High Tide: Building A Global Cannabis Empire

Thesis

The ongoing price war in the Canadian cannabis sector is very likely a prequel of what will happen in the United States when the laws change. All of the multi-state operators will have to abandon their quasi-monopolies and truly compete with each other for the first time. The removal of the 280e tax obligation may not be enough for these companies to recover from the loss in revenue a price drop brings. This will cause the ecosystem of the US cannabis sector to begin resembling Canada’s.

High Tide Inc. (NASDAQ:HITI) is the only company in Canada that has thrived in its sector-wide price war. As a pure retailer, High Tide’s discount model relies on profits from the sale of smoking accessories to make up for the losses incurred by selling cannabis at or below wholesale prices. Producers cannot compete with High Tide’s ability to sell flowers and concentrates as a loss leader, making High Tide the passed-pawn of the sector. I am assigning a Strong Buy recommendation to High Tide, as they are well-positioned to capture significant market share in any market they enter.

Company Background

High Tide is headquartered in Alberta and has operations in Canada, the United States, and Europe. The company has over 150 brick-and-mortar stores in Canada and exposure to international markets through multiple CBD and accessory e-commerce platforms.

After switching to a discount model in late 2021, it has been capturing market share at a rate of roughly 1% per quarter and has grown their loyalty program to over 950,000 members. In late 2022, High Tide rolled out a Costco (COST) style paid membership option for customers who want even deeper discounts. By leveraging its better margins and lack of production exposure, High Tide is waging a price war in Canada.

Welcome to the Jungle

In 2018 Canada legalized cannabis for recreational adult use. A wave of money flowed into startups and already established players as a new legal market emerged. Overproduction and competition resulted in a price war as the wholesale price of cannabis fell. The present state of the sector in early 2023 is grim, bankruptcies are common and toxic dilution is rampant.

In order to survive this extremely competitive environment, High Tide was forced to find efficiency as quickly as possible. It focused on collecting multiple high margin revenue streams and currently has better overall margins than any of its competition. Its core business is producing glassware and other smoking accessories in India to sell to customers in North America and Europe. They bought several already existing glassware and CBD websites and used the revenues from these to build out its brick and mortar footprint. This is how they can afford to buy cannabis from growers and then sell it at or below cost, the cheap cannabis is a loss leader to get customers into the store so they will buy high margin accessories.

This puts all the licensed producers, whose primary goal is to grow and sell cannabis, in an untenable position. Retaining customers becomes especially troublesome as they have to deal with a competitor who will forever undercut them. Several years into the price war, even poorly managed large Canadian growers have realized that hope is not a strategy. During 2022, in what I can only describe as separate acts of quiet desperation, SNDL Inc. (SNDL) bought a chain of liquor stores, Canopy Growth Corporation (CGC) sold off all of its Canadian retail locations, and Tilray (TLRY) has announced they have to start growing fruits and vegetables.

The Coming Price War

When the United States reclassifies cannabis and removes it from being a Schedule 1 drug, two significant changes will occur. The 280e tax obligation that prevents companies from taking deductions will be removed, and at the same time, federal restrictions on moving cannabis across state lines will also go away. Unfortunately for most of the cannabis companies currently operating in the United States, the benefit they receive from the removal of 280e will not be enough to make up for the loss in revenue they suffer due to the inevitable drop in the price of wholesale cannabis.

None of these US based companies are used to operating in a highly competitive environment. Almost all of them are vertically integrated and are used to operating as a sort of quasi-monopoly where they get to control both supply and price. For the first time ever, these 50 separate ecosystems are all going to have to truly compete with each other.

Price varies significantly from state to state. The very few cannabis operations in the US that have found net profits have only been able to do so in places where the wholesale price of cannabis is extremely high. For example Green Thumb Industries (OTCQX:GTBIF) has found a profitable business model but when you look at where they have positioned their stores they are in Illinois, Washington DC, Connecticut, Florida… all of these places have more expensive cannabis prices. What do you think is going to happen to Green Thumbs profits when the average price of cannabis in the United States drops down to Oregon’s level, how do you think they will handle a 30 to 40% drop in the value of the product they grow?

Oregon’s present day prices are not even the worst case scenario. Competition is very likely to drive prices down into Canada territory. Canadian consumers are already buying cannabis for as little as $100 CAD ($75 USD) per ounce. If the producers in Illinois are used to selling for $351 USD per ounce, what do you think is going to happen to their profits when the price of cannabis drops to $75 USD per ounce?

This price drop due to competition is not going to happen overnight, it will take time to play out. There will be a brief period of time where the removal of the tax burden is going to help out all of these companies, but that’s not going to last. The companies that don’t use that brief window of opportunity to adapt their business models are not going to survive the coming price war.

