Aegis Brands: Decent Upside Potential If Coffee And Cannabis Retailer Can Make It Through The Pandemic
Long Only, Value, Growth At A Reasonable Price, selective contrarian
Seeking Alpha Analyst Since 2018
Summary
- Aegis Brands has pivoted from being a single-brand entity into a portfolio of brands that include the Second Cup Coffee Co., Bridgehead Coffee, and Hemisphere Cannabis Co.
- A recently-announced secured credit line, virtually no other debt, and positive cash flows in 2020Q3 should help its liquidity position as it navigates through the pandemic.
- Hemisphere Cannabis, and the Bridgehead acquisition in January 2020, are potential bright spots in an investment case.
- But legacy issues with the Second Cup, and continued headwinds from the pandemic, risk weighing down the company.
NOTE: This blog post discusses a thinly-traded micro-cap. Please exercise caution if you trade in this security, e.g. by using limit orders.
Just over a year ago, Aegis Brands (OTCPK:SCUPF) launched a strategic move away from being a single-brand entity (i.e., "The Second Cup") towards managing a portfolio of retail brands: The Second Cup (a Canadian coffeeshop chain, with 200 franchised cafés and 31 company-owned cafés as of 2020Q3), recently-acquired Bridgehead (with 19 Company-owned coffeehouses located in Ottawa, Ontario), and the recently-launched Hemisphere Cannabis Company, with 4 retail cannabis dispensaries open by the end of 2020. My view on the stock is that there is potential upside of around 50% that would go along with an economic recovery that might take place over the next year or two. However, caveats make me reluctant to recommend the stock, unreservedly.
I didn't take much notice of the Second Cup in my past few years of stock investing — it appeared to be shrinking rather than growing, with some locations being lacklustre in popularity — plus the decaf was kind of low on flavour (the rest of their coffee is alright). The roughly 93% decline in share price since 2007 reflects that the Second Cup did not live up to expectations of becoming Canada's answer to Starbucks.
The acquisition of Bridgehead in January 2020 piqued my interest, however — I have frequented Bridgehead locations for several years, and have a high regard for the coffee and brand. While the acquisition's timing proved not to be fortuitous, with the Second Cup's system sales plunging 68% year-over-year in 2020Q2, and 43% in 2020Q3, these headwinds could abate as vaccines are rolled out. Meanwhile, the share price is down 44% in the past year.
Aegis has survived the pandemic so far, and 2020Q3 cash flows nudged into positive territory. With a recently-announced secured credit line and virtually no other debt, they might actually survive long enough to see a recovery. Overall, the effort to pivot towards a portfolio of brands gives a plausible way forward, if Aegis can emerge without too much damage from the pandemic.
In this post, I look at each of these three brands, as well as Covid-19 risks, financial strength, and valuation.
The Second Cup
Despite the pivot, the Second Cup Coffee Company remains the largest part of Aegis Brands, by store count and revenue.
The decline in store count from 349 in 2010Q4 to 244 in 2019Q4, and 231 in 2020Q3, along with years of (mostly) losses, could speak for itself. Same-store sales comps have been slightly negative since at least 2011. The Second Cup’s travails over the past several years are described in more detail in articles on SA such as "Second Cup: No Second Chance" (June 2017), and "Second Cup: A New Loan from Serruya Won’t Save the Company" (January 2017).
Part of the misery stems from increased competition from Starbucks and independent coffee retailers on the higher end, and Tim Hortons and McDonalds on the lower end. To compound the issue, a poorly-executed re-branding sometime in 2014-2016 exacerbated weak franchisee relations (e.g.: facebook group). And there is ongoing litigation by a group of franchisees based in Quebec, seeking damages of C$2.7M, based on the misuse of ad funding, and problems with supply sourcing.
The company’s practice of "taking back" underperforming cafés presumably adds to such frictions — though perhaps this is common in the world of franchising. Simple arithmetic suggests that Company-owned stores have revenues in the C$300K-400K range, versus around C$565K in system-sales per store in 2019, overall.
In response to a continued decline, a loan from Serruya Private Equity was converted to equity in July 2017, and a bought deal in April 2018 led to additional equity of about C$10M (net proceeds of C$9.2M), at C$3.45 a share. There was a period of executive turnover, which seems to have stabilized, with Steven Pelton now in place as CEO since June 2019. Aaron Serruya and Michael Serruya both sit on the Board of Directors. Serruya is known for Yogen Früz, along with investments in Pinkberry, Wind Mobile, Milestones, and others (but also the now-defunct American Apparel). They appear to be long-term oriented and focus on "transforming companies by collaborating with management".
Growth plans for the Second Cup involve opening 17 "non-traditional" Second Cup café locations by the end of 2021, along with two drive-thru locations. The emphasis on non-traditional locations, e.g. sites at hospitals, airports, train stations, etc., could signal a step back from previous franchise efforts, which haven't led to great results in recent years. The drive-thrus are planned at Petro-Canada locations in Ontario. This seems like it will only partially offset the declining secular trend for the Second Cup, on top of the effects from the pandemic.
The pandemic has resulted in multiple lockdowns, the timing of which has varied by region. By Q3, 180 Second Cup cafés had reopened, but Ontario (where more than half of all stores for the three brands are located) recently entered another month of lockdowns, making it roughly the third month for the province, in total.
Bridgehead
Bridgehead has 19 locations that are all company-owned and located in Ottawa, Ontario, a city with a population of about a million. Four of these locations are in office buildings downtown, and have been closed since the pandemic started. Its financial performance was described as having "average unit volumes approaching C$1 million", in a competitive coffee market that includes a few dozen Starbucks, many Tim Hortons, along with countless other coffee retailers of various forms.
