Introduction:
Pyxus International (PYX) is a heavily indebted seller of loose leaf tobacco looking to gain exposure in the recreational marijuana sector as part of a growing mania for international legalization of the drug. The company’s sales have been on a constant decline since 2015 and, currently, has absolutely no cash to set aside for capital investments in the marijuana field. Every single pot player in this business has both healthier balance sheets and better marijuana exposure than PYX. Investors should not be fooled by the company’s deceptively low P/E and P/B metrics and stay well clear of PYX in anticipation of either default, dilution, and/or failure in its marijuana business venture. Let’s take a look as to why this is the case.
Legacy Tobacco Business in Double-Digit Decline:
Source: Gallup
The percentage of smokers in the U.S. has more than halved since the 1950s and remains at an all-time low of 16% since the inception of tobacco. Ever since the Tobacco Master Settlement of 1998, the restrictions of sales practices, the introduction of new tobacco taxes, and the requirement to display revolting cancer ads on cigarette brands have successfully deterred the practice for most Americans. This is not only limited to the United States, however:
Source: OECD
All countries in the developed world, including those in the E.U. and Japan, are currently seeing a consistent single-digit decline in its smoker population since the 1990s. This is rather alarming news for PYX, as 100% of its sales in FY2019 came from selling tobacco leaves to cigarette manufacturers.
Source: Jonathan Cooper, Seeking Alpha
Ever since 2015, PYX’s revenues have seen consistent -%Q/Q and -%Y/Y declines in the double digits. This is certainly alarming to a company which is barely breaking even in terms of net margins (and only generating single digits in adjusted %NI margins before interest). Cash flows from this company are essentially redirected solely for the payment of interest obligations, let alone debt, and we will see why below.
Balance Sheet is a Massive Red Flag:
To see just how bad PYX’s situation is, let’s quantify the company’s leverage using two ratios, net debt to EBITDA and EBITDA/interest expense:
Source: 10-K Filings
As of FY 2019, PYX’s net debt amounted to $898.4M + $429.0M – $192.0M = $1.1354b. Next, we’ll have a look at the company’s raw cash flows:
Source: 10-K Filings
Source: 10-K Filings
The company’s EBITDA equates to $87.3M in operating income plus $47.863M in non-cash items, giving a grand total of $135.2M. When accounted for an interest expense of $135.6M, this yields the following:
net debt to EBITDA: 8.40x
EBITDA to Interest: 1.00x
Not only is PYX excessively leveraged, but the company is also currently having troubles generating cash flows just to fulfill its interest payments! These numbers are devastating for a company enduring double-digit revenue declines in its legacy business. The author sees no way PYX can steer away from a default within the next 2 years unless the company raises equity and dilutes existing shareholders to pay off debt. On the other hand, refinancing is extremely unlikely with bonds trading below junk status and yielding double digits.
This is absolutely not very good news for a company in need of extra cash for capital expenditures in the marijuana sector.
Marijuana Farming is Not the Right Approach:
Source: Oregon Office of Economic Analysis
Source: Marijuana Business Daily
First of all, PYX has no exposure in the marijuana sector aside from a cultivation license from Health Canada to recreational leaves. As we can see on the chart above, recreational marijuana prices have been on a steady decline since legalization in Oregon and Washington. In fact, leaf prices have fallen by over -53% to -65% within one-year post-legalization for wholesalers and -50% for the past 3 years for retail. This is largely due to the low barrier to entry, i.e., any company with low 6 figures in capital to purchase the necessary equipment and meets the standards can obtain a cultivation license and begin selling marijuana. Thousands and thousands of farmers are hitchhiking onto the sector craze; thereby over-harvesting the commodity, squeezing margins by reducing prices, and some have resorted to destroying their weed to curb oversupply.
This is just the beginning of the iceberg, however:
Source: Quartz, Statistics Canada
Dispensers are not only competing against themselves but also against do-it-yourself recreational growers and, more importantly, the black market. Contrary to public opinion, legalization has not dealt a killing blow to marijuana’s illegal retailing, and Statistics Canada has estimated 79% of all marijuana sales are currently derived from unlawful streams. Sector players are finding it extremely difficult to compete using legal sales prices, which due to the Marijuana Tax, can be up to 30% more expensive than getting it from one’s local pot dealer.
With leverage levels nearing default and a questionable business strategy to enter a deflationary sector, let us compare PYX to how other companies in the sector are doing.
Just How Well Are The Pot Players Doing:
Source: Multiple SEC and SEDAR Filings, Author’s Curation
First of all, the author believes all the talks surrounding edibles and recreational use to be just hype. The barrier to entry is simply too low, and any food company can and will diversify into creating their own edible products without the need of pure-player marijuana companies listed above. On the other hand, clinical trials with cannabinoid have the potential to disrupt the healthcare sector as a first or second line of treatment for moderate to severe pain treatments, utterly disrupting the use of opioids. In terms of new developments, there is already an FDA approved drug by GW Pharmaceuticals (GWPH) for the treatment of multiple sclerosis.
Nonetheless, phase III trials can involve thousands of investigators + patients and require up to $2 billion to develop. Looking at sector participants, every single one of these companies such as Aurora Cannabis (OTC:ACB), Tilray (TLRY), Canopy Growth (OTC:CGC), Aphria (OTC:APHA), and Cronos (OTC:CRON) have some kind of cannabinoid clinical trial exposure except for Pyxus. In addition, the company does not have any kind of even medical marijuana or edibles and remains the most leveraged player in the sector. To expand into any of the lucrative fields for cannabis derivatives listed above, capital is absolutely vital. Yet, the author fails to see how PYX’s cash flows can be used for anything else other than marginal survival of its interest obligations.
Valuation
Using the analysis presented throughout the article, that is: double-digit decline in tobacco leaf sales, non-existence of net margins due to interest crippling obligations, heavy capital expenditures due to marijuana investments, and poor pot sector exposure; the author estimates PYX’s future cash flows to be as follows:
Source: Author’s Curation
As we see above, PYX may have had a shot with its new marijuana venture if the company did not inherit over $1B of debt from its legacy tobacco leaf trading business. With this added to the balance sheet, however, it completely destroys any meaningful value to the company as this results in a debt to equity ratio of over 5x. Furthermore, PYX’s high yield, junk status debt is wiping out all of the company’s EBITDA every single year and is crippling the necessary capital required to make investments in the marijuana sector. With most of these debt maturities due in 2022 and bonds trading at double-digit yields, the author sees very little possibility for PYX to refinance and expects either a default by this time period or an offering of equity which will further erode shareholder value due to dilution. While trading at a 33% discount to book value (0.66x P/B), investors should be well aware of the deceptive nature of this metric and understand the disastrous nature of this company with regards to capital management.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in PYX over the next 72 hours. 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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