Flora Ready To Grow Like A Weed

Summary

• The cannabis sector is ripe for the picking.
• Great brands and cost advantages are optimal traits for long-term market leadership as well as ROI.
• Flora Growth Corp. has these properties.
• Flora has enormous opportunity ahead of it and appears undervalued compared to its peers; this should become apparent over the course of 2022.

Aleksandr_Kravtsov/iStock via Getty Images

In this article, I argue that the small-cap and cannabis sectors present investors with the opportunity to make an attempt to pick long-term, high-quality cannabis companies at a discount. I give my opinions on what qualities will be required for the long-term growth of such a company, and dive into my selection of Flora Growth Corp (NASDAQ:FLGC) as a primary long-term investment in cannabis. All of the ingredients for success are there; it will only take execution over time for this idea to work out to its fullest potential.

Recent Legislation and Market Conditions Present an Opportunity

Just weeks ago, the U.S. GOP introduced legislation that, if put in place, would deschedule cannabis.

“...the SRA would deschedule cannabis from the Controlled Substances Act (CSA) (and all implementing regulations) yet preserve states’ authority to regulate or prohibit cannabis (similar to the legal framework for alcohol); expunge past cannabis convictions; grandfather in existing state licensees; apply a federal excise tax of 3%; and revise the Federal Food, Drug, and Cosmetic Act (FFDCA) to create a pathway for cannabis-infused foods, drugs, dietary supplements, and ‘designated state medical cannabis products.’”

Aside from recreational users, this is exciting for consumers who rely on cannabis for a wide range of illnesses or issues, including pain management, relaxation, stress relief, reducing anxiety, and improving sleep quality. But investors have much to gain if they can select the long-term profitable and growing companies in the space. Now might be the time to search for best-in-class smaller cannabis companies as the entire cannabis sector has deflated from its intra-year highs. Furthermore, microcaps and small caps have underperformed compared to the S&P 500 (SPY) this year to arguably an unprecedented extent. So, investors should be looking for the best small or microcap cannabis company. Cannabis’ underperformance for nearly a year can be seen in the chart below, which depicts 11 different cannabis ETFs.

Source: TradingView/Seeking Alpha,

ETFs: (MSOS), (YOLO), (POTX), (CNBS), (THCX), (TOKE), (PSDN), (MJ), (MJJ), (THCX), (BUDX)

No doubt, there is enormous opportunity in the cannabis space, and even when commoditized—or if cannabis products move in that direction—they are likely to end up with relatively high margins in the long run like alcohol. But nonetheless, cannabis investors need to find their favorite cannabis companies that have certain properties that will ensure the companies execute and have a competitive moat.

5 Sources of Economic/Competitive Moats

I would argue that the two most important aspects of a competitive moat for products like cannabis are cost advantages and efficient scale, which go hand-in-hand. Thus, for dry flower or oil producers, investors want to invest in a cannabis company that has (or will have) cost advantages and the capacity to produce at scale. While there have to be standards for cannabis commoditization like biomass, crude oil, etc, ubiquitous availability of these products will likely inevitably bring prices down for consumers. In fact, one cannabis consultant and greenhouse expert cites that:

In the United States, prices for high-CBD cannabis biomass declined up to two-thirds in value in 2020 compared to the previous year. Prices for CBD extracts, isolates and distillates also declined, although not as precipitously. CBD biomass and CBD raw materials are becoming commodities.

However, for marijuana products other than the commoditized raw material, the important aspect is brand, which is an intangible. Successful consumer marijuana companies will need to develop popular and respected brands to enhance their margins and market shares, just like leading alcohol, beverage, or snack/food companies. With the regulatory environment and similarities in reasons for consumption, I wouldn’t be surprised to see the alcohol and marijuana industries have similar profit margins in the long term.

Source: MJBizDaily

Thus, a market-leading cannabis company will need to have two primary non-human properties to win in the long term: 1) cost advantages, and 2) great brands. To elaborate, a vertically integrated organization will need brands for a moat, pricing power, and long-term visibility in the market. But to support profit margins, the best company will need to build these brands on the back of high-quality, low-cost cannabis supply.

And on top of that, investors need to look for small-cap companies that will grow substantially so that these traits can allow for robust returns. So while there may be more than one small-cap cannabis company as a winner, I found Flora Growth, which has great brands, an excellent management team, growing revenues, and production costs lower than virtually every other producer in the industry.

Flora Growth Corp at a Glance

Flora is a global cannabis company that recently IPOed and is growing at an impressive rate, both geographically and financially. The company has a cultivation operation in Columbia, arguably the best place in the world to grow cannabis outdoors, as well as international distribution channels, a variety of brands, and ongoing medical research. They focus on natural, low cost cannabis.

