2023-05-10 13:53:40 ET
Summary
- Vice products such as alcohol, tobacco, and cannabis are less affected by economic slowdowns.
- The cannabis market is expected to grow at a rate of 14% annually, reaching $81.32 billion USD in 2026.
- The American market constitutes nearly 70% of the total cannabis market.
- SNDL is the fastest-growing stock, has one of the healthiest balance sheets, and trades way below its tangible book value.
Thesis
SNDL Inc. ( SNDL ) is the highest-growing stock, with one of the healthiest balance sheets in the yet unprofitable cannabis industry. I believe this industry is a good option during a recession due to its potential ability to withstand economic downturns and its comparatively low valuation.
With the economic activity slowing down, as seen in the real GDP growth rate dropping to 1.1% annual rate in Q1 2023 from 2.6% in the previous quarter; we might be moving closer toward a recession.
Investors who are considering Consumer Staples Select Sector SPDR Fund ( XLP ), an ETF that tracks the consumer staples sector, should be aware that it is already trading at a high P/E ratio multiple of 26. Another viable option, as previously mentioned, is the cannabis industry. It currently trades at a low valuation despite growing at 14% (5Y CAGR). This growth rate is likely to increase further in the future due to the anticipated federal legalization in the United States and some legalization in Europe.
However, investors should also be aware of the challenges facing the industry, such as the struggle for profitability due to the unreasonable excise tax regime in Canada, increased competition, and the still-existing black market. In addition, the industry is highly leveraged in hopes of entering the American market, which accounts for approximately 70% of the total cannabis market.
SNDL, not only covers the yet unprofitable canopy market but also the liquor market that thrives during the recession. I believe that this stock is heavily undervalued, even among the already discounted cannabis industry. Therefore, I recommend buying this stock, with an estimated valuation of $3.84 USD, which might be reached after the Canadian excise tax reform or the federal legalization of cannabis in the United States.
Recession resilient
Vice products such as alcohol, tobacco, and cannabis have addictive qualities that give businesses stronger pricing power and make them less affected by economic slowdowns. For example, during the Great Recession, alcohol sales grew by 9% and Altria Group, Inc. ( MO ) saw a top-line expansion of 3.4%, indicating that people tend to purchase more of these products during a worsening economic environment, such as high unemployment. The strong pricing power is demonstrated by Altria’s cigarette shipping volumes steadily declining from 2012, while the top-line continued to grow since 2014. The addictive qualities of these products enable companies to pass along higher costs to the customer.
The National Institute on Drug Abuse reports that up to 30% of cannabis users develop marijuana disorder, which qualifies cannabis as a vice product. So why take a chance on the cannabis market when there are other viable options such as tobacco and alcohol? Table 1 shows that the cannabis market is actually the most attractive option with a high 5Y CAGR of 14%, trading at a low valuation, and a positive outlook on the regulatory environment. Although the cannabis market is relatively new, the fact that humans have been using marijuana for over 5000 years proves that there has always been and will continue to be a demand for cannabis.
Market | Valuation | 5Y Industry CAGR | Regulatory outlook |
Alcoholic beverages | Neutral | ||
Tobacco | Negative | ||
Cannabis | Positive |
Table 1
Business Overview
I currently view SNDL as a liquor company that is valued as a cannabis business due to its main source of revenue coming from that segment. To maintain a strong balance sheet, SNDL has diversified itself from the unprofitable cannabis industry. Nevertheless, it plans to become a significant player in the Canadian cannabis industry through vertical integration. Instead of using a common industry strategy of acquiring U.S. cannabis businesses and burning cash, SNDL is gaining exposure to the U.S. market by lending money to cannabis companies located in that region. I believe this strategy is a better alternative because it also can lead to acquisition through the equitization process explained in the Investment segment below. SNDL operates within four segments: Liquor retail, Cannabis retail, Cannabis operations, and Investments, further discussed below.
Segments
The most crucial factor in the success of the cannabis business is financing and expansion of the retail footprint. I believe the Liquor Retail segment to be a huge benefactor to the still-developing cannabis segments. The liquor division was created after the acquisition of Alcanna in March 2022. It consists of four brands, Wine and Beyond, Liquor Depot, and Ace Liquor Discounter. SNDL plans to expand its retail presence to grow revenue and build out its distribution network, which can be used for its cannabis business. Liquor contributed 62% to the company’s top line, growing 5% (Q4) quarter-over-quarter, as shown in Table 2.
