2023-09-06 17:23:34 ET
Summary
- The Department of Health and Human Services has recommended moving cannabis from Schedule 1 to Schedule 3, boosting American cannabis companies.
- The New Cannabis Ventures Global Cannabis Stock Index rallied 21.7% during the week, while the NCV American Cannabis Operator Index soared 46.6%.
- Hydrofarm, a leading manufacturer and distributor of hydroponics equipment, saw its stock rise after the rescheduling news, but it is still down 24% for the year.
- I include a large position in my Beat the Global Cannabis Stock Index model portfolio.
There was very big news this week for cannabis investors. The Department of Health and Human Services has recommended that the DEA move cannabis from Schedule 1 to Schedule 3, a move that not only makes sense but that would also really help American cannabis companies. Of course, it's not a done deal yet, but the stocks soared on this news. The New Cannabis Ventures Global Cannabis Stock Index rallied 21.7% during the week, but it is still down 8.0% year-to-date. Looking at the American cannabis producers, the NCV American Cannabis Operator Index soared 46.6% during the week. It is now up 31.7% in Q3 so far and up 15.2% year-to-date.
I was concerned about the current state of the cannabis industry, but this could change the game if the rescheduling takes place as expected. Of course, it could take a while, and the DEA might move only to Schedule 2, which would be a disaster. I remain a bit cautious despite the stocks still appearing cheap because of the short-term run-up. One stock that I owned ahead of the announcement and to which I added afterwards is Hydrofarm ( HYFM ). I added to it at $1.02 on Wednesday, and then I reduced it at $1.28 on Thursday. It is currently 9.3% of my Beat the Global Cannabis Stock Index model portfolio that I share with subscribers of my investing group.
I like the idea of adding ancillary companies, like HYFM, after they lagged the big MSO rally. I think that if this goes through, it will be great for the MSOs, who are the customers of ancillary companies. If it doesn't go through as expected, well there is no 280E tax for ancillary companies. HYFM has some debt, but it is not due until 2028. It trades at a very low multiple to its tangible book value. In this piece, I discuss the company's operations and financials, look at the chart and assess its valuation.
What Hydrofarm Does
Hydrofarm went public in late 2020 on the NASDAQ at $20 per share, just ahead of the peak for cannabis stocks in February 2021. It stayed very high in price despite the market for cannabis stocks having peaked, and the company priced a secondary offering at $59 in late April of 2021. I had no interest at first due to the valuation after it ran up and the involvement of the Serruya family from 2017. That was a big red flag to me!
The company has been around for a long time, as it was founded in 1977. Based in California, it is a leading manufacturer and distributor of branded hydroponics equipment and supplies to growers, mainly of cannabis. Its operations are global, but mainly in North America. In 2022, the company generated 81% of revenue from the United States and the balance from Canada.
Near the end of 2022, the company described its revenue as about 2/3 from consumables like nutrients, grow media and supplies and 1/3 from durables like lighting and equipment. Its sales are mainly to specialty hydroponics retailers, but it also sells to lawn garden centers and commercial partners.
An odd constraint that the company faces due to borrowing from JPMorgan Chase Bank is that they can not sell their products directly to the cannabis industry customers. Instead, they must sell to retailing companies. This revolving loan of up to $75 million (currently limited to about $40 million) terminates currently in March 2024.
While it is not that current, the investor presentation from year-end can help readers learn more about the company.
The 2023 Results So Far
The company reported revenue of $63.1 million in Q2, up slightly sequentially but down 31% from a year ago. This was below what analysts had projected. At the same time, though, the operating loss of $9 million was much better than a year ago, when the company reported an operating loss of over $208 million. Even after excluding the one-time impairment charge a year ago, the operating loss was bigger at $18.6 million in 2022.
Adjusted EBITDA was reported at $2.5 million, ahead of expectations and much better than the -$6.8 million a year ago. The aspect that really excited me was that cash flow from operations was nearly $10 million. The company reported free cash flow (operating cash flow less capital expenditures) of $8.3 million, a big improvement from the -$10.6 million in Q1.
