Background
Village Farms (NASDAQ:VFF) was traditionally a vertically integrated producer of high-quality premium produce with more than 30 years of growing experience. Today, the company is one of the lowest cost producers of tomatoes and cucumbers in North America. The company prides itself on their prowess in technological and sustainable farming practices.
Over the last 20 years, VFF built a solid distribution system, sophisticated greenhouse operations, and an experienced growing staff. This infrastructure and expertise provides an excellent foundation for VFF’s transition into a low cost, high quality cannabis and CBD producer. I’ve seen the Delta compound outside of Vancouver, British Columbia, and can attest it is a sophisticated operation in a rural area, ideal for growing cannabis, with easy access to transportation.
VFF has many marquee grocery accounts across the US and Canada, but vegetables are a commodity business. As a result, the company has historically had very low margins and minimal growth potential. While VFF was an interesting agriculture business, it didn’t attract much investor attention.
The New Village Farms
Within the last 2 years, VFF has transformed itself from a low growth, low margin vegetable grower into a high margin, high growth cannabis company. VFF began this transition by entering into a 50/50 JV, Pure Sunfarms (“PSF”), with Emerald Health Therapeutics (OTCQX:EMHTF) to create a large-scale, high quality, low cost producer of cannabis. Below is the road map and timeline management implemented to complete this impressive transition in just over two years.
(Source: Sept. 19 VFF Investor presentation)
VFF’s initial contribution to the JV was a state-of-the-art greenhouse, called Delta 3, which was converted to grow cannabis. Additionally, VFF provided experienced growing staff to operate the greenhouse. Emerald provided $20M in cash and expertise in the cannabis industry compliance and licensing processes. Finally, the JV has options to convert VFF’s Delta 2 and Delta 1 facilities to cannabis production.
On April 1st, 2019, Emerald Health chose to exercise their option to convert the Delta 2 greenhouse and anticipate first production in mid-2020 with full run rate reached by YE 2020. Completion of the Delta 2 greenhouse will effectively double PSF’s annual growing capacity from 75,000 kg/yr to 150,000 kg/yr. The option on the larger Delta 1 facility expires in September 2021 and would provide another 180,000+ kg/yr of production.
(Source: Sept. 19 VFF Investor presentation)
Transitioning their existing greenhouses away from vegetables and toward cannabis is an excellent opportunity for VFF to redeploy their fixed assets at higher rates of return. Management believes they can achieve 10-15x the revenue from growing cannabis compared to the current revenue derived from vegetables while also improving EBITDA margins by over 10x. Given these striking improvements, it’s no wonder why management has been so aggressive in transitioning their greenhouses toward cannabis and hemp/CBD production.
(Source: Investor Presentation on Cannabis JV)
As mentioned above, VFF’s goal is to become the lowest cost, vertically integrated producer of high-quality cannabis, similar to their current position in tomatoes and cucumbers. One of VFF’s competitive advantages is that they already own and operate millions of sq/ft of technologically advanced greenhouse space. This allows the company to transition to cannabis with minimal capital expenditures, unlike many peers who need to spend significant capex to bring their capacity online. VFF’s execution on the Delta 3 transition gives us confidence that Pure Sunfarms is well-positioned to increase production and scale, allowing them to maintain their cost advantage as the cannabis market matures.
Additionally, the existing greenhouse footprint provides PSF a significant time to market advantage compared to some of the other, more well-known peers. All of PSF’s products will be grown indoor, which should provide a quality advantage versus their peers who tout significant capacity potential, but much of which is outdoor. As one would expect, higher quality should directly correlate to higher sales prices.
Cannabis Market
The opportunity for VFF in Cannabis is quite large relative to the size of the company today. According to Deloitte,
“the total cannabis market in Canada, including medical and illegal as well as legal recreational products, is expected to generate up to $7.17 billion in total sales in 2019. Legal sales are expected to contribute more than half of this total – up to $4.34 billion – in the first year.”
