High Tide’s Quest For Cash Flow Should Lead To Valuation Improvement

Thesis

The Canadian cannabis industry is extremely competitive. Overproduction has led to a situation where most of the growers are forced to operate at a loss. While the price war that has been raging there has claimed many victims, it has also allowed for the most competitive players to rise to the top.

As of the recent Q1 2023 Earnings Report, High Tide Inc. (NASDAQ:HITI) has abandoned its goal of opening another 40-50 stores in 2023, and declared a new goal of generating cash flow. I am reaffirming my Strong Buy recommendation for High Tide because I believe their pivot from maximizing growth to emphasizing cash flow will lead to a significant rise in valuation.

Company Background

High Tide has operations in Canada, the United States, and Europe. The company has 151 brick-and-mortar stores in Canada and exposure to international markets through multiple CBD and accessory e-commerce platforms.

The company sells cannabis as a loss leader so it can generate revenue off of high margin smoking accessories. This has proven wildly popular with Canadian consumers as they currently have over 975,000 customers enrolled in their discount membership program. Same store sales growth has reached 52% YoY as they capture roughly 1% of market share per quarter. Their retail footprint now controls roughly 9% of the Canadian market. These customers are unlikely to leave as their discount model and paid membership option promote repeat business and cultivate brand loyalty.

Long Term Trends

The global smoking accessory market has a projected CAGR of 6.5% though 2030. CBD is projected to have a global CAGR of 31.5% until 2031. The Canadian cannabis industry is expected to have a CAGR of 13.26% until 2027. High Tide already has exposure to the United States market through several online retailers but has been forced to wait for the federal laws to change before it can begin an expansion of its brick and mortar operations. The cannabis industry in the United States is projected to have a CAGR of 14.2% until 2030. The company also has plans to expand into the German cannabis market, which is projected to have a CAGR of 14.01% through 2027.

Since Canada changed its laws in 2018, it has developed into both the most mature and the most competitive cannabis market on the planet. As other countries change their laws, I expect similar stories to play out in those markets. I believe competition will drive the price of wholesale cannabis in these emerging markets down towards the prices that it already sells for in Canada’s more mature market.

Financials

Unless otherwise noted, all values are in USD instead of CAD. As of Q1 2023, the company had $17.21M in Cash and Equivalents, was spending $2.85M per quarter on operations, and had a quarterly net loss of $2.8M. The company has been Adjusted EBITDA positive for the last 12 quarters and EBITDA positive for the last 4. The announced pivot away from growth and toward cash flow means that the slope of revenue growth on the below chart is likely to decrease. It would seem the era of this company doubling its revenue every year is over, as it’s about to be replaced by an era of margin expansion and EPS rises.

I expect the shift toward cash flow to lead to lower annual growth rates. The actual pace of revenue growth will mostly be a function of same store sales growth and new store openings. With annual same store sales growth currently at 52%, and new store openings projected to be in the 10 to 20 range, a back-of-the-envelope estimate for what I think its minimum is can be produced.

If I exclude the 16% of revenue that doesn’t come from the Canadian retail portion of the business, and instead only look at the remaining 84%, and assume no new stores are opened and that same store sales growth drops from 52% down to the 30-40% range, the company will still see an annual revenue gain in the 25.2 – 33.6% range. A 25.2% increase in revenue, at today’s operating margin of 27.25%, would be a 6.87% boon toward net profitability. 6.87% of today’s quarterly revenue represents an additional $5.89M.

Since the company is planning on opening 10 to 20 stores instead of zero, and same store sales growth is unlikely to fall off quite so quickly, I feel that the 25.2% annual is a safe estimate for minimum expected revenue growth and that actual growth will be higher.

Q1 2023’s operating margin of -3.32% is an improvement over Q1 2022’s -7.21%. Over that same time period, net margins improved from -10.21% to -3.27%. Gross margins have been stable for the last three quarters, and if we ignore the write-down the company took Q4 2022, then operating and net margins have been improving.