Source: Investor Presentation, October 2021

The company has been busy lately getting its Colombian production up and running as well as completing strategic acquisitions to jumpstart sales and distribution globally. Currently, they boast over 340 different products, over 70 medical and/or cosmetic licenses, and over 2,500 points of distribution (stores, drug stores, pharmacies, department stores, supermarkets, gas stations, etc) across Latin America and the United States (1500 in Columbia). They already have sales in other countries.

The company recently completed a $34.5 million secondary offering and has made acquisitions and collaborations, so it has a good balance sheet (nearly debt-free) and the near-term risk for investors concerned about near-term profitability is decreased.

Significant Cost Advantages

The most easily understood and notable inherent advantage Flora has over other cannabis companies is its cost of bulk cannabis, specifically dry flower. With many brands competing for store shelf space, it's important to be able to compete on pricing and still make a profit; otherwise, there is no sustainable way to grow. Many companies, specifically with CBD products, are selling products at a loss. So let’s take a look at how significant Flora’s cost advantages are and how they might translate to pricing. Flora highlights its cost of cultivation below.

Source: Flora Growth Corp Investor Presentation, October 2021

Personally, I would take these numbers with a grain of salt since they can change. For instance, Tilray (TLRY) already lowered its Leamington facility costs to $0.72 whereas in 2018 Tilray cited a cost per gram (dry flower) of $3.73. Regardless, $0.72 is still 12x Flora’s cost and one would expect cost reductions to come to the point of diminishing returns in lieu of some amazing technological advancement.

But how does Flora manage to produce dry flower at this cost? It comes down to selecting the perfect place to grow. Colombia, which is now not as unstable as people might think, has the perfect climate for growing cannabis, especially the area in which Flora selected to place its Cosechemos facility. It’s the perfect place to grow cannabis outdoors. In fact, 70% of all cut flowers come from Colombia. Up in the mountains where they grow, there’s a steady, slow wind that lowers the incidence of plant-harming pathogens and yields healthier plants. There’s also nutrient-rich organic soil for the plants to thrive in.

It doesn’t end there. The company has agricultural experts, and they have picked an optimal region of Columbia, due to the heat and altitude, sunlight (330 days/year, 12 hrs/day), and optimal rainfall. They have optimized an agricultural strategy to get 3 harvests per year (many growers can only manage to get one harvest), and to top it all off, they use a local, agriculturally highly skilled workforce that is reportedly eager to earn good wages with honest, hard work.

This is also a testament to management’s capability in strategic decision-making.

The company uses an example in its presentation, adding up COGS for a generic product, and comparing the suggested retail price after all is said and done.

Source: Investor Presentation

If we instead use the $0.72 figure from Tilray’s recent conference call—giving the competition a bit more credit—one can calculate that the competition will still have about double the cost of Flora for an eighth of dry flower. Flora’s crop is organic so it will be able to sell as premium quality at a very competitive price, both boosting profit margins while undercutting the competition, a recipe for taking market share.

To top it all off, the company has a massive footprint to grow cannabis compared to leading cannabis companies. While yield per area metrics may vary, Flora has much more area to grow low-cost cannabis than current leading companies do to grow more expensive cannabis.

Source: Investor Presentation

Relative Valuation

When factoring in Flora’s recent financial guidance, the shares appear inexpensive and undervalued compared to its peers, without considering its low-cost production. In the chart below, one can see that Flora’s valuation as a multiple of enterprise value or sales (which is relatively consistent among the competing companies, is much less.

Company	Market Capitalization ($M)	TTM Revenues ($M)	FWD P/S Ratio	FWD EV/S Ratio
Aurora Cannabis (ACB)	1210	187.7	6.19	6.58
Tilray (TLRY)	4090	563.6	5.6	6.79
Curaleaf Holdings (OTCPK:CURLF)	6720	1120	5.4	5.75
Green Thumb Industries (OTCQX:GTBIF)	5050	827.2	5.6	5.72
Trulieve Cannabis Corp. (OTCQX:TCNNF)	4620	801.5	4.9	5.11
Canopy Growth Corp (CGC)	3770	448.4	8.3	7.86
Cronos Group (CRON)	1590	56.6	23.1	7.16
Sundial Growers (SNDL)	1200	37.3	29.37	15.34
Planet 13 Holdings, Inc. (OTCQX:PLNHF)	648	109.8	5.28	4.88
Flora Growth Corp (FLGC)	105	2.2	2.63*	2.16*

Click to enlarge

Source: Seeking Alpha Data, data gathered between 12/10/21 and 12/13/21

*using values based on guidance

It’s clear that Flora shares should easily double from these levels based on forward P/S and EV/S ratios, especially given the fact that many of these companies are already large and will not have as much headroom to grow, and don’t have cost advantages Flora has. However, the primary question one might have is: why are Cronos Group and Sundial Growers so expensive compared to its peers?

