NVACF - Nova Cannabis Is Sailing Against The Wind

2023-03-31 11:27:42 ET

Summary

• Nova Cannabis recently entered into a license agreement that helped its balance sheet but saddles it with significant fees.
• 14.3 million shares of Nova Cannabis, held by SNDL, were returned to Nova for cancellation.
• The company had steadily improved operating and net margins for several quarters until this most.
• I rate Nova Cannabis as a Hold.

Thesis

Nova Cannabis ( NVACF ) has struggled to find profits in Canada's extremely competitive ecosystem. They experienced significant rises in revenue during most of 2021, but growth has been anemic since then. Although they have been improving margins for most of the last two years, their cash supply dwindled, and they took on debt.

In what I can only describe as an attempt to give the company breathing room, Nova recently entered into an agreement that solves some of their liquidity problems but replaces them with permanent headwinds. It is unclear if the company will be able to use its improved cash situation to grow margins. I am recommending a Hold for Nova Cannabis.

Company Background

Nova Cannabis is a Canadian retailer with 88 stores in Alberta, Saskatchewan, and Ontario . In December 2022, Nova and SNDL Inc. ( SNDL ) entered into a license agreement. Before I continue, I should note that all the dollar values are stated in USD unless otherwise noted.

Two of the terms of the agreement were extremely favorable. SNDL agreed to eliminate $11.05M in debt and offered a fresh $11.05M at a rate of Canadian prime plus 2.75% with a $7.37M expansion option. 14.3 million shares of Nova Cannabis already held by SNDL were returned to Nova for cancellation. Two of the terms were extremely unfavorable. A corporate service agreement was restructured between Nova and Alcanna, a subsidiary of SNDL. The new terms of the agreement have Nova pay Alcanna $1.47M CAD per year, after three years. The terms of the license agreement also have Nova pay SNDL between 5 and 15% of gross profit on a per store basis, with the most profitable stores being hit the hardest.

Long-Term Trends

The Canadian cannabis industry is projected to have a CAGR of 13.26% through 2027. Because of overproduction , the wholesale price of cannabis has been dropping in Canada since its legalization in 2018.

Financials

Nova Cannabis was able to grow revenue significantly through most of 2021, but growth has dropped significantly since then. With the exception of the most recent quarter, net income has been improving since Q2 2021.

As the company began rapidly increasing its revenue, it experienced a significant gross margin contraction. Gross margins bottomed in the first half of 2021 and have been slowly climbing since then. Net margins hit a bottom in Q2 of 2021 and then saw improvements until mid-2022. The company experienced a significant decline in both operating and net margins in the most recent quarter.

I also like to look at the relationship between float, cash, and revenue to see how their relationships have been playing out over time. One of the most important things to look at, is how well-growing companies are able to translate dilution into revenue growth. This revenue growth typically lags the dilution events.

Nova increased its share count from 12.9M to 57.2M. That 343% increase in share count was able to turn $10.6M in revenue into $45.23M, or 326% additional revenue. While this is not the best conversion rate, when compared to the rest of the sector, it's far from the worst. Nova had dwindling cash through 2021 and in mid-2022 entered into a loan agreement with SNDL. Since then, it has drawn on the loan to maintain liquidity.

Plotting total equity shows that it has been steadily dropping since the beginning of 2021. This is typical of companies that are not cash flow positive.

Valuation

As of March 29th, 2023, Nova Cannabis was trading at $0.54 per share and had a market capitalization of $29.43M. Based on the most recent quarterly report, it is trading at a price to sales ratio of 0.16x. Since the company has negative operating and net margins, markets are giving it a low valuation. I should be clear that I'm not trying to say the company is undervalued, just that the overall sentiment in the cannabis sector is sour and companies that aren't cash flow positive are being treated very poorly valuation-wise. If the company were able to achieve positive net margins, its valuation should improve significantly .

Risks

I am expecting Canada's cannabis ecosystem to become less competitive as competitors continue to drop out . However, it is possible that Canada becomes even more competitive over time and the price of cannabis continues lower.

Catalysts

The entire cannabis industry is anticipating another major rally once news of rescheduling is finally announced . I expect the United States based companies to experience significantly larger reactions than their Canadian counterparts, but Nova should also experience a significant rally.

Conclusions

The deal between Nova and SNDL isn't expected to be completed until May 2023. I am unclear if the 5-15% gross margins are already being collected or if the recent margin decline is being caused by other factors. If this present margin decline is unrelated, and the 5-15% licensing fees haven't kicked in yet, then Nova is facing a further margin decline.

This deal with SNDL has improved their balance sheet and given them extra cash. They were effectively able to use dilution to grow revenue in the past, and I am hoping to see them use the additional liquidity this deal grants them to perform an operational pivot toward positive operating and net margins.

Also, there were some unknowns here that are hard to for me to quantify because I don't have all the information. Since the core of this deal revolves around Nova putting SNDL products on their shelves, it's possible that this actually improves Nova's cost of revenue by more than the 5-15% hit they are taking on gross margins. This entire relationship might be less one-sided and more of a win-win than what it looks like on the surface.

All of these separate companies are competing for the same customer base and the deal Nova entered with SNDL helped their balance sheet in the short term but makes them inherently less competitive over the long term. I am currently on a quest to try and find the long-term winners in the cannabis sector. Nova is currently on the list because of its high gross margins. If their operating margins fail to improve, I will eventually have to take Nova Cannabis off of my list of cannabis companies that are worth watching.

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