GLASF - Glass House Brands: At A Turning Point In The Company's History

2023-04-11 09:06:08 ET

Summary

• Expansion of Glass House's crown jewel greenhouse could lead to explosive cash flow generation in the next few years.
• The company has one of the lowest costs of production in the California market, which will provide it with the ability to navigate a downtrodden cannabis market.
• The stock has come down significantly, but its risk profile has improved markedly, and investors need to hear its story.

Company Overview

Glass House Brands ( OTC:GLASF ) is the largest cannabis cultivator in California, one of the biggest cannabis markets in the world. On the surface, Glass House looks like any other cannabis company out there… But it's not. Not by a long shot. Glass House started as a small grower/retailer in Santa Barbara, CA. The company's founders Kyle Kazan and Graham Farrar, stumbled upon an opportunity to set the company apart from every other commodity-like cannabis company in the US, maybe in the world.

Investment Thesis

I previously wrote up Glass House in this article . Feel free to read it, but here's a refresher.

The founder's opportunity came in the form of a 5 million square foot tomato hothouse built in the finest growing environment in America. The location has the most natural sunlight, the best average temperature, and access to water in the US. Glass House's founders were able to buy the facility for $93 million.

You could argue that bigger doesn't mean better, and you'd be right. Considering the finicky nature of cannabis makes it an expensive crop to grow. It needs optimal temperature and light to yield a consistent, scalable harvest. Those conditions come at a considerable cost to growers unless you get them largely for free from mother nature.

That is the case for Glass House's gigantic greenhouse. Greenhouses in colder northern states or Canada require extra heat and lighting due to their colder temperatures and lower average daylight throughout the year. Arid or humid climates in the South also require significant costs to control the growing environment and temperature. Therefore, Glass House can produce a pound of weed for significantly less than the average cost.

What's happened since then?

The market for cannabis in California has continued to suffer. CEO Kyle Kazan had this to say on the company's third-quarter 2022 earnings call :

The last two years have been challenging for the industry, and since the beginning of July 2022 alone the number of cultivation licenses in the state of California dropped by over 1,200, which we estimate is an 11.7 million square foot (or 13%) decrease in acreage under cultivation.

But transformational steps have been taken by management to advance Glass House's competitive position. With Phase I of the SoCal retrofit in the books, the company was able to continue bringing down the average cost of cultivation.

In just one quarter, we nearly matched the total amount of wholesale biomass we sold in all of calendar 2021, but even more remarkable is our cost structure. Despite a 21% sequential drop in cannabis flower prices, our costs fell to $134 per equivalent dry pound of production, enabling gross margin on our wholesale business to soar from 5% which excluded start-up costs in Q2 to 36% in Q3. This is precisely why we are so excited about this greenhouse; we are only operating at 20% capacity utilization of the entire farm in a market with falling sales pricing, and our gross margin is still almost 40%. Clearly we answered the 2 biggest questions we've heard since announcing the purchase of the massive facility, 'Can we grow high quality cannabis cost effectively to the extreme?' and 'Can we sell it all?' The answer is a resounding yes to both.

Glass House's first expansion phase, which included both cultivation and nursery to support the entire facility, has done wonders for its financial statements. Q4 revenue increased by 75% and surpassed guidance despite a weak market to set a record $32.2 million. Also, despite depressed retail and wholesale cannabis prices, Glass House increased its gross margin to 36%, its highest since Q2 21, when prices started falling.

The company's reduction in production cost to $127 per pound aided further gross margin improvement. During the Q4 call, management went on to prophesize that costs could come down to $110 per pound in the second half of 2023.

A look ahead

There has been some improvement in the California cannabis price recently, which management has incorporated in their 2023 guidance . For the year, Glass House expects to produce 310,000 pounds of biomass. That's a 62% increase over 2022, which included only two full quarters of Phase I production. For the year, management expects revenue to reach $160 million between wholesale, retail, and CPG.

Previously, Glass House's management team predicted that the company would be cash flow positive by Q3 2023. Due to price improvements in the California market, management has moved that prediction forward to Q2 2023. The forecast excludes cash spent on its next expansion.

With Phase I of the SoCal retrofit in the rearview mirror, the company is turning its attention to the next Phase. Announced on March 1, the expansion will include 1 million square feet of additional cultivation space capable of producing 250,000 pounds of cannabis annually. Management expects to begin cultivation by the end of 2023.

What could GLASF look like when Phase II is complete?