Long-Term Trends

In the United States cannabis was already a $33 billion industry in 2022, and is projected to grow to $52.6 billion by 2026, and to $72 billion by 2030. As of late 2022, 88% of Americans think it should be federally legal for either medical only or both medical and recreational use. President Biden was elected on a platform that included cannabis reform and on Oct 6, 2022 he asked the Attorney General and the Department of Health and Human Service to launch an investigation into the prospect of rescheduling cannabis from Schedule 1 to a new designation.

High Tide is still far from approaching saturation in Canada and plans on building another 40 to 50 stores there in 2023. The company also has announced intentions to expand its brick and mortar operations into both Germany and the United States as soon as their laws change. As other countries also open up for recreational adult use, High Tide will be there.

It’s hard for me to produce estimates for how many stores constitute saturation in a given population until the company begins approaching saturation in Canada. The company already maintains 151 stores in Canada and is planning on building another 40 to 50 in 2023. Using a conservative assumption that Canada can only support up to another 100 stores, Germany’s population translates to another 550-600 stores, and the equivalent store density in the United States comes out to another 2,125 stores. The above estimate is only looking at three countries, I expect most of the rest of the western world to follow the lead of the United States soon after it changes its laws.

Financials

High Tide is currently in hyper-growth mode and recently reported a quarterly rise in revenue of 13.4% from $95.4M CAD ($74M USD) to $108.2M CAD ($80.36M USD), and an annual rise of 83% from $59M CAD ($44M USD) from Q4 2021. As of the release of the Q4 2022 Earnings Report, the company has been Adjusted EBITDA positive for the last 11 consecutive quarters and spends every available penny on expansion. Between the cost of opening new stores and the tax write offs from depreciation, the company has been outpacing its tax obligations. With the exception of the write-down they took in Q4 2022, this is exactly what one expects to find when looking at a company that is prioritizing growth over net profits.

The write-down was the result of a drop in revenue for the e-commerce CBD subsidiaries. Inflation is hitting markets unevenly and CBD sales have dropped. Nothing is fundamentally wrong with that branch of the business, CBD sales have dropped across the sector. As the economy recovers, so should that revenue.

Valuation

As of February 23, 2023, High Tide has a Market Capitalization of $102.32M and trades on the Nasdaq for $1.37 USD. This is the type of company that gives value investors headaches and makes growth investors thirsty. With negative net income, and being years away from a dividend, anyone using the more popular ways to calculate fair value will be staring at a formula that says the company is worth zero. Value investors will have to resort to looking at its trailing EV/Sales of 0.53 or its forward EV/Sales of 0.39. Its book value of $121M produces a trailing Price/Book ratio of 0.85. Even for a company that is not profitable, this company is undervalued.

When Biden was elected, it caused a sector-wide bull run, and at the height of the euphoria in February to March of 2021, HITI was trading at Price/Sales ratios in the 11 to 12 range. It’s reasonable to assume that a change in how the United States Federal Government treats cannabis will result in a rally of similar, if not greater strength. As the company currently trades at a trailing PS of 0.33 and has significantly increased its revenue since early 2021, a PS of 11 to 12 for present-day sales numbers translates to a share price in the $45.66 to $49.81 range. As the company continues to grow its revenue at a relentless pace, the longer we have to wait for the next major sector bull run, the higher we can expect the share price to reach.

Assuming annual revenue growth drops to 75% and dilution stays at roughly 30% a year, a PS Ratio of 11 to 12 a year from now equates to $61.47 to $67.06 per share. In two years, $82.74 to $90.26 per share. If three more years of growth occurs before a PS ratio of 11 or 12 is reached again, then that translates to $111.39 to $121.5 per share. These estimates provide clear values for what constitutes extreme euphoria for this ticker and will help me identify potential exit points. The entire cannabis industry has seen valuations tumble as the largest producers have struggled to find profitability. A more reasonable price target would be the company merely returning to fair value. As a brick and mortar retailer with an online component and an operating margin of 26.97%, this company should be trading at a PS ratio in the 1.5 to 2.5 range. Yet it is trading at a trailing PS of 0.33 and a forward PS of 0.28. This produces an estimate of $7.34 to $12.23 per share for this time next year.

Risks

Before I talk about actual risks, I need to talk about the possibility that the United States delays for several more years before it approves adult recreational use. High Tide doesn’t need legalization, a delay in the United States is actually good for the company. The larger and more established it is before its time to expand into the United States, the better equipped the company will be to go win another price war.

It’s entirely by design but this company operates on thin margins. If a large enough outside competitor were to step into the Canadian ecosystem with the intention of giving High Tide a taste of its own medicine, the company would have extreme difficulty adapting. While it would be easy for High Tide to raise prices to bring the company into net profitability, it has very little price flexibility for offering even deeper discounts. An extremely well-funded Alcohol or Tobacco company could choose to buy a competing chain of retailers and then sell cannabis and accessories at a loss until High Tide is eventually driven into irrelevancy. Companies like Philip Morris (PM) or Altria (MO) could afford to do this.