Sundial recently acquired Alcanna, Canada’s largest private liquor retailer (171 locations), so this may have affected the financial metrics provided. Regarding Cronos, it appears that retail investors, as well as investment banks, remain bullish on the Cronos based on their collaboration with Ginkgo Bioworks in cannabinoid biosynthesis, with some estimating that this will lower their “cost per gram” to about $0.10 CAD equivalent to dry flower. This is an apples-to-oranges comparison for Flora since cannabinoid levels in different plants can vary, and the biosynthesis of various cannabinoids from microorganisms may vary. And consumers that want natural products or broad-spectrum cannabis products will not be buying products from Cronos. So in this aspect, these two companies do not directly compete. However, this goes to show the premium some investors are willing to pay for a company that promises inexpensively produced cannabinoids—similar to Flora’s anticipated cost per gram. Should Flora trade at a massive premium?

As 2021 is Flora’s first year of full operation, whereas peers have been operating for 5+ years, it may become evident that Flora’s management team can generate better returns on invested capital compared with leading peers, and thus the company may demand a premium valuation.

Why Is There a Valuation Disconnect?

I think that the company hasn’t yet posted its explosion of revenues and its value is obscured compared to companies already producing more revenues. Flora did, however, guide for $35-45 million in revenue for 2022. It takes a bit more work to put the pieces together to see the larger-scale enterprise that is being built, quite rapidly, organically, and inorganically.

Flora’s extraction facility in Cosechemos is expected to be up and running this quarter; at full capacity (1200L/mo), and $4k/L, this would be annual revenue of $57.6 million for crude oil. The facility will use cryogenic ethanol extraction, which is a high-volume, medium-to-high quality process that can extract a wide range of compounds. This is good for the company’s medical focus using extracts containing a range of from THC and CBD to rare (premium) cannabinoids like CBN or CBG and allows further research on these cannabinoids as well as their effects when used in combination. Specifically, Flora is launching global clinical trials in fibromyalgia/chronic pain and intends to partner with organizations to study the effects of cannabinoids at the cellular level.

Their flower is GACP certified, which is the precursor certification required for any product (flower or extract) to be used in medical markets such as Germany. This means that the company can sell its low-cost flower to EU-GMP certified extractors to produce active pharmaceutical ingredients (APIs) for medical markets. The company’s own extraction facility has also been built to EU-GMP standards, where they have already initiated the pre-audit process to obtain that certification. When certified, Flora can sell extracted products directly from Cosechemos to medical markets globally.

Perspectives on the Valuation Disconnect

What these comparisons didn’t take into account are margins on sales. What has been going on broadly in the industry in the last few years is that the industry has been flooding the market with non-psychoactive cannabis (think CBD products), with costs far above $0.06/g, presumably in an attempt to establish brands’ market share as the industry grows. The problem is that so much inventory is sold at a loss just to gain this shelf space. Flora shouldn’t have these problems, and the psychoactive (think THC products) side of things should be an industry-wide boon for profitability. Speaking of fighting for shelf space, one key thing Flora is doing is medical research on their cannabis, in an attempt to prove the potential benefits of cannabis use for consumers and distributors to see. This should help with consumer rapport.

Medical Research

Flora’s initial fibromyalgia/pain clinical trial will enroll 90 patients globally, and will gather empirical evidence of molecules to try to help tie their levels to therapeutic effects. This is exciting for the industry since minor cannabinoids such as CBN, CBG, etc. are under-researched compared with THC and CBD. Therefore broad spectrum cannabis use inherently has a lack of foundational scientific research behind it. These clinical trials aren’t intended to support an investigational new drug (IND) application or regulatory approval for drug treatment. Thus, like consumers’ favorite dietary supplements like ChromaDex’s (CDXC) Tru Niagen (nicotinamide riboside), Flora’s products will be backed by research.

The prominent person leading the research charge for Flora is their newly Lead Scientific Advisor, Dr. Annabelle Manalo-Morgan, Ph.D. She has an extensive research background and was, in my opinion, “converted” to a cannabis supporter when she healed her son, who was having seizures, using cannabis as a last-ditch effort after she had nowhere else to turn. She has an amazing story that I highly recommend listening to here. Her involvement gives me confidence that Flora will be a fact and science-driven organization intent on providing the highest quality, research-based medical cannabis products to consumers to help them in an honest manner. But beyond medical cannabis are other brands with recreational products and even hemp textiles and beverages. These will be briefly reviewed.

Brands, Collaborations, Acquisitions, and Recent Events

While the company has dynamic internal teams for various subsidiaries’ product lines and portfolios, the company has been busy with acquisitions and collaborations recently. Priorities have been in the “wholesale-side plus brands”—brands that help accelerate distribution. According to the company, their focus, or as I would call it, a checklist, for each acquisition has been to 1) complement revenues while adding to cash flow in the short term, 2) complement global distribution, and 3) complement the leadership team with the best human capital.

