Merger Between Cresco Labs And Origin House: Massive Undervaluation

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About: Cresco Labs Inc. (CRLBF), ORHOF, Includes: ACB
by: Bilbao Asset Management
Summary

Cresco Labs Inc. is a cannabis company operating in 11 states having 15 production facilities and 51 retail licenses.

Based in Canada, Origin House operates in the global cannabis industry and focuses on California.

The business combination is expected to target a 185 million market offering more than 56 brands in collaboration with more than 725 partners.

Cresco Labs has experience of acquiring other competitors, which most M&A analysts should appreciate. It means that the company knows well how to integrate new businesses.

Using an EV/Sales ratio of 20x and forward revenue of $167 million, the total enterprise value should be equal to more than $3 billion.

On April 1, 2019, Cresco Labs (OTCQX:CRLBF) and Origin House (OTCQX:ORHOF) reported a merger agreement that may create a new leader in the cannabis industry. What matters the most in this deal is that the companies are expecting revenues of $383 million in 2019. If this is correct, using an EV/Sales ratio of 20x, the total enterprise value should be larger than $3 billion. With this in mind, the fact that Cresco Labs has an enterprise value of $1.56 billion and Origin House has an enterprise value of $548 million represents a clear opportunity. They should have larger valuations.

Cresco Labs Inc. And Origin House

Based in Chicago, Cresco Labs Inc. is a cannabis company operating in 11 states having 15 production facilities and 51 retail licenses.

Source: Cresco’s Website

The company offers several cannabis products including everyday cannabis, medicinally focused, connoisseur grade, and edibles. The images below provide some of the brands offered by Cresco Labs.

Source: Cresco’s Website

Based in Canada, Origin House operates in the global cannabis industry and focuses on California. The company has access to more than 50 cannabis brands and has agreements with more than 450 dispensaries. Take a look at the network created by Origin House in the image below:

Source: Company’s Website - Origin House

The image below provides further details on the brands distributed by Origin House:

Source: Company’s Website - Origin House

Investors should get to know what these two companies are expected to achieve together. As mentioned in the presentation below, the business combination is expected to target a 185 million market offering more than 56 brands in collaboration with more than 725 partners.

Source: Business Presentation - Seeking Alpha

Balance Sheet Of Cresco Labs Inc. And Recent Acquisitions

As of September 30, 2018, Cresco reported $93.9 million in cash with $149 million in total assets. The amount of cash and assets increased quite a bit as the company acquired many businesses in 2018. The image below provides a list of assets:

Source: Consolidated Statements of Financial Position

Cresco Labs has experience of acquiring other competitors, which most M&A analysts should appreciate. It means that the company knows well how to integrate new businesses, which increases the likelihood of closing the recent merger agreement with Origin House.

Take a look at some of the businesses acquired by Origin House:

  • On September 30, 2018, the company entered into a definitive agreement to merge a subsidiary with Gloucester Street Capital, LLC, a New York limited liability company.

  • In the fourth quarter of 2018, the company completed its acquisition of 100% of FloraMedex, LLC for $10 million cash consideration.

  • In Q4 of 2018, the company acquired 100% of Arizona Facilities Supply, LLC for $22.3 million.

  • In Q4 of 2018, the company entered into a definitive agreement with MedMar, Inc., an Illinois corporation. Total consideration for purchase is $27.5 million, with $10 million in cash and $17.5 million in stock.

The list of liabilities should not create fear. The company reports only $9.3 million in total liabilities with only $1.5 million due to related parties. The image below provides a list of liabilities:

Source: Consolidated Statements of Financial Position

Cresco’s Income Statement

In the nine months ended September 30, 2018, Cresco reported revenue of $26 million, 243% more than that in the same period in 2017. Market participants should appreciate that the gain from operations in this time period was $6 million and the net income was $6.5 million. It will be shown below that Cresco was reporting better gross profit margin than Origin House.

Source: Consolidated Statements of Financial Position

Target’s Income Statement

Like many other peers in the cannabis industry, Origin House reported massive revenue growth in 2018. In the nine months ended September 30, 2018, revenue was equal to CAD 10.7 million, 438% more than that in the same period in 2017.

