- Smart and prudent management decisions are starting to pay off
- Second mover advantage is undercutting the competition
- 5th consecutive profitable quarter and more to come
- Cannabis 2.0 products on the way will unlock further potential
Only A Few To Choose From
At the moment, Canadian cannabis is a minefield, with licensed producers across the board attempting to dilute their way out of the current economic situation. Personally, I'm shocked that some of these producers still have access to capital markets. While I've kept close tabs on the Canadian cannabis market since late 2017, now almost halfway through 2020, I believe there are only a handful of viable options left and Village Farms is at the top of my list. If you haven't already, go ahead and read my original article on Village Farms, which you can find by clicking here. Since my recommendation on Village Farms almost two months ago, the stock has beyond a doubt done very well. More importantly however, things are just starting to take off. The next few quarters will be crucial for the company as it sets the standard going forward in the cannabis industry for low cost high quality cannabis.
Experienced Management Matters
This is one thing that I keep having to repeat in regards to Canadian cannabis, which is that most leadership teams in the space are largely inexperienced, and that is really starting to show after almost two years of legalization of recreational cannabis. The Village Farms team is one of a kind in the space as they've successfully operated a vegetable business in North America for the last 30 years and continue to do so. It is well understood that at the end of the day, like any other agricultural product that involves farming and cultivation, cannabis is no different. The cost to produce, along with prudent capital management is a big factor in determining the viability of operating a cannabis business. The village team understands this very well and that is exactly the reason why they diversified out of the produce business with the help of Emerald Health, which allowed them to offset the cost of retrofitting existing greenhouse facilities without much help from shareholder capital. This is in stark contrast to the rest of the industry that vastly overpaid for their facilities, building out obscenely large amounts of production capacity only for them to be shut down or offloaded in recent months.
The Village Farms management team continues to show their prowess, as they aim to create a fully vertically integrated cannabis business by not relying on 3rd parties in any way. This is evidenced by their recent developments, of in house extraction capabilities. There are only a handful of pure extraction plays in the industry, but the village team knows that this will be a big part of the industry moving forward. As cannabis 2.0 continues to gain momentum and cannabis 3.0 on the way(1), the village team is getting ready to dominate this segment of the market. Second mover advantage has played out in a huge way for the Pure Sunfarms brand, as they have carefully studied each facet of the product segment they plan to enter into before jumping in with both feet.
Being Aggressive On Price Is Working
What's unique about Village Farms' majority owned joint venture Pure Sunfarms, is that due to their best in class cost per gram figures, which came in at C$0.78 per gram for FY2019 (including depreciation), they are capable of being flexible on price while continuing to produce a profit. If you thought that price compression has been bad thus far in the industry, there is more to come. The black market isn't going to magically disappear, and currently still accounts for a large portion of the overall recreational cannabis sales in Canada. Village Farms has been taking advantage of economies of scale and delivering the best priced value product which come in the 14 and 28 gram formats, beating both the legal and illegal producers in terms of cost while maintaining a high level of quality. This was evidenced by feedback that was highlighted in the recent Q1 2020 conference call: "After my good luck with the 28 gram bag I acquired of the Pure Sunfarms' Indica blend pulled me back to the legal market"(2). This kind of feedback is highly encouraging, and shows the power that pricing has on consumer purchases. If the price is low enough, people will willingly take the risk of trying out your product. This strategy seems to have worked incredibly well for Pure Sunfarms, as the 28 gram Indica SKU has been on the best sellers list on the OCS since it was introduced, now running for almost two months. Not only this, but Pure Sunfarms managed to up their market share on the OCS to over 20% in the month of April(2).
Cost Advantage Leads To Increased Wholesale Demand
Let me recap from the Q1 2020 earnings that for the approximately C$18 million of revenue that Pure Sunfarms brought in, they sold in total 10,365 Kgs of cannabis, 3065 Kgs of which was retail sales which brought in C$8.5 million, and just under C$10 million brought in by wholesale(3). The pricing on wholesale, despite being very low is still profitable and represents a good outlet for excess inventory for Pure Sunfarms. Numerous other LP's continue to see their inventories bloat quarter to quarter. The interesting thing to note from the earnings call, is that while Pure Sunfarms mostly engaged in transactions with two extraction companies, other LP's showed interest in acquiring wholesale cannabis from Pure Sunfarms as mentioned by the CEO: "Believe it or not, there are other LPs that are asking us for product and I'm a little bewildered by it, but maybe it has to do with cost structure"(2). Pure Sunfarms has the capability to produce up to 150,000 Kgs per year through two greenhouse facilities. While one of the facilities is not producing at the moment due to there being an excess of producers in the market, the competitive pricing could lead Pure Sunfarms to turn on this facility at full capacity. As recreational sales continue to ramp up for Pure Sunfarms and other inefficient LP's are forced to go out of business , Pure Sunfarms will continue to be able to supply the wholesale market with better product at the cheapest price. The end goal however, is to have as much production as possible meet the needs of the recreational market.
Cannabis 2.0 Product Launch Coming This Summer
As margins in the flower business continue to reduce over time, the 2.0 segment of the market represents a huge potential for Pure Sunfarms. While Pure Sunfarms continues to work with Health Canada for licensing of their extraction facility, they smartly acquired 368 litres of cannabis distillate at an attractive price point in exchange for some high quality wholesale cannabis. The COVID-19 situation means that Health Canada will be even slower to grant the license, however the management team is not waiting around for approval for their extraction facility, and instead acquired the distillate needed to make 2.0 products. Similar to the budget dry flower SKU launch that went incredibly successfully, Pure Sunfarms intends on applying the same strategy on pricing for 2.0 products. While dry flower prices have come down considerably over the last few months, most edible products are still bringing in high margins, where price compression hasn't been as much of a problem. This is especially the case in edibles, which has seen very little price reductions. I myself have tried a few edible products, and can definitely tell you that i'm not paying 15$ for 10mg cookies ever again. Pure Sunfarms has scope to dominate this segment of the market just like they have in the budget ounce category. The management team has proven that they can maximize their second mover advantage by diligently studying existing trends in the market in terms of price and products, and launching their products accordingly. Based on past performance, I see huge potential to grab market share in this segment of the market.
The market is finally catching onto the fact that there are very few legitimate players in the cannabis space, and that Village Farms is a top contender. Based on Canadian operations alone, they continue to remain a great value play. The true value is unlocked when the hemp - CBD opportunity is realized in the U.S, however there are still some regulatory hurdles that need to be overcome. Noting that the first quarter of 2020 marked five consecutive quarters of net income for Pure Sunfarms, it's not hard to see why this trend won't continue. To quote Mike Degiglio the CEO - "I'm going to come back to something you've heard me say before, it's Ferraris famous mono that we are the competition"(2). Remember, when investing in a company you are trusting that the management team has the best interest of the shareholder in mind, and it's not hard to see that that is the case here when the CEO himself owns over 15% stake in the company.
About The Author
I am an electrical engineering graduate from Carleton University, and have always had a keen interest in investing. I have been following events as they unfold in the cannabis space in Canada since 2017 and have always had the opinion that decriminalization is the way to go as it reduces drug related crime and can be monetized as a source of tax revenue for the government. My goal is to help people who invest in a risky space like cannabis understand what to look for, as the amount of information available is often overwhelming for new investors. Aside from that, there are several companies all competing with each other to get your investment dollars!