock starts to work, I won’t hesitate to add.