GLASF - Mindset Value Wellness Fund Q1 2023 Investor Letter

2023-05-04 22:00:00 ET

Summary

• Mindset Value Fund's Aaron Edelheit is passionate about introducing interesting money managers, executives and startups that no one has heard of. His background includes investing professionally for over 25 years and starting and running the American Home.
• The Mindset Value Wellness Fund finished the first quarter up 11.7%.
• Thanks to our diverse investments in convertibles, preferred equity, and common stocks, we are earning over a 7% annual yield.

The Mindset Value Wellness Fund finished the first quarter up 11.7%.

A Timely Reminder as to Why We Are Invested in Cannabis

Most cannabis stocks have been crushed. Funds are shutting down; analysts are leaving, and assets are fleeing the sector. And yet I think it is helpful to remember why being invested in the industry is so compelling.

Cannabis is an industry that does about $100 billion in revenue and with the medicinal applications of cannabis could be on its way to $200 billion. Thanks to the conflict between Federal and State regulations, 99% of the smartest financial people in the world are not involved in the industry and thus there is no competition to research or to do due diligence. In short, competition is low for investors, so your odds of producing alpha (outperformance) is quite high.

I was recently interviewed by AlphaSense about why I continue to believe the opportunity in cannabis is so extraordinary. You can find that interview here .

Growing Cannabis at Scale Consistently is Really Hard

But what are the implications if 99% of the smartest people in the financial world aren’t involved in cannabis? To me, it means there is almost no due diligence, or at best poorly done research, very little efficiency, and broad misunderstandings about how the industry functions. Please note that I haven’t been immune to those mistakes or misunderstandings, but I continue to learn and apply those lessons to course correct when necessary.

How poorly understood is the cannabis industry? One great example is the common view that growing cannabis is quite easy. There are many smart individuals and investors who have not done much in the way of research who believe that it is easy to grow cannabis and thus there is no value in cultivating cannabis and therefore prices will continue to fall or remain low and so all cannabis businesses must be inherently worthless. In other words, why waste the time on a low margin commodity business?

I recently wrote a whole post about the big myth of cannabis . Here is some of what I wrote:

It turns out that cannabis is a very sensitive plant mainly due to the fact that the cannabis bud or flower has no real protection. Graham Farrar, the President of Glass House ( GLASF ), told me that you need to imagine that you are “growing an apple without the skin to protect the fruit.”

That leaves it vulnerable to mold and pests. My bet is that most investors have no idea that large cannabis farms employ “spotters.” These are employees who are trained to look for mold and pests and are constantly checking to make sure any infected plant is immediately removed, and any infestation of pests is mitigated. Pests like aphids and others can quickly spread. Ever notice how in a lot of grow facilities, employees are wearing full protective gear? That’s not to protect them, it is to protect the plants.

Then there is the consumer and their ever-changing tastes and desire to have new strains and new experiences. Investors and outside observers may have heard about the need to have the latest genetics and strains. It turns out that high-quality cannabis is very much like fast fashion. You must stay up to date on consumer preferences and the latest and most desired strains, or your flower will not sell.

Obie Strickler, the CEO of Grown Rogue ( GRUSF ), has bi-weekly meetings with his cultivation and sales teams to make sure they are growing the most desired strains and to make sure they don’t lose sight of what consumers want right now.

Another argument used when saying cannabis is easy to grow is that it is like broccoli or any other agriculture commodity. Could you imagine asking your friends if they had tried the latest strain of broccoli that just came out?

I can just hear the conversations: “That Cookies and Cream broccoli is lit yo!” Again, investors reveal a lot of ignorance when they don’t even understand how important it is to stay on top of the latest genetic trends.

Now imagine you are trying to stay on top of different strains in different grow facilities in different states while turning harvests 4-5 times a year, all the while trying to avoid pests and mold.

Then after you grow it, there is trimming and drying and storage. And one strain may need different drying, humidity, and temperature conditions than another for the best yields and results.

This is why most cannabis farming is done in an indoor industrial setting. It is also why indoor flower prices are often three times what outdoor prices are. You need to tightly control the environment with cannabis, or you could be screwed.

Our fund’s focus is on those companies that are solving the biggest problem in cannabis: how do you grow consistent quality cannabis flower at the lowest possible price, at scale? We believe that for brands to thrive, you need consistency, you need cost efficiencies, and you need scale. And this explains our intense focus on Glass House.