Management estimates that the Canadian market will have a demand of 600,000 kg/yr by 2021, as seen in the second slide below. Upon execution of the remaining option to convert Delta 1, PSF could produce over 330,000 kg/yr. Since the JV’s conversion option expires in September 2021 and it took PSF under 24 months to convert the other two Delta Greenhouses, we anticipate the remaining facility could come online as early as late 2022-2023.
(Source: Sept. 19 VFF Investor presentation)
In the early days of the recreational market in Canada, many expected there would be a significant supply shortfall. While recent indications are that producers are sufficiently covering demand, we believe this may not continue going forward. Edibles, oils, liquids and other forms of cannabis will become legal in the recreational market in Q4 2019. Additionally, Ontario recently announced their intention to open more retail stores with other Provinces expected to follow. These two impending demand drivers could strain the current supply/demand equilibrium.
If the demand forecasts for 2021 of 600,000 kg/yr prove accurate, there appears to be potential for a shortfall, which would benefit VFF. The slide below is a few years old, so the industry capacity estimate is out of date. Our research of the major competitors found that existing capacity is actually closer to 450,000 kg/yr as shown in the table below.
(Source: Investor Presentation on Cannabis JV)
(Source: Company Presentations/Filings)
US Hemp and CBD
In the US, the recent passage of the 2018 Farm Bill legalized hemp and CBD cultivation, overturning a long-standing federal ban. This opens up a new opportunity for producers of hemp and CBD in a wide range of products from concrete to clothing. In the slide below, management expects the US hemp/CBD market to reach $16B by 2025. VFF is aggressively pursuing this significant opportunity through field grown product as well as high purity greenhouse grown product. The first entry into this market for VFF will be through sales of field grown biomass and CBD oil on the wholesale market to drive near-term cash flow. Management will then use this cash flow to create a branded products business. Management currently expects first biomass sales in Q4 2019 and ramping from there.
(Source: Sept. 19 VFF Investor presentation)
Separate from the company’s JV with Pure Sunfarms, VFF entered into another JV to address the US hemp fiber and CBD markets. The hemp JV is for field cultivation and extraction and includes more than 920 acres across 4 states. There are two outdoor hemp operations VFF is involved in – the first is Village Fields Hemp, which has access to 800 acres across Virginia, North and South Carolina. The second has access to 120 acres in Colorado through Arkansas Valley Green and Gold Hemp as shown in the slide below.
(Source: Sept. 19 VFF Investor presentation)
VFF is anticipating selling both branded and white label hemp/CBD products to big box retailers beginning in 2020. We believe VFF’s hemp/CBD strategy should benefit from its historical relationships with big box retailers across the country as well as the company’s reputation for quality and reliable supply. Additionally, management expects to put in place CBD oil extraction capabilities in Q1 2020 with sales and product manufacturing to follow later that year.
Below is the road-map management provided investors on their journey to outdoor hemp/CBD sales. Given the execution on the Canadian Cannabis JV, we are comfortable with their milestones and timelines to enter the field grown hemp biomass market by YE 2019 with CBD oil sales commencing in 2020.
(Source: Sept. 19 VFF Investor presentation)
According to Kush.com, hemp biomass typically sells for $77/kg-165/kg ($35-75/lb @ 2.2 lbs/kg). Using proprietary strains, tests have shown up to 5 tons of biomass per acre (907.185 kg per ton). With 920 acres secured for growing hemp across 4 states, quick math uncovers the large potential of the US CBD business for VFF, which we believe investors are ignoring at today’s share prices.
Assuming just 1 ton of biomass yield per acre and 907 kg/ton, VFF’s CBD business has the potential to produce 834,000 kg of hemp biomass on current acreage. If the initial sales prices are at the low end of the range of $77 kg, we can easily see this as a near-term ~$65M+ opportunity for the outdoor grown hemp business compared to VFF’s 2019 total expected sales of $200M.
Similar to the greenhouse conversion opportunity for the Canadian cannabis market, VFF also has one for hemp/CBD in Texas. VFF owns 5.7M sq ft of state-of-the-art greenhouse in West Texas, independent of the assets involved in the Canadian JV. VFF recently initiated the conversion of 650k sq ft for hemp cultivation.
