DavidsTea: Management Is Dumb As A Fox

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About: DAVIDs TEA (DTEA), Includes: BUD, GWPH, KO
by: Courage & Conviction Investing

Summary

Conventional wisdom suggests that shares of DavidsTea traded up 63% (On Oct. 2nd) based on speculation. However, there is more to the story.

On late September 27th, the DEA moved CBD from its list of Schedule 1 controlled substances to Schedule 5.

Porchlight Equity is smart money and protects against a stealth, low-priced, take-private deal by DavidsTea's management before a CBD deal is struck.

On the afternoon of September 21, 2018, after watching a wild day of trading, where shares of DavidsTea (DTEA) actually traded as high as the $5.80s (in pre-market) and then sold off sharply, throughout the day, I got long shares at an average of $2.68. However, because of the super-high implied volatility, I wrote DTEA $2.50 10/19/2018 covered calls (on my then entire position) for a juicy options premium of $0.76 per contract. Assuming that shares are trading north of $2.50 on October 19th, this trade will yield a 21% return. Not too shabby for a one-month bet. Because of the amount of cash on DTEA's balance sheet, the fact the stock was trading at or near book value, the upcoming legalization of Cannabis on October 17th, and DTEA's 200 + stores in Canada, this seemed like a compelling bet. Notwithstanding the wide call option bid/ask spread and the resulting mark to market valuation of the calls before expiration, this looked like a good way to generate 21% in a month. And in a worst case scenario, my downside risk was simply that I would own DTEA shares with an effective cost basis in the low $1.90s, again should the stock close below $2.50 on October 19th. Frankly, I didn't think too much more about the bet until October 2, 2018, when shares of DTEA gapped up in pre-market and then closed the trading day at $4.16, or up 63%. By the way, volume that day was 31.9 million shares, and the company only has a float a total share count of 26 million. Also, for anyone that has ever written covered calls knows, you are handcuffed to agree to giving away the upside in exchange for the call premium. So, in this case, because I wrote the covered calls, I couldn't take advantage of the October 2nd move and sell any DavidsTea shares north of $4 per share.

As it turns out, however, that evening, after the bell, for the second time in less than two weeks, DavidsTea's (interim) management issued a formal press release stating that:

They were unaware of any corporate developments or other reason for the recent market activity.

Source: DavidsTea Investor Relations

The second statement was what got my antenna up. One statement is business as usual, but the second statement, in less than two weeks, is more than just a coincidence. This got me to do some digging. And as a result, I write to share my findings. There is much more going on here then animals' spirits associated with the excitement for Canada's October 17th cannabis legalization. In this piece, I will explain why, at least optically (and I am simply following the facts based on reviewing public information), DavidsTea's co-founder, now 87 years old, and management are dumb as a fox.

Dumb As A Fox

And before we get started, the conventional wisdom (see this piece by Cornerstone Investments) is DavidsTea is just a busted IPO and money losing business. The October 2nd 63% pop was simply animal spirits associated with the market's infatuation with CBD drinks. With limited pure play CBD stocks, combined with DTEA's small float, again, the conventional wisdom is that this was just a once in a lifetime and lucky 63% pop.

Source: Yahoo Finance

I don't see it that way. Instead, I would argue there is more to the DavidsTea story than that. And when it comes to investing, you need an active imagination and a willingness to think beyond the first level.

CBD for Medical vs. THC

However, before we go there, I want to highlight a few articles, as I would guess that most readers are unaware of the differences between CBD and THC.

To help readers understand the difference, here is a good article: (Drinking weed: Here’s everything to know about cannabis-infused drinks). It also has an informative short video. Basically, when most people think of cannabis, perhaps they might think of clouds of smoke, the pungent smell, and very well might have a perception of lazy people with no life's ambition that have the munchies. Actually, THC (Tetrahydrocannabinol) is what gets people high and triggers the psychoactive effects. CBD (Cannabidiol) is thought to have natural medical benefits and in some circles thought to be effective for pain management, inflammation, stress management, and epilepsy (see this informative article).