Glass House’s Competitive Advantages on Full Display

Lowell Farms ( LOWLF ) operates a 250,000 square foot greenhouse in Monterey County in California. For fiscal 2022, it reported this number: Gross profit for the year was negative 4.2%.

In fact, it’s worse than that because in Q4, the company earned $9.3 million in revenue, but $12.3 million in COGS, for a gross margin of -32%.

Lowell Farms’ stock currently trades for around 4 cents a share.

Why should we care about Lowell Farms’ results? Because it illustrates perfectly the durable competitive advantages that Glass House and its state-of-the-art unicorn of a greenhouse possesses over every other greenhouse or outdoor producer in California.

Glass House reported a 32% overall gross margin in Q4, but more importantly, Glass House reported a 43% wholesale gross margin, which represents its greenhouse flower production. It’s simply incredible watching one company produce a negative 32% gross margin and another produce a 43% gross margin in the same quarter supposedly doing very similar things with what are reported to be similar assets.

As an analyst, it’s one thing to do the due diligence and hear competitors call Glass House’s greenhouse “the Ferrari” of greenhouses and to be able to dive into the numerous advantages which include:

1. Ebb and flood floors that allow for more efficient water use and lowers mold risk.
2. Bigger boiler capacity which leads to a better heat canopy over the plant.
3. Taller Dutch style ceilings that allow for better environment control.
4. CO2 that flows in one direction that allows better control for pests.
5. The perfect climate of Ventura County.
6. A water filtration system that would make a small city proud.
7. Onsite natural gas cogeneration that allows Glass House to buy natural gas at half the price of others.

But it is another to see the advantages that you have confirmed with research in cold, raw numbers when comparing Glass House to Lowell Farms.

And now Glass House wants to press its advantage and expand while others are in full retreat. In a March press release and their quarterly earnings call, management revealed that they are working on turning on an additional greenhouse of one million square feet that would add 250,000 pounds of production. It will cost approximately $10 million of additional capex and working capital to turn on this next phase. But at conservative pricing assumptions, this expansion would pump out an additional $30 million in EBITDA.

Now that is one hell of an IRR on additional capital. And this is where Glass House’s flywheel starts turning. They have a cost advantage in production and now that they have demonstrated it, they are going to start turning on the other 80% of their Ventura facility, one greenhouse at a time. And their costs will continue to go down and thus their competitive advantage will only increase as time goes on.

Warren Buffett and Charlie Munger like to talk about the difference between two copper producers, one whose cost to produce are $1.50 a pound and another whose cost is $2.50 a pound. When the price of copper is $2 a pound, it is as if these two producers are in different industries. Right now, Glass House is operating as if it is in a different industry than its California competitors.

Grown Rogue Might be Trading at an Estimated 2 times 2024 EBITDA

Grown Rogue ( GRUSF ) is one of the most efficient indoor craft cannabis cultivators in the U.S., if not the world. My research shows that it is operational excellence that is in short supply, not limited licenses and that is what Grown Rogue has mastered and it gives it a competitive advantage over other indoor producers.

We invested in the company through a convertible debt deal that pays us 9% annual interest but allows us to convert into approximately 6% of the company.

That interest rate doesn’t seem high until you remember that Grown Rogue produces something quite rare in cannabis: free cash flow. And not only that, but it also produces that free cash flow in both Oregon and Michigan despite fierce competition and low cannabis prices. And the company has been growing at more than 25% a year and doing so at prices that are driving larger companies out.

And now the company is working on entering other limited license markets, where pricing is much higher, and quality is much lower. I believe that if Grown Rogue can enter a few new markets, the company might be trading at TWO times estimated 2024 EBITDA. What other industry can we invest in a fast-growing company with durable cost advantages that generates free cash flow in an exciting growth market, get paid 9% interest and have the option to convert into the company at two times EBITDA? Even if the company can’t enter those markets, it still trades at four times my estimated EBITDA for this year.

This is why I’m so focused on the sector and why I love that so few other investors are participating. As an investor, all I must do is patiently wait as these companies execute and in Grown Rogue’s case get paid while I wait.

Summary

We are already having a better start to the year than we had last year, and I believe our companies should continue to not only grow but expand their competitive advantages. And while we wait, thanks to our diverse investments in convertibles, preferred equity, and common stocks, we are earning over a 7% annual yield.

Thank you for your support and trust and if you have any questions or comments, please feel free to reach out to me.

Sincerely,

Aaron M. Edelheit

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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