Having mentioned the remarkable revenue growth, the gross profit margin was not that elevated. In the nine months ended September 30, 2018, the gross profit margin was equal to CAD 1.29 million. In addition, while the company increased its sales expenses by 230% amounting to CAD 3.53 million, in the same time period, the losses from operations did not increase. The loss was equal to CAD -19.7 million, 151% more than that in the same period in 2017. The image below provides the top of the P&L:

Source: 10-Q

The net loss for the nine months ended September 30, 2018 was equal to only CAD -2.85 million, 63% less than that in the same period in 2017. While investors should appreciate the reduction in the losses, the positive trend may not continue in the future. The net loss decreased as a result of a non-recurring gain on investments worth CAD 12 million and the sale of licensed technologies worth CAD 4.19 million. Market participants should not expect the company to deliver the same gains in the future. The image below provides the top of the P&L:

Source: 10-Q

Origin House invested in cannabis companies like Aurora (ACB), AltMed, and Anandia. The recent increase in the market capitalization of cannabis stocks has pushed the profitability of Origin House up. It is positive. However, market participants should understand that this income is non-recurrent. If the cannabis market does not perform in 2019, Origin House could not report the same figures. The image below provides a list of investments:

Source: 10-Q

Target’s Assets: Goodwill And Intangibles Should Be Reviewed

With cash equal to CAD 75.2 million representing 34% of the total amount of assets, Origin House should attract many growth investors. Other relevant assets are intangibles worth CAD 49 million and goodwill worth CAD 55 million. Let’s understand these assets. They are not small.

During the nine-month period ended September 30, 2018, the company acquired four businesses paying a total of CAD 91.2 million. In total, Origin House paid 24% of the total contribution in shares, which does not seem a lot. Market participants should appreciate that Origin House is not making extensive use of its shares to pay acquisitions. The image below provides further details on this matter:

Source: 10-Q

Regarding the goodwill registered, it comprised of 56% of the total amount paid for the acquisitions. Acquired licenses represented 23% of the total amount paid. It means that the total valuation included a large number of intangible assets, which may represent a risk. If accountants believe that these assets are not worth that much in the future, they may get impaired. As a result, the share price may decline. With this in mind, market participants should study asset impairments in the near future very closely. The image below provides further details on this matter:

Source: 10-Q

The image below provides a list of assets:

Source: 10-Q

Investors Should Not Worry About The Target’s Liabilities

With respect to the total amount of liabilities, in the nine-month period ended September 30, 2018, the company increased its liabilities to CAD 72 million, 1,185% more than that in the same period in 2017. The total amount of debt increased as the company sold new convertible debt. The convertible debt was valued at CAD 27.9 million. The image below provides a list of liabilities:

Source: 10-Q

The Business Combination

In the nine months ended September 30, 2018, Origin House reported revenue equal to CAD 10.7 million, 438% more than that in the same period in 2017. With this in mind, assuming forward revenues of CAD 50 million or $37 million seems reasonable in this case.

In the same time period, Cresco reported revenue of $26 million, 243% more than that in the same period in 2017. Taking into account these figures, forward revenues of $130 million can be expected.

In total, the business combination should be able to report forward revenue of $167 million. Note that the company is expecting to make a total of $383 million in 2019. Other analysts may use forward revenue of $383 million. However, with CAD 10.7 million and $26 million made in the nine months ended September 30, 2018, $383 million appears to be very optimistic.

As reported in the press release about the transaction, holders of shares of Origin House expect to receive a total of 0.8428 shares of Cresco Labs. The lines below provide further details on this matter:

Source: Business Presentation - Seeking Alpha

Source: Press Release

Let’s assume that Cresco Labs has 126 million subordinate voting shares before the IPO, and Origin House reports a total of 51 million shares. The total amount of new shares to be issued should amount to 43 million. As a result, the total number of shares after the merger should be equal to 173 million. The lines below provide further details on total amount of shares reported by Cresco Labs:

Source: 10-K

Valuation Of The New Company

As shown in the image below, cannabis companies are trading at 10x to 40x sales. It means that expecting forward revenues of $167 million and using an EV/Sales ratio of 20x, the business combination could have a total enterprise value of more than $3 billion.

Source: Ycharts

With that, if the new company is able to report revenue of $383 million in 2019, the enterprise value could be larger than $3 billion. Using an EV/Sales ratio of 20x again, the total enterprise value may be equal to more than $7 billion. Market participants should understand that this appears to be a very optimistic case scenario.

Conclusion

As of April 9, 2019, Cresco Labs reports an enterprise value of $1.56 billion and the enterprise value of Origin House (OTCQX:ORHOF) is equal to $548 million. With the company announcing that the business combination may generate revenue of $383 million in 2019, the valuation of these two companies is too low. Using an EV/Sales ratio of 20x and forward revenue of $167 million, the total enterprise value should be equal to more than $3 billion. With all these numbers in mind, both companies represent an opportunity for investors. They should have larger valuations.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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