The adoption of the discount model in late 2021 caused a noticeable margin contraction. The company runs a discount model and enjoys some price flexibility so it could easily improve margins by raising prices. Net Margins are at -3.27% so raising prices by 3.5% across the board will instantly make the company net income positive. This easy solution may not be as appealing as it first seems since the entire reason the company enjoys 52% same store sales growth is its deep discounts. If they raise prices, the demand curve for their stores will shift to the left as some of their customers go find better deals elsewhere.

The Float – Cash – Revenue chart is showing revenue continues to outpace dilution. Since the company appears to have slowed the pace of its aggressive merger and acquisition campaign, I expect both the slope of revenue, and the slope of dilution to decrease. Both of these lines are about to inflect downward and what I am looking for with this pivot, is for the difference between these two slopes to remain the same or widen.

Since this company has been capturing market share at an impressive rate, and we have a second data point for the Elite membership enrollment, I decided to plot market share and club members on the same chart. I fully expect to have to shift the units on this chart over time as the Elite membership numbers continue to grow. As it’s a new effort, the company has only managed to convert about 1% of their discount members into the paid membership program. The primary factor for how many of their customers convert to Elite will be how appealing the company makes the program. The more products they make available for Elite level discounts, the more customers the Elite program will attract.

The entire reason I was originally drawn to following the company two years ago was its Data Analytics Services. Since all of these companies are competing for the same customer base, I view them from a Game Theory perspective. Because it collects metadata on purchasing habits, High Tide has a more complete picture of all the public and hidden variables that constitute Game State. Their competitors recognize this information gap and are paying for data as an attempt to mitigate it. When they pay to reduce the information edge, they produce a financial edge.

Cabanalytics data sales were $4.8M USD for Q1 2023, representing a 3% rise over the previous quarter and a 28% rise over Q1 2022. Selling data to competitors currently represents 5.58% of total revenue, and it’s one of their best edges.

Valuation

With a market cap of $88.51M and Q1’s quarterly revenue of $85.76M, this company is currently trading at a P/S ratio of 0.258x. This company is more than just its brick and mortar operations. It has multiple high margin revenue streams and continues to collect more. Over a long time frame I expect operating margins to end up in the 15-20% range with net margins in the 5-10% range. This is unusually high for a retailer and should translate to this company trading with a P/S ratio of 1.5x to 2.5x.

The cannabis industry is cyclical and occasionally abandons rational valuations based on things like net profits or cash flow. Near the heights of the last sector wide euphoric rally, this company was trading with P/S ratios in the 10x-12x range. The last rally was the result of Biden getting elected. He had made campaign promises about cannabis, and it was driven entirely by hope. It’s fair to assume that a change in how the United States treats cannabis on a federal level will result in a rally of similar, if not greater strength.

The company has grown significantly since February and March of 2021, if a rally of comparable strength were to happen tomorrow, today’s P/S ratio of 0.258x translates to a share price of $4.49 at a P/S of 1x, and $44.94 and $53.95 at P/S ratios of 10x and 12x.

I wouldn’t even be looking at them as possibilities, if P/S ratios like this hadn’t already materialized. If these numbers seem a little high for you, I again have to emphasize that the cannabis industry has a history of hype driven rallies that do not care about fundamentals.

More realistic price targets would assume no euphoric rally occurs and so would be based off of revenue growth and a margin expansion. If you look back at old quarterly reports the company was able to achieve operating margins of 7.22% and 5.35%; and net margins of 5.35% and 16.11%. The company has achieved better economies of scale and additional high margin income streams since then, so a net margin of 5% should eventually be possible again.

Assuming the company manages to achieve a net margin of 5%, it should be trading at a P/S of around 1x. Using my previously estimated minimum 25% YoY revenue growth, a fair value estimate for a year from now comes out to $5.61 per share.