So here’s a brief overview of their recent moves:

Closed a $2.4 million investment in Hoshi International, an EU cannabis company. Flora is now Hoshi’s preferred supplier and has an equity investment in Hoshi, as well as ROFR for any oil or derivative product supplied. This will also open up a route for EU distribution of Flora’s other products and provide Flora with Hoshi’s EU-GMP (good manufacturing practices) auditors. Signed a 1-year sales agreement with Tropi through its subsidiary, Kasa Wholefoods, which is expected to generate $2 million in sales per month (CPGs—food and beverages, including hemp and CBD products). This also increases distribution and relationships and the revenues should become apparent next year. Forming a JV with KaLaya pain cream brand (Canada-based, award-winning brand with significant sales) to produce their products using Flora’s cannabis and then distribute across Latin America and export to the United States. LOI signed with Robust Farms for expansion of CBD and medical-grade cannabis into Panama. Strengthened its supply chain security with agreements with TruTrace Technologies (OTCPK:TTTSF) and Applied DNA Sciences (APDN) to track inventory and product testing using TruTrace’s SaaS platform (security enabled by blockchain), and molecular tagging using Applied DNA’s CertainT platform. This will ensure cannabis products are indeed coming from Cosechemos and will reduce concerns about counterfeit products. Secured 2021 quota from Columbia to export 7,900kg dried flower (high THC), enough for 2021 international demand—using a price of $1489/lb; this equates to almost $26 million in exports. Executed distribution agreement with Evergreen Pharmacare in Australia for wholesale medical cannabis. Signed agreement through Flora Beauty with GlossWire to feature Flora’s skincare products and received initial orders of these skincare products to Evergreen for the Mexican and Spanish markets Acquired Vessel Brands (TTM revenue of $6.6M and year-over-year growth of 90%) Signed a licensing agreement with Tonino Lamborghini to produce and distribute their branded beverages in North American and Columbia.

Also of note is their brand Stardog Loungewear, where they produce hemp and textile products (clothing and shoes). This brand is receiving major attention due to the sustainable aspects of hemp fabric, including launching on Macy’s (M) - one of the world’s largest retailers. This type of growth is unprecedented for a brand that is only one year old.

Lastly, I believe regulatory risks are less than some other companies who are really depending, even waiting, on the U.S. to deschedule cannabis.

Distributed Regulatory Risks

Flora is not a U.S. grow operation, so it's unclear even if federal descheduling happens what each individual state will do to regulate cannabis. So with the 50 States as well as the federal government, U.S.-based growers are essentially a lottery ticket, according to Tilray’s CEO:

“It’s waiting to buy at the right time,” he said. “At the end of the day, if we have to pay more, I’d rather be sure and pay more for something that I know is right, rather than buy a lottery ticket and hope that ticket comes in at the right time.”

The regulatory environment in Colombia is arguably a bit more progressive and friendly. Without going into the details too much, Flora has a great relationship with the locals in Colombia and also with the government. Colombia is interested in subsidizing cannabis to support industrial growth. And this goes beyond production and exports. They want to support R&D, and the development of revenue streams beyond growing, such as packaging. Local growers want to continue to stay in the cannabis industry. Flora has been an active part of cannabis associations in Colombia, with founding members being involved in a couple of them, meeting with cabinets, etcetera.

That being said, in the U.S. market, it is no secret that the regulatory environment has not cleared up as quickly as many have hoped or expected. Will the U.S. subsidize local growing, tax imported products, etc?

Conclusion

With Flora ramping up revenues through brands and wholesale, the stock is in for a major reprice to the upside even if it is to run in line with its competitors. If one considers that Flora is likely going to have 1) higher than average industry growth for a few years, 2) an easier time grabbing market share and making profits with its low COGS, 3) analyst targets for various leading cannabis companies are significantly above where they are now due to the delay in U.S. descheduling of cannabis, one might argue that FLGC shares deserve a larger premium than the average of largest in the pack (hundreds of millions to billions of dollars in market capitalization). Thus, Flora should easily reach $4 or more to be in-line with the sector and perhaps deserves a bigger premium for its massive projected growth rate (~300% FWD revenue growth YoY) and low cultivation costs, like Cronos Group. If one is less conservative in estimations, perhaps using ~60 million shares outstanding and 10x projected P/S, shares should be worth $6.66. Either way, I think this company is set up for significant long-term revenue growth and gradual market share growth. The cost advantages of their cultivation and agility of the team seem difficult to match and could represent a large competitive moat.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of FLGC either through stock ownership, options, or other derivatives. 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.