So, when Coca-Cola (KO) and Anheuser-Busch InBev (BUD) are signaling they are strongly evaluating CBD beverages, this is what they are referring to. It isn't THC they are after, it is the CBD and utilizing its healthy benefits.

Incidentally, while learning more about this stuff, I learned that on September 27th, the U.S. removed CBD from its Schedule 1 list of controlled substances (see this press release from a small company Phivida).

Albeit with a slight lag, this is why shares of DTEA leapt 63% on October 2nd and traded 31.9 million shares! This wasn't some random occurrence.

As I did more digging, it is more nuanced. What actually happened was the U.S. Drug Enforcement Administration (DEA), for the first time ever, removed CBD from the Schedule 1 list of controlled substances. And specifically, the FDA approved GW Pharmaceuticals plc's (GWPH) (see here), Epidiolex, an epilepsy drug.

This is very significant as Marijuana Business Daily article points out:

It’s a decision that immediately affects CBD producers but also signals the agency’s first admission that the plant has medical value.

The DEA announced Thursday that drugs including CBD with THC content below 0.1% are now considered Schedule 5 drugs, as long as they have been approved by the U.S. Food and Drug Administration.

Source: Marijuana Business Daily

So, again, the U.S. moving CBD off the schedule 1 list to a schedule 5 drug (think a prescription that you get filled at a CVS or Walgreens) is a big deal. This is why DavidsTea had the big leg up on October 2nd. So, it wasn't some random and spontaneous speculation. The 31.9 million shares traded and 63% increase was triggered by the CBD news.

Also, please note that CBD isn't yet legal in Canada, but based on my reading, it is believed that it will be approved in some time in 2019.

Here is Where it Gets Interesting for DavidsTea

What is equally interesting is the Bloomberg holders list for DTEA. DTEA has 26 million share outstanding. The co-founder, Herschel Segal, owns 12 million shares. In March 2018, he stepped down from the board and said he was considering taking DavidsTea private (see here). In April 2018, he proposed a new slate of independent directors and ultimately won a nasty proxy fight (see here) in June 2018. With this win, he gained control of the company, fired the former CEO, Joel Silver, and the CFO, Howard Tafler, was also pushed out, but at slower pace.

So, since we are all critical thinkers, it probably isn't rocket science to work out that Mr. Segal isn't in any rush to explore a CBD deal and doesn't want the stock to run up based on the prospect of a CBD deal (see here). After all, if you want to take a company private, you want to do so at the lowest price possible and do so when a company's underlying financials results are subpar, and the market is pessimistically viewing the company's turnaround prospects (see fellow SA contributor, Villamayor Capital's, piece on DTEA's historical financial).

However, given the excitement and strong projected growth and excitement for the CBD beverage industry, there is no question that a pivot and potential partnership (see here) could create meaningful shareholder value. And as we know from Mr. Segal's interview with La Presse, even the Canadian majors want to talk.

Therefore, perhaps this is why DavidsTea's management issued two statements that the company has no idea why its stock has gone bananas on September 21st and October 2nd! Again, why the second statement?

As you dig deeper, it gets really, really interesting.

If you look at the number two and number three holders, Peter Cornetta and Porchlight Equity (Peter is one of the founding partners of Porchlight), it appears he personally owns 3.3 million shares and his fund owns 3.2 million shares. The two separate filing dates (May 2nd) and (September 26th) suggest that Bloomberg isn't double counting Peter and Porchlight's stakes. That said, I do acknowledge that Bloomberg might be double counting, and Porchlight only owns the 3.2 million stake.

For perspective, Peter is a seasoned private equity investor and, earlier in his career, worked at the super well respected Advent International. Peter and Porchlight aren't dumb money, and this isn't some trade to make $1 point per share. In fact, if you look at Porchlight's website, they list DavidsTea. So, this signals, at least to me, that this isn't a trade.

Source: Porchlight

Also, in early August 2018, after two newly elected board members resigned from DavidsTea's board, Peter Cornetta and Porchlight filed a lawsuit (see here) for information surrounding these abrupt resignations. Reading between the lines, as a major shareholder, it certainly appears that Porchlight isn't thrilled with Mr. Segal's corporate transparency.