It is more likely that the company instead takes a full two years to reach a 5% net margin. If they continue to grow revenue the second year by 25%, then a fair value estimate for two years from now comes out to $7.01 per share. Both of these estimates assume zero new store openings, zero dilution, and don’t account for factors such as very high or very low perceived future growth.

After two quarters of post-pivot operations, we will have a more clear picture of the new dilution rate, and the new revenue growth rate. During the recent Q1 earnings call, they made it clear they still expect to open between 10 and 20 stores by the end of the year. In order to maximize valuation appreciation, dilution has to fall off to almost zero, so a majority of those 10 to 20 stores have to be paid for with cash and not shares. Several quarters with little or no dilution will destroy the narrative that it’s out of control.

Risks

If the company decides to improve margins by raising prices across the board, then they risk losing their impressive same store sales growth numbers. The rate they draw in new customers will diminish. If price raises are significant enough, they will begin losing some of their already established customers.

The planned margin expansion might fail to meet financial goals or take longer than expected. Judging by comments the company has made both in the past and during the Q1 earnings call, they plan on increasing the number of white label products they have available and will continue expanding their high margin revenue streams. They are also planning on lowering their relative cost of revenue and operating expenses through consolidation. High Tide has been rapidly expanding its brick and mortar footprint while buying subsidiaries; this has left them in a situation where they have operational efficiency improvements available to them. I am confident they will be able to pull off a margin expansion, but I still have questions about how effective it will be and how quickly it will play out.

Because High Tide refuses to produce its own cannabis, they have also removed themselves from the risk of production. Because this company sells cannabis as a loss leader, they put a downward pressure on its price. Their discount model is enhancing the financial suffering of all of their competitors. They have the tools to actually thrive during price wars. This is the single most powerful competitive edge a cannabis company can have, so if High Tide ever decides to start producing cannabis they lose it.

Catalysts

As most of the cannabis sector is not profitable, overall market sentiment has soured and valuations are low across the industry. The market sentiment is so sour on cannabis companies that I suspect this company to have to post a second consecutive net income positive quarter before markets will truly believe the first one. However long it takes, when the public perception on net income changes, I expect a significant improvement in valuation.

It’s not exactly right around the corner but it looks like Germany will be opening up as a new market for High Tide. The company plans on opening stores there under the name High Street and within a year of beginning operations, the efficacy of coupling high margin accessories with cannabis as a loss leader will be proven in a second market.

As per the request from Biden on Oct 6th, there is a major announcement coming from the DHHS about the rescheduling of cannabis. When news of this announcement hits, it is almost certainly going to cause yet another sector wide rally. This could happen as early as tomorrow, but it’s politically motivated so I expect the DHHS to announce their findings before the 2024 election.

The longer the United States drags its feet on full recreational legalization, the better it will be for High Tide. Currently, the company is focusing on honing operations in Canada and preparing for an expansion into Germany. The more time they have to grow and mature before an expansion into the United States, the better armed the company will be when the time comes to go fight another price war.

Conclusion

I always knew that doubling revenue every year was unsustainable and that growth would follow a logistic curve instead of an exponential one, but I wasn’t expecting this pivot to be announced until near the end of this year. The changing market environment has forced management to adjust their plan and move the pivot closer.

When I examine a sector I look for companies with high quality edges. Over the long run I expect their edges to lead to better financials, and for those improving financials to lead to rises in share price. This company has a disruptive business model, is extremely undervalued, and just announced they are planning on experiencing EPS rises in the near future. I believe High Tide stock could be a multibagger, and is worth the risk.

I am currently picking up HITI shares and call options. I am also buying LEAPS calls on several of the cannabis ETFs and a couple of the U.S. based MSOs with the best margins. Since this company is so competitive, I am planning on selling all of the calls at the top of the next major sector rally, and holding on to my shares of HITI for the long term.

Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.