Founded in 2010, KushCo Holdings (which started its life as Kush Bottles) is considered by many to be the supplier of choice to the cannabis industry. One of the best ancillary cannabis stocks, the name change, which happened last year, was made in order to better reflect the broader offering and expanding product lines and channels that KushCo was developing.
Essentially, KushCo operates across 3 divisions or channels. Their core division is Kush Supply Co. which supplies packaging and bagging to other cannabis stocks; design and compliance; and energy and gas. The company, based in California, focusses primarily on states that have legalised for adult recreational use, as these markets are characterised by much higher purchase volumes and increased levels of compliance complexity.
Kush Supply Co.
Kush Supply Co provides ancillary products to other cannabis stocks. The company sources products both domestically and abroad (they have just set up offices in China to further strengthen their supplier relationships), and utilise contract manufacturers to distribute.
In packaging, the company currently stocks over 1,500 SKU's and have products that cover a variety of form factors including flower, pre-rolls and concentrates. One of the keys to their packaging is their inherent knowledge of each State's laws and compliance regulations (the US still considers cannabis illegal at the Federal Level) governing cannabis stocks, and hence all States have different rules and regulations governing packaging and distribution).
This is no small market. Cowen estimates that the US cannabis industry could be worth over $80 billion by 2030. In addition, they estimate that packaging and supplies could account for almost 6% of the market at that time. That's an addressable market of $4.8 billion for KushCo by 2030. Not small at all.
The company also sells vape cartridges, batteries, all-in-one-disposables, and pen kits, through their exclusive CCELL (ceramic cell) distribution rights (they are 1 of 4 licensees) in the US. In mature states such as California and Colorado, vaping is the preferred method of consumption and growing year on year.
Kush Energy, previously Summit Innovations which KushCo bought in April 2018 for $3.2 million in cash and 1.28 million shares, is based out of Denver, Colorado. Kush Energy distributes solvents and hydrocarbons, which are the foundation ingredients in the extraction process used to create cannabis oils, to cannabis stocks across the US.
The oils and extract market is one of the fastest growing areas of the industry, and Kush Energy sits at the epicenter of this. With 8 hazmat distribution facilities in the US, they are one of the largest suppliers of high purity butane and propane to the industry.
Koleto and Hybrid Creative
Supporting the Supply Co. division, are the Koleto Packaging and Hybrid Creative business units. Koleto Packaging is KushCo's innovation arm and is responsible for developing and building new products for the mass market, that will garner IP and assist in building a defensible product portfolio.
Koleto Packaging also contributes to the compliance IP of each State's packaging requirements for and evolving form factors. It is Koleto, in our opinion, that creates the largest potential for a defensible market position in the industry, come Federal Legalisation.
The Hybrid Creative (originally Zack Darling Creative Associates) is a full-spectrum creative agency, purchased in July 2018 for $1.45 million in cash and 360,000 shares. This is KushCo's answer to the growing need for marketing support to their clients. KushCo is now able to offer a turn-key product packaging and marketing solution to other cannabis stocks. However, with a revenue target of only $2.5 million for 2019 (less than 4% of revenue), this is not going to move the dial.
On January 8th, KushCo released their Q1 2019 financials. Although showing stellar top-line growth, the results were marked by falling margins and increasing operating cash flow deficits.
Revenue of $25.3 million for the quarter was 186% up on the corresponding previous quarter (166% of this growth was organic) and was 27% up on Q4 2018. No doubt KushCo are really driving sales growth, however, it's the gross margins that are most worrisome.
In Q4 2017, KushCo's gross margin peaked at a healthy 42%. This number has been rapidly declining quarter on quarter ever since, with Q1 2019 margins reported at only 13%. Increases in lower-margin vape product sales and inefficiencies in order deliveries are to blame.
This lower gross margin is putting significant pressure on their cash position. To put it in perspective, KushCo earned the same dollar value of gross profit in this quarter (with $25 million in revenue), as they did four quarters back, with top line revenue of only $9 million.
In addition to this, KushCo's operating costs have also risen dramatically. One year ago, their operating expenses were $2.9 million for the quarter, accounting for 33% of revenue.
In Q1 2019, their operating expenses of $11.3 million account for just over 45% of their revenue. In the quarter, they spent $1.25 million on air freighting orders to customers. They totally underestimated their own growth, and the ability to deliver on that growth. Moving forward, KushCo is going to need to demonstrate better operating leverage if they are to right this ship.
And cash? Interesting question.
KushCo has not yet produced a positive cash flow quarter. In Q4 2018, they had a cash flow deficit of $17.7 million, and in Q1 that trend continued, albeit slightly better, with a deficit of $15.5 million. However, on the upside, KushCo did increase its inventory by $5.5 million in the quarter, in advance of Chinese New Years.
At the time of their earnings report, they had a line of credit for $6.7 million, $15 million in warrant liability, and only $3 million in cash in the bank (down from $13 million in the previous quarter).
Cash burn is something KushCo are going to need to sort and fast. They could do so by getting a larger line of credit from their suppliers (delayed payment terms) or through additional equity financing, as they simply do not have access to debt facilities, operating in the US.
Subsequent to the quarter, Kush completed a bought deal for $9 million at $5.15 per share, with 1/2 share warrants at $5.75 each. The market reacted very, very poorly to this and the stock price got hit hard.
The Bottom Line
With deep knowledge of State-specific compliance, solid IP in their current product portfolio, and a growing reach across the US, KushCo Holdings represents one of the best ways to play the current ancillary cannabis stocks market.
They have shown a strong ability to cross-sell their products and services across their customer base, with increasingly larger SKU's sold to larger customers in the past couple of quarters. This has seen their revenue increase significantly, but with this, has come significantly decreasing margins.
Kush have suggested that they are targeting a gross margin of 30% and aim to achieve this through a combination of mixed employee shifts and operational efficiencies. In this regard, they have installed new warehousing systems and upgraded their Chinese suppliers to handle high volume, but they gave no indication of when they would be achieving this margin target.
With the current level at 13%, this represents a significant leap of faith by the shareholders and is very worrisome given the fact that the margins for an ancillary company are really a function of their underlying individual product margins.
Recently, KushCo has given significant revenue guidance for FY2019, predicting revenue of between $110 and $120 million, which would represent 111 – 130% increase over their $52 million in FY2018.
However, in our opinion, revenue is not really the question. The real question, is can KushCo scale profitably? Time will tell.
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