In order to capture more market share, the company offers both premium and low-cost cannabis products in its Cannabis Retail segment. What I appreciate is that the company places importance on collecting consumer data and insights. I believe this approach helps the company to capture more market share in the future, and become a knowledgeable player in the industry. This segment made up 28% of total sales in 2022, growing almost 13 times its size since 2021. This growth was largely driven by the Zenabis acquisition in November 2022 and the Alcanna (Liquor segment) acquisition, which had a majority stake in Nova Cannabis (63%). The segment expanded by 3% (Q4) quarter-over-quarter, as shown in Table 2.
The company established the Cannabis Operations segment to become a leading third-party manufacturer (a part of the vertical integration plan), scale its operations, and be more responsive to fluctuations in demand. SNDL is already a preferred partner of 21 licensed producers (LPs) in Canada. The recent acquisition of The Valens Company , which develops laboratory-graded cannabis products, further strengthens the company’s vertical positioning within the industry. The company anticipates achieving 20 million CAD cost synergies from this acquisition. The division’s sales grew by 529% year-over-year, primarily due to the acquisition. Furthermore, the segment grew by 19% (Q4) quarter-over-quarter, as illustrated in Table 2.
To take advantage of the undervalued and cash-restricted cannabis industry, SNDL plans to enter the U.S. market by using the equitization process through its Investments segment. This strategy involves swapping debt for equity and aims to partially or fully privatize a business. SNDL's Investments segment is a 50/50 joint venture named SunStream between SNDL and SAF Opportunities LP, a private equity firm based in Calgary, Canada. The segment aims to invest in high-yield debt in U.S.-based cannabis businesses. The portfolio has a value of 638.4 million CAD and consists of six investments in Jushi, Skymint, Ascend, Parallel, Columbia Care, and AFC Gamma. These investments have a forecasted yield of approximately 11% of performing credits. Skymint and Parallel, both located in the U.S., have the potential for equitization. SNDL's equitization plans are depicted in Figure 1, which shows a potential increase in retail cannabis stores by 74 and an estimated 40% revenue growth. However, the company reported unrealized losses of 65 million CAD in 2022, up from 44.5 million in 2021, despite the interest and fee revenue increasing by 27% year-over-year in 2022.
Figure 1, Equitized portfolio (SNDL.com)
In (000's) CAD | 2022 | 2021 | YoY | Q4 | Q3 | QoQ |
Liquor retail | 462,180 | - | - | 159,700 | 152,488 | 5% |
Cannabis retail | 205,610 | 16,091 | 1178% | 68,400 | 66,202 | 3% |
Cannabis operations | 61,904 | 9,842 | 529% | 14,053 | 11,810 | 19% |
Investments | 16,739 | 13,149 | 27% | 6,000 | 4,312 | 39% |
Total | 746,433 | 39,082 | 248,153 | 234,812 | 17% |
Table 2
Growth
Over the past three years, SNDL’s annualized revenue has grown by 127%, which is significantly higher than the industry’s growth rate of 36%, as shown in Figure 2. The primary driver of this growth has been the acquisition of Alcanna in March 2022, which now makes up the liquor segment of the company. SNDL currently holds a 7% market share, up from 1% in 2021, marking a 6-percentage points increase that is the largest in the industry. Despite the strong growth, the company closed the year with a net loss of 372 million CAD, up from 226 million due to costs linked to acquisitions. In my opinion, the company's growth will eventually level off but still surpass the industry average, thanks to its robust liquor segment.
Health
SNDL's balance sheet is one of the healthiest in the industry, with a current ratio of 5.61 and a debt/equity ratio of 12.79, both surpassing industry averages of 3.33 and 49.64, respectively (see Figure 2). Given the current macroeconomic environment of high-interest rates, the industry's high leverage is unsustainable, which could lead to companies being acquired. SNDL financed its acquisitions with equity, increasing outstanding shares from 0.13B (2020) to 2.04B (2021). However, the company reduced outstanding shares to 0.23B (2022), indicating its commitment to preserving shareholder value rather than sacrificing it for a strong balance sheet.
Multiple
SNDL currently trades at a lower EV/Revenue multiple of 0.36, compared to the industry average of 1.50, as shown in Figure 2. Moreover, the company's tangible book value ((TBV)) is worth at least twice the share price, with $3.97 USD ((TBV)) versus the share price of $1.49 USD, providing investors with a potential gain of 166% in the event of liquidation. Despite researching, I could not find any reasons for the company to trade at a lower multiple than its peers. Hence, I believe SNDL to be significantly undervalued.