Looking ahead to 2024, when the current expansion is completed, Glass House should have the capacity to grow well over 500,000 pounds of cannabis annually. At which point, Glass House will still only have roughly half of its greenhouse fully producing. At Glass House's projected (and depressed) selling price of $300 per pound and $110 per pound cost, the company could generate over $100 million in gross margin.

The question that remains for the company is: How do you get there?

We estimate that it will cost approximately $10 million to fund this expansion. And we are considering a number of options to fund it, given the scale of the expansion and the margins that SoCal Farm is producing, we expect to be able to complete the funding rapidly with little to no dilution to common shareholders and to pay the funds back quickly.

Risks

• Last year, Glass House did multiple funding rounds. Its Series B preferred generated $50 million but came with a hefty 20% interest for two years, 22.5% for the third year, and 25% until the 54-month anniversary. After that, the Series B Preferred will pay 20%. The proceeds were used to pay off a bridge loan, Series A Preferred, and to fund working capital. Each $1,000 Preferred came with 200 five-year warrants exercisable at $5. An add-on Series C tranche added another $4.7 million of capital. The terms of the Series C tranche were the same as the Series B, except for its junior ranking. Altogether, that adds about $11 million in preferred dividends annually. That's a tough pill to swallow.
• Glass House exited 2022 with $14.1 million in cash in the bank. The cash will fund losses until it presumably becomes sustainably cash flow positive in the second quarter. If those projections are off, a cash crunch could ensue. A recent recovery in cannabis prices in California should relieve some of that pressure.
• The price tag for the expansion is about $10 million and will require financing, but Kazan believes crippling financing won't be an issue considering the success of the first phase. Even so, I don't expect the financing to be cheap. But if the funds are repaid quickly, as Kazan anticipates, that would imply the company could generate enough cash to pay for the completion of the entire retrofit without further financing.
• Of course, these predictions could be overly optimistic, especially if weed prices remain depressed.

Catalysts

In the long run, cannabis prices will swing like any other commodity. However, with many California cultivators closing up shop and leaving supply limited, Glass House sold 47% of its February flower for over $600 per pound . That's up from an average selling price of $236 in Q4 22. If that price proves to be somewhat sustainable throughout the year, Glass House is in for a banner year.

On the other side of this thing, assuming the company's capital structure isn't too damning is an extraordinary upside.

• Upon completion of the entire SoCal retrofit, Glass House should have the capacity to grow roughly 1 million 1.5 million pounds of cannabis per year.
• Though it might be several years before we see legalization or cross-border cannabis sales, these things will provide enormous tailwinds for Glass House.
• As these things materialize and states open up cannabis licenses, the illicit market should subside and boost the legal cannabis scene and stability in its prices. However, that could be many years from now.

In the near term, the crushing environment for Glass House's cultivator competitors has produced a limited-supply environment for cannabis in California. Lower supply could provide a tailwind for cannabis prices for 2023, as it did in February at a pivotal time for the company.

Valuation

At this point, the amount of capital Glass House needs to get to where it can fund the business's growth with internally generated cash is much less than it was a year or two ago. The stock price has come down since my last article, and though it's not out of the weeds yet (pun intended), the risks are much more tolerable, and a turning point for the company is seemingly only a quarter or two away.

The building is 5.5 million square feet, and the founders paid $ 93 million . The economic book value of the cultivation assets (including its preexisting greenhouse) is reduced by the Preferred shares and other encumbrances. But the return Glass House can produce with the assets is what will make the investment click.

Bear Case

Due to its low cost of production, Kazan's estimated free cash flow positive estimation is achievable, in my opinion. If prices continue to languish around $275 per pound, it has in 2022 and most of 2021, Glass House can still make money on a gross basis. After biting the bullet to fund Phase I, production should proliferate to over 500,000 pounds per year in 2023.

If cannabis prices trend downward, though, it could threaten the company's ability to move forward with its expansion plans without raising crippling capital. In that case, management could delay expansion until a more favorable cannabis market emerges.

Bull Case

Producing 1 to 1.5 million pounds at the mid-February price of $675 per pound and $100 per pound production cost, Glass House can generate gross margins of $575 million and $863 million. If that's the case, the $11 million annual preferred payment looks almost non-material.

Conclusion

The stock doesn't come without risk, but those risks are fewer than in the last couple of years. Now the stock is down, and investors can buy at a much more attractive price than in the past. I think the company can navigate its Phase II expansion later this year. If they can, Glass House will be in a position to dominate the cannabis market in California and someday become the crown jewel of US cannabis cultivation. The long-term risk-reward trade-off here is in favor of today's investors.

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