Enclosed below is the Bloomberg holders list. Also, the sale of most of its share by TDM Asset Management, who owned its stake as far back as February 2, 2017 (see here), and November 3, 2016 (see here), doesn't concern me. I don't have any opinion about TDM per se, but clearly, just following DavidsTea's share price back in Q4 2016 and Q1 2017 (from TDM's SEC filing dates), TDM liquidated its position at a big loss. Moreover, this sale by TDM was actually a gift, at least to anyone on the sidelines looking to acquire cheap shares of DTEA, as it threw the scent off the detective's trail. And if the Bloomberg holders list is accurate, it appears that Peter Cornetta (and/or Porchlight Equity) was snapping up those shares, hence the September 26, 2018, filing date coincides with TDM's liquidation.

Lo and behold, as this is a fluid situation, on October 9th, EdgePoint Investment Group filed the they liquidated their entire position (see here). Based on the fact that DTEA shares are near an all-time low, they had to have taken a loss and simply moved on. For perspective, and according to WhaleWisdom, EdgePoint has roughly $8 billion of assets under management. Three million shares of a $3 stock is a rounding error for a firm the size of EdgePoint.

Source: Whale Wisdom

Incidentally, on October 9th, as news that EdgePoint exited stage left, shares of DTEA actually traded up as much as 25%, albeit briefly, but on heavy volume. Perhaps, the market worked out that other market participants were able to absorb a block of 3 million shares without strongly affecting the underlying share price. In other words, the underlying bid for DTEA shares might be stronger than people think.

Two Interesting DavidsTea independent directors

Finally, to add to the intrigue, note that on August 24, 2018, DavidsTea added two new independent directors, Anne Darche and Susan Burkman. I want to highlight two "interesting aspects" of each these women's well respected biographies.

Look at this aspect of Anne's background.

Ms. Darche serves as a director of Groupe Germain Hôtels, a company based in Quebec City that owns and operates hotels across Canada, Knowlton Development Corporation (KDC), a leading North American contract manufacturer of health and beauty-care products, and 48North Cannabis Corp., a company listed on the TSX Venture Exchange whose wholly-owned subsidiary is a licensed producer of medical cannabis in Canada.

Secondly, note that Susan is an expert in fairness opinions for M&A!

Susan L. Burkman is an experienced financial consulting executive. Throughout her 35 years in the investment banking industry, she has successfully led equity, M&A, and valuation and fairness opinion transactions in excess of $6 billion for Canadian companies across numerous industries.

On balance, at least to a critical thinker, it certainly appears that DavidsTea's management team are a dumb as a fox. They are only tangentially aware of the potential of CBD because they were contacted by top Canadian cannabis producers and have stated the company has no immediate interest in pursuing it. Yet, Mr. Segal wins an aggressive proxy fight, and sooner after, two well regarded directors swiftly depart and then two new well regarded directors are appointed to serve on his board (one that has knowledge of medical cannabis (think CBD), and the other is an investment banking and M&A expert that has a specific expertise in M&A fairness opinions (can you say take private...?).

Takeaway

Although it is easy to superficially say that DavidsTea is just a busted IPO and money losing retailer, there is more than just animal spirits and speculation going on here. With a significantly depressed valuation, despite a significant cash balance and strong name brand, due to the recent poor financial performance and operating results, the foxes (that know the business) are licking their chops. Under the cover of "we need to turn around the business, and let's wait to explore a CBD partnership", the market still appears to be underpricing the optionality of a DavidsTea turnaround. This is most likely because of public statements made by foxes. Because of this underpricing, I added some unencumbered (not restricted by covered calls) DTEA shares, in the high $2s. Besides the prospect of an activist pushing DavidsTea's management to explore a CBD partnership, what caused me to add shares was my perception that Porchlight Equity (and Peter Cornetta) is smart money, and this gives me some added comfortable. Moreover, perhaps the market is missing that Porchlight acts as the unofficial nightswatchman tasked with watching over the hen house. In nano-cap land, you need a capable and watchful guard to protect the hen house from hungry foxes.

Disclosure: I am/we are long DTEA.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.