Considering the plants used to produce cannabis and hemp are similar in size and shape, we assume that 650k sq ft of greenhouse space is equivalent to at least 45,000 kg of hemp flower biomass available from the Texas facility in addition to field grown hemp/CBD discussed above. These numbers are based on the 1.1M sq ft of greenhouse space in Delta that is allowing the company to produce 75,000kg of dried cannabis flower per year. Indoor hemp will likely be better quality and higher potency than their field grown hemp. As a result, it would likely sell for more than the $77/kg assumed for the outdoor product above.
VFF will begin growing and processing hemp in their Texas greenhouse as soon as the regulatory framework is in place, which is why they are converting 650k sq ft of their greenhouse space now. Given the similarities to the conversion projects undertaken at Delta, we believe VFF management will similarly execute on this opportunity and likely be a low-cost supplier in this market as well. Should cannabis become legal in Texas or federally in the US, VFF could quickly transition to cannabis sales at the Texas facilities converted to grow hemp, likely leading to even higher revenues and margins from these greenhouse assets.
(Source: Sept. 19 VFF Investor presentation)
Pricing
On September 9th, 2019, VFF announced that PSF received a packaging license from Health Canada. On September 16th, it announced shipping its first retail product into Ontario with sales to BC following shortly. This is a MAJOR milestone for VFF as it debunks one of the most persistent short theses on the company – that VFF are “just farmers” and will only sell wholesale to other licensed producers, meaning that they will continue as just an agricultural commodity supplier, not deserving of a higher multiple.
However, packaging license in hand, PSF will now be able to sell branded product directly to retailers, increasing prices and margins for the JV and ultimately VFF. Combined with their best-in-class production cost of just CAD $0.65/g, we believe PSF is well-positioned to take significant share in the Canadian cannabis market due to its low-cost and high-quality product. Additionally, strict regulations in Canada limit the ability of companies to market their product in order to differentiate themselves and create brand loyalty. Therefore, price and quality will likely be the two biggest determining factors for Canadian consumers.
The addition of the retail packaging license will allow PSF revenue/g to trend toward the average sales price in the market over time. As shown in the table below, today, the average price/g is about CAD $6.30/g compared to PSF’s most recent quarterly sales price near CAD $4/g. While we do not expect the company to start selling all of their product at the average price in the market overnight, we do expect to see price/g begin to trend up over the next few quarters. It is important to note, we expect that PSF will use its cost advantage to aggressively price their product relative to peers in order to take share, meaning the price/g will likely always be somewhat below the average market price, in our opinion.
(Source: Company Presentations/Filings, except CGC Rev/g – authors estimate, all numbers in table are $CAD)
Edibles, oils, extracts and other forms of cannabis are still illegal in the recreational market in Canada for a few more months. Legalization and sale of these products, collectively referred to as cannabis 2.0, should provide an additional opportunity to improve pricing and margins for VFF as these products sell at a premium to dried flower. To give investors a sense of the pricing difference between dried flower and extracts, Aurora Cannabis (OTC:ACB), another large player in the market, provides the rev/g received for each. ACB receives $10.37/g for extracts vs $5.58/g for flower, or almost twice the price per gram.
While VFF does not currently have extract capabilities, they expect it online for their Canadian JV in Q4 2019 and begin sales of extracts in the 1H 2020. Additionally, they expect to begin CBD oil sales sometime in 2020, which, similar to the cannabis market, provides higher prices than hemp biomass. Both of these extract opportunities should help drive pricing and margins for VFF beginning in 2020.
Why do we like VFF now?
In our articles, we often mention that one 1035 Capital’s core tenants of investing is “front running the black box” (see our interview with seeking alpha here to learn more about our strategy). We want to invest in companies undergoing positive change before these changes become obvious to other participants in the market and are more likely to be priced in. We believe VFF fits this characterization nicely as many investors still view the company as a low margin farming operation. This perception has been exacerbated by disappointing execution at some of the bigger names in the space which we believe has soured appetites for stocks in the industry.