Figure 2, Cannabis industry by market cap (Author's calculations)
Industry Outlook
The cannabis market is expected to grow at a rate of 14% annually, reaching $81.32 billion USD in 2026. This growth is primarily driven by the recreational segment, as shown in Table 3 . The American market constitutes nearly 70% of the total market and is expected to grow by 13% each year, also driven by the recreational segment. Therefore, it is crucial for a company to enter the American market and serve the recreational segment, which SNDL is well-positioned to do. While the Canadian market makes up only about 8% of the total cannabis market, it is projected to grow faster, with a growth rate of 15%, attributable to recreational cannabis. Finally, Europe is expected to experience the fastest growth, with a rate of 16% per year, primarily due to the therapeutic cannabis segment, although I believe this might change in the future as cannabis gains broader regulatory acceptance in that region for recreational use.
In $ (bn) | ||||
Market | 2022 | 2026 | 5Y CAGR | Driver |
Worldwide | 41.59 | 81.32 | 14% | 50% Recreational |
U.S | 28.28 | 53.13 | 13% | 50% Recreational |
Canada | 3.08 | 6.32 | 15% | 75% Recreational |
Europe | 6.53 | 13.73 | 16% | 80% Therapeutic Cannabis |
U.S | 68% | 65% |
Table 3
Valuation
As previously mentioned, I believe the stock to be considerably undervalued with an upside potential of 148%, which would bring it to $3.84 USD. This valuation is reasonable as it is slightly below the tangible book value of $3.97 USD. To arrive at this valuation, I used the industry average EV/Revenue multiple of 1.50 as the highest value and the latest company multiple of 0.36 as the lowest value. I also factored in the 52-week high-low share price range of $4.95-$1.29 to normalize the valuation. Additionally, analyst projections ($5.95 high/$3.22 low) were taken into account to add credibility to the final valuation, as shown in Figure 3.
Figure 3, Football field valuation (Author's calculations)
Catalysts
1. The cannabis industry has been pushing for a reform of the federal excise tax rate for years, citing that the current tax rate ends up as high as 30% or more of their revenue. The excise tax is currently set at 1.0 CAD per gram or 10% of the sale, whichever is higher. Another problem with the excise taxes of the cannabis industry is the government’s inaction on the collection of these taxes. Zachary George, the CEO of SNDL, believes that this inaction subsidized the cannabis price compression.
2. The SAFE Banking Act allows financial enterprises to provide services to legitimate cannabis businesses without being penalized. The passing of this bill will improve the industry’s balance sheet by providing more borrowing opportunities and enabling the flexibility of depositing capital within American banks with less scrutiny.
3. Marijuana Opportunity Reinvestment and Expungement Act , The cannabis industry eagerly anticipates a bill that would legalize the manufacturing, distribution, and possession of marijuana on a federal level. This bill will unlock ~70% of the total addressable market, which is what Canadian cannabis enterprises are waiting for. Once passed, the companies that are well-positioned for the American market, such as SNDL, will experience a significant boost to their revenue, and move towards profitability.
Risks
1. Race to the bottom continues
Legitimate cannabis businesses are struggling to turn a profit because of two factors: high excise taxes and competition from the illicit market. The average price of cannabis has decreased significantly, going from $11.78 per gram in 2019 to $7.50 in 2021. To compete with the black market, which sells marijuana at a discount, the cannabis industry has had to reduce its margins. Unfortunately, the illicit market still makes up 33% of the Canadian cannabis market. Unless there is a reform of the excise tax or a greater crackdown on the black market (which is unlikely), the industry will continue to struggle and operate at a loss due to decreasing cannabis prices.
2. Incapable of entering the U.S market
If SNDL is unable to break into the U.S. market, it will be disastrous for the company. The business will continue to be unprofitable while its competitors who have succeeded in capturing the U.S. market share will experience a boost in revenue and move towards profitability. As a result, SNDL will remain undervalued and begin to fall behind its competitors. This could lead to obsolescence and make it vulnerable to takeovers.
Conclusion
SNDL is a rapidly growing liquor and cannabis company in Canada. It sets itself apart from its peers with its strong balance sheet, the low valuation multiple, and its interesting plan to enter the U.S. market by equitization. Both cannabis and alcohol products are less affected by economic downturns. The cannabis industry is experiencing fast growth, with approximately 70% of the market located in the U.S. I value the stock at $3.84 USD, which is just below its tangible book value of $3.97 USD. I believe the stock will reach its valuation once excise tax reform for the cannabis industry is implemented in Canada, or marijuana is federally legalized in the United States.
For further details see:
SNDL Is The Best Pick In The Cannabis Industry