Looking at H1, revenue of $125.2 million was down 40%. The operating loss was $22.0 million, and adjusted EBITDA was $0.3 million, an improvement from the -$3.8 million in the first half of 2022.
The balance sheet has some debt, but its not due until 2028 for the most part. HYFM has total debt of $118.8 million and cash of $26.7 million. This cash should work, as the company is now generating free cash flow. The net debt of $92 million has declined from Q1 and from year-end.Tangible book value is about $36 million.
The Outlook
Ahead of the Q2 financials, 3 analysts were expecting revenue to fall in 2023 to $280 million and then to increase in 2024 to $307 million, according to Sentieo. They had projected adjusted EBITDA of $1 million in 2023 and $14 million in 2024.
Now, they expect revenue in 2023 to decline 31% to $236 million with adjusted EBITDA slightly positive at about zero. These numbers are worse than previously projected, though profitability is still expected to be a lot better than it was in 2022.
In 2024, analysts project Hydrofarm will grow revenue 2% to $241 million with adjusted EBITDA of $12 million, a 5% margin. In 2021, the company had an adjusted EBITDA margin of 9.8%, and the projected margin for 2024 is a little higher than the forecast ahead of the Q2 report.
For 2025, just two analysts are sharing an outlook. They expect revenue to increase 8% to $261 million with adjusted EBITDA expanding by 33% to $16 million. This would be a margin of 6.3%, still below the margin in 2021, when revenue peaked at $479 million.
The company provided guidance when it issued a press release for the Q2 results, and it is projecting 2023 revenue of $230-240 million with modestly positive adjusted EBITDA and positive free cash flow.
The Chart Looks Decent
The stock shot up initially, trading way above its $20 IPO price, peaking in early 2021 above $90:
Since the peak, it has been a total disaster! No wonder few seem to care much about HYFM. It has been flirting with delisting risk, as NASDAQ listing rules require the stock to trade above $1.
Looking at the recent action, the stock has a very high-volume sell-off to an all-time low in late June and appears to be in an upswing:
Even with the rally last week, the stock is still down 24% in 2023. With sentiment towards the sector improving, I sense that the stock could get back to its year-end price of $1.55 or perhaps higher. I see some resistance at $1.70. My target a year out, discussed below, is more than double this $1.70 level, but it would still be below the peak in August 2022 near $5.
HYFM Is Cheap
Hydrofarm is not the cheapest ancillary that I follow closely, but it is very attractively priced in my view. It is also part of the index that I am trying to beat. The share structure is pretty simple, and there are 47.9 million fully diluted in-the-money shares. Even if all of the warrants and options outstanding were to become exercised, the share-count would rise to only 48.6 million.
The company has a lot of debt, as I discussed above, but it trades at just 1.3X tangible book value. That debt is just debt and not convertible to equity. Still, the company could sell some stock in the next few years to reduce it.
Looking at projected adjusted EBITDA for 2024, the stock trades at an enterprise value of just 11.6X very depressed levels. A year out, I think it should hit 18X projected adjusted EBITDA a year out. Taking 67% of the 2025 estimate and 33% of the 2024 estimate, this would be $264 million. This works out to a price of $3.59, up 204% from the $1.18 close on 9/1.
While I am pretty bullish, there are many risks. The company does have a lot of net debt relative to its tangible equity, and if the cannabis market remains challenged, this could become a problem. It seems okay for now, but below $1 it could face delisting risk and need to reverse-split, an action that could turn off investors.
Conclusion
Hydrofarm has been very beaten up by investors as its business has declined. It has a lot of debt, but it is not due until 2028. If cannabis is rescheduled, its revenue could do even better than analysts currently project, as its customer base will be stronger. The big gains I envision would still leave the stock far below its IPO price and even further below its peak in 2021 above $90.
For further details see:
Beaten-Up Hydrofarm Stock Is Cheap And Could Increase Significantly