Unlike peers, VFF’s management has consistently executed on their strategy to become a high margin, high growth vertically integrated cannabis company. In our opinion, VFF has executed the best strategy in the entire Canadian cannabis market during the last two years, which gives us confidence that the outlook for this transformed company is bright.
With the recent approval of their packaging license by Health Canada, VFF has essentially completed this transition to a low cost vertically integrated high margin, high growth company. Yet investors are still only paying ~1.8x P/S versus 10x or more for peers. We believe this is a large disconnect, given the stronger execution of VFF management, lower cost production, significant capacity growth, and much higher margins than peers. This provides investors with a compelling opportunity to profit as the improvement in fundamentals continues to show up in coming quarters bringing more investors to this company.
Another tenant of our investment philosophy is to invest in strong management teams. VFF’s execution reveals itself in several areas, including the time it took to convert and ramp production at Delta 3, as well as their industry-leading gross margins and obtaining necessary licenses in a timely manner. Additionally, we like that VFF management is aligned with shareholders, owning almost 20% of the company.
Valuation
As shown in the table below, VFF trades at a significant discount to peers (FY1 P/S of 1.8x vs the median of peers at ~10x). We believe some discount is justified due to the proportion of low margin produce sales and limited high margin cannabis sales/production up to this point. However, we argue that even given this dynamic, the current discount to peers is too punitive. With the recent completion of the Delta 3 conversion, ongoing conversion of Delta 2, the latest news of their retail packaging license, as well as the underappreciated CBD opportunity, there is no justification for an 8-turn discount to the peer median.
(Source: Seeking Alpha, Koyfin.com for estimates, Authors Calculations, based on USD financials)
(Source: Seeking Alpha, Table in USD)
(Source: Actuals – Seeking Alpha in USD, Estimates – KoyFin.com in USD)
VFF has emerged as the lowest cost producer of cannabis in the Canadian market, and now, they should begin to see their sales price trend up toward the average sales price in the market with their new packaging license. Last quarter, VFF had 84% GM which was significantly above anyone else in the industry and the industry median of ~50% GM. As the new packaging license drives higher prices/g, we should see margins continue to improve as sales mix improves. This is a powerful combination for a company trading at 1.8x FY1 sales.
In our opinion, there should continue to be some multiple discount on VFF as long as low margin produce remains a significant portion of sales. However, going forward, we expect produce sales to rapidly decline as a total percentage of revenue due to the conversion of greenhouse space to cannabis and hemp production supercharged by higher priced cannabis/hemp sales. Declining produce sales and ramping cannabis/hemp sales should provide a multiple expansion tailwind for the next several years for VFF shareholders.
In the table below, we show the USD share price of VFF at various P/S multiples based on consensus sales estimates which, in our opinion, seem about 20% too low for 2020 and 2021. Given the combination of low margin produce sales and that PSF is not 100% controlled by VFF, we believe the company should trade between 5x and 6x sales, a 4-5 turn discount to the peer median of 10x sales.
Using the 5-6x sales multiple implies a share price of $21-26 USD (green highlighted area in table below) in the next 12 months and $30-36 in 24 months, assuming analyst estimates are accurate. However, as mentioned above, we think consensus estimates are about 20% too low for 2020 and 2021 providing additional upside on upward estimate revisions.
(Source: USD, Authors Calculations, based on multiple and Cons Estimates, via Koyfin.com)
Conclusion
Based on the extreme multiple disparity to the closest peers, we think VFF is the most compelling stock in the new and explosive growth markets of cannabis and hemp/CBD. Additionally, sell side estimates have considerable room to move up as investors come to appreciate the US hemp/CBD opportunities as well as the additional pricing and capacity at Pure Sunfarms.
We expect VFF’s share price to respond over the next few quarters as financials continue their significant improvement, management provides additional color on the importance of the Canadian packaging license, and gives more clarity on the US CBD opportunity. Finally, VFF could create considerable shareholder value by buying out the other 50% of the PSF JV and bringing 100% of the sales and earnings from PSF onto VFF’s financial statements.
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Disclosure: I am/we are long VFF. 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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