Analyst: This Cannabis Stock Is Undervalued, Trades At 'Steep Discount To US Retail Staple Peers'

The Analyst

Pablo Zuanic, analyst at Cantor Fitzgerald, initiated coverage of Fire & Flower Holdings Corp. FAF FFLWF with an Overweight rating and a 12-month price target of C$1.30 ($1.04).

The Thesis

“We see an opportunity with Canada’s largest cannabis retail chains (operating in a market that we project will potentially double to $8 billion by 2024), as these stocks are undervalued vs. domestic producers (1-2x CY22E sales vs. 5-15x), in our view, and trade at a steep discount to U.S. retail staple peers on a growth-adjusted basis (operating in rather matured industries, those trade at 1x),” Zuanic said, in a recent analyst note.

The analyst noted that the retail segment remains fragmented, in addition to a crowded market with decreasing margins. A situation that “will likely lead to consolidation (M&A, attrition).”

Zuanic highlighted that there is an opportunity for Fire & Flower as Canada’s recreational cannabis market is on track to reach an estimate of $4 billion in sales in 2021 and $8 billion by 2024. Retailers in the major provinces operate as standalone entities in a three-tier system (where private producers and centralized state-owned wholesalers cannot own retail). He considered that this sector “is ripe for consolidation” and added that “as more provinces allow retailers to offer home delivery, the actual addressable market for retailers has expanded. On paper, a retailer with 15% national share by 2024E could be generating sales of $1.2 billion.”

About July Quarter Results

Total sales of $43 million were up 51% YoY, but down 2% sequentially, with retail (74% of net revenues) down 5%. Net wholesale went up 2% sequentially (18% of the revenue mix), and the digital development line (8% of sales) was up 29% sequentially and 293% YoY. Gross margins of 37.3% were stable quarter-to-quarter, up from 34.8% a year ago, mostly helped by the high margins in the digital business, which helped offset retail margin pressure. 

Management said retail sales were impacted by pricing pressures due to “an unprecedented number of licenses being issued in Ontario, and also by aggressive pricing strategies by deep-discount retailers.

Although pricing/affordability remain key factors overall; (the illicit market still represents approximately 40% of Canada’s cannabis usage, and, according to Ontario Cannabis Store, 70% of Canadian consumers are “extremely price-sensitive”), FAF's management believes in a “value strategy” that is different from category discounting.

The company launched a value range for its customers in the Fire & Flower stores, besides its more value-oriented Happy Dayz retail banner, noted Zuanic.

Management highlights five “growth pillars”:

a) monetize the Hifyre proprietary data and retail analytics platform;

b) expand the U.S. entry ahead of federal permissibility;

c) continue to grow the Spark Perks loyalty program organically and through the 250,000 subscribers of Wikileaf and PotGuide;

d) continue to expand FAF’s retail footprint throughout Canada; and,

e) expand the relationship with A. Couche-Tard (a $50Bn market cap company).

Company-Owned Retail Footprint

The company-owned retail footprint comprises 93 stores, with a four-pronged strategy targeting different segments.

Convenience store company, Alimentation Couche-Tard, (owner of Circle-K convenience store banner), already owns ~22% of the stock (with warrants that could take its stake to 50.1%), and new outlets (at Circle-K stores) “that will further expand FAF's footprint on a strategic and asset-light basis in Canada first, and elsewhere when legal.

“To put it in perspective, retail generates high revenues, but low margins. FAF.TO has three business segments: a retail store footprint in Canada, a tech-based services platform, and a private wholesaling and distribution business. In the latest reported quarter (May-July 2021), these businesses accounted for 74%, 18%, and 8% of revenues, respectively. But the economics of these divisions vary: in the latest quarter, retail EBITDA margins were 1% (gross margin 34%), wholesale 17% (21%), and tech 60% (100%); corporate expenses were 1.7% of total sales, for consolidated EBITDA margins of 7.3%,” Zuanic explained.

The analyst believes the company’s partnership with Alimentation Couche-Tard should lead to meaningful footprint growth over time with minimal investment. Couche-Tard and FAF have successfully launched a pilot program of Fire & Flower co-located cannabis stores adjacent to Circle-K stores.

Couche-Tard will provide ~$300Mn of potential growth capital for expansion. “The deal will help accelerate FAF’s growth pace, leveraging Couche-Tard’s vast international infrastructure.”

“In addition, FAF has an ambitious tech strategy that, according to management, should allow it to compete with Weedmaps MAPS. We believe Fire & Flower has a multi-pronged strategy to benefit from the changing retail landscape,” Zuanic said.

According to management, FAF is not just a brick-and-mortar retailer, but a “technology-driven global consumer commerce company.” Data, captured every step of the way, is used to enhance store performance and enables monetization through advertisements, Zuanic said.

FAF will be transforming the Wikileaf website, an online cannabis platform that has proven to generate significant user traffic through “engaging content” into a virtual online dispensary for cannabis and accessory products utilizing the same e-commerce proprietary technology platform that powers the company’s Fire & Flower retail network.

Photo Courtesy of Lelen Ruete