This company has a history of accretive dilution, but that could change. The CEO does not like to use at-the-market offerings to raise cash, but instead prefers to buy things with shares directly. This means that instead of large dilution events, this company sees a steady stream of small dilutions. Looking over the revenue increases for the last several years and comparing that to the average annual dilution, it becomes clear that this has been paying off for the shareholders. While revenue growth has varied, the last several years has been consistently in the 85-105% range. At the same time, the dilution has been roughly 30% of the float each year.((Revenue^1.95)/(Float^1.3))^(Per Year) = Runaway Exponential Growth

The risk here is that this changes. The company has a history of being able to translate dilution directly into revenue. If for whatever reason that goes away, any future dilution can easily switch from accretive to toxic.

The company has gone through a rapid expansion over the last two years and during the recent 2022 year-end audit a material weakness was discovered in the internal reporting system the company uses. The weakness was caused by the overly complex subsidiary structure and impairs the company from producing fully audited statements in a timely manner and also interferes with accurately reporting its income for tax purposes. Since this company has never had to pay income taxes, is still many months away from even reporting net income, and has already initiated an accounting restructure, this is turning into a nothingburger. There is still a risk that the restructure also produces a flawed system on the other end, but since they are walking into it with the goal of addressing these problems, it’s unlikely.

The CEO-founder Harkirat “Raj” Grover built this company all the way up from a single store with two employees in 2009, to 151 stores and a quarterly revenue of over $100M CAD today. He is both extremely competent and extremely charismatic. His business prowess is the reason this company is the diamond in the rough that it is today. If something were to happen to him where he was no longer able to perform, it would be a cause for major concern.

Catalysts

The company has been avoiding paying income taxes by outpacing its tax obligations with new store openings and depreciation write-offs. At some point in the future they will stop building new stores at a breakneck pace and will be forced to post positive net income. Because many investors have been burned one too many times by the supercycles the cannabis sector experiences, it will probably take two consecutive quarters of positive net income to attract value investors in any meaningful numbers. It may take a few months to play out, but the transition from non-profitable growth into profitable growth should cause a significant rise in share price.

Germany announced in October of 2022 that they are planning on opening up to companies like High Tide soon. High Tide has already entered into a tentative relationship with German-based Sanity Group in preparation for expansion there. The company plans to open a chain of stores there under the name ‘High Street.’ Germany has a little over twice the population of Canada and opening up this new market will allow the company to stay in hyper-growth mode. Within a year of opening new stores in Germany, the efficacy of selling cannabis as a loss leader will be proven in a second market.

The United States has a little over 8 ½ times the population of Canada and High Tide is already operating websites that sell glassware, seeds, and CBD to consumers there. As soon as the laws change, these websites will be able to sell flowers and concentrates to its already established customer base and the company can begin their planned rapid expansion of its brick and mortar retail footprint.

Cannabis reform legislation in the United States has both bipartisan support, and bipartisan resistance. As much as I would love to be wrong, I do not expect Congress to pass anything meaningful until 2024. This leaves the cannabis sector waiting for the findings of the Attorney General and the Department of Health and Human Services. Considering how long it takes for the wheels of bureaucracy to turn, I hope they manage to release their findings on rescheduling as early as this coming summer or fall, but it could happen sooner or take significantly longer. When this announcement is made, it will almost certainly trigger yet another sector wide rally.

Conclusion

I have been studying the cannabis sector for the last three years. In February of 2021 I built out a list of players and it was over 300 tickers, today its down to about 75. Very few of these companies have competitive strategies, almost everyone playing this game thinks the big money is in growing it. The important takeaway here is that because most of them think growing the plant is a moat, almost none of them have bothered to build out truly unique moats; and a moat that isn’t special, isn’t a moat, it’s a delusion.

Selling cannabis as a loss leader, while refusing to grow any yourself, is downright predatory. When I look at how all these separate trends are likely to play out over the long term, it’s hard for me to envision a scenario where this company doesn’t end up as one of the top 5 cannabis companies by global revenue.

The Canadian cannabis sector has been a knife fight in the gutter and High Tide has emerged as its single most competitive player. When this apex predator is finally allowed out of its native habitat, we are going to get a case study on why invasive species are so destructive to local ecosystems.

So what is my personal investment plan with High Tide?

Normally this is the part where I talk about waiting for a good entry price, but that ship has sailed. The news from the DHHS about rescheduling could hit at any time so I already have a significant position in this company and will continue adding to my share count for as long as this company continues to stay undervalued. Eventually, either the entire sector will enter a bull run on rescheduling news, or this company will post an earnings report that is so loud the market has to listen. I am expecting to hold this position until it becomes clear the sector has entered extreme euphoria and the company is overvalued, or the company experiences a loss of its already existing moats and edges. Because of High Tide’s extremely competitive business model, if none of my sell conditions are met, I am willing to adopt a Warren Buffet holding time.