My back-of-the-envelope calculation is that Bridgehead had sales of roughly C$750K per store annually, leading into the pandemic, which would have meant a 53% increase in revenues versus 2019, in normal times, for Aegis. This compares to roughly C$565K/store for the Second Cup, around C$2.1M for company-operated Starbucks stores in the Americas, and C$1.7M for Tim Hortons, in 2019. Of course, this is hardly a complete comparison, and the latter two trade at much higher valuations.
NOTES:
Starbucks: 2019 revenues/(midpoint # of stores) = $16,288.2M USD/((9974 + 9690 stores)/2) = $1,657K USD, for Company-owned stores in the Americas.
Tim Hortons: 2019 revenues/(midpoint # of stores) = $6,716M USD/((4932 + 4846 stores)/2) = $1,374K USD.
Bridgehead operates in the same "upper" tier of the coffeeshop market as Starbucks, with similar price points, but still offers better coffee-value than most independent coffee shops. With coffee sourced from small-scale farmers, local-sourcing for other ingredients, and compostable packaging, fair-trade and sustainable practices are highly visible and integral parts of the Bridgehead identity. I would contend that management's statement that "the affinity for Bridgehead Coffee brand remains strong despite the pandemic" is likely an accurate one.
Based on the corresponding press release, the plan was for Bridgehead to maintain autonomy. Not to state the obvious, but if a retail concept is successful in one region, there's a realistic possibility that this success could be replicated elsewhere. As per the 2020Q3 release, the pandemic has delayed plans to expand into Toronto, but this might resume by early 2022.
Hemisphere
Aegis Brands has been relatively slow out of the gate in cannabis retailing. With ~4 locations opened so far in 2020H2, in Toronto and Ottawa, and three more that are getting ready to open, they are much smaller than the leaders in the space, which include Fire and Flower (OTCQX:FFLWF, FAF.TO), High Tide (HITIF, HITI.V), and Inner Spirit Holdings (OTC:INSHF, INSH.TO), which have 71, 66, and 67 retail locations respectively, as of December 2020 (and plans for more, of course). Cannabis was legalized in Canada in October 2018 for recreational use, but the legal retail market is arguably close to saturated already in Alberta, with varying degrees of room to grow in other provinces. Their goal is to have 30 Hemisphere locations across Canada by the end of 2022.
It looks like these other cannabis retailers did about C$400-500K per store in 2020Q3, or C$1.6-2 million at an annual run rate. So with just the seven locations that are either open or getting ready to open, even if they only reach C$1M per store, this will soon be a non-trivial part of Aegis, in terms of total revenue.
I'm not convinced that Hemisphere will knock it out of the park. It's still early days, but they seem to be getting somewhat fewer Google reviews than some competitors (although the ratings are okay), and the best coffee shop locations might not necessarily be the best locations for cannabis dispensaries.
The extent that increasing competition could dampen sales is another unknown. On the plus side, the Fire & Flower CEO stated on a call that around 75-80% of the cannabis market was still illegal, so there could be room for legal retailers to capture some of that.
It seems plausible that there could be some synergies in the context of a portfolio of brands, and having CBD-infused beverages at the Second Cup (pending future deregulation of CBD) could be a meaningful differentiator versus other coffee places.
Cannabis should be relatively pandemic proof, and the company states that Hemisphere is achieving store level profitability, with operations currently limited to curbside pickup, in the Ontario lockdown.
COVID-19 Exposure and Recent Performance
Being in the retail industry, Aegis obviously has significant exposure to Covid-related risks. Delays in rolling out a vaccine, a more contagious Covid variant, and/or further lockdowns would be significant headwinds that would put additional pressure on the company.
As seen in Table 1, system sales declined by 68% year-over-year in 2020Q2, and partially recovered to a 43% decline in 2020Q3. For total revenue, the declines were 46% in Q2 and 6% in Q3, factoring-in Bridgehead and Hemisphere. E-commerce has picked-up for Bridgehead, from C$150K in 2019 to an expected C$700K+ in 2020, although this is only around 2.7% of LTM total revenue.
The fact that most Second Cup locations are franchised might help to absorb the impact of the crisis. While small businesses (e.g. franchisees) have borne a large brunt of the crisis, they do have access to government support programs. So far, eleven Second Cups, or 4.5%, have closed permanently since 2020Q1.
Table 1: Recent Performance (C$ ‘000s, except per-share info)
Financial Strength
Aegis entered the pandemic with virtually no debt on its balance sheet. It had C$70.3M million of long-term lease liabilities in 2020Q3 — of that, C$42.8M was offset by sub-leases to franchisees.
Aegis says it's confident it has enough liquidity for short-term business needs — I suppose we'll find out how long "short-term" could mean. A recently announced secured credit line of C$4 million, from Canadian Western Bank, should help in this regard.
Aegis plowed through about C$3.5M in cash, in 2019. Interestingly, though, with some help from rent abatements, cash flow nudged into positive territory in 2020Q3, seen in Table 2.
Table 2: Summary of Cash Flows (C$ ’000s)
The credit line's cost of financing is Prime + 3.20%, and has fixed charge coverage ratio (FCCR) and funded debt to EBITDA (senior leverage) covenants that kick in around FYE2021 and mid-2022.
Valuation
My assumption is that there won't be any long-term disruption to coffee-consumption patterns. Coffee shops are ideal as a third place, while cannabis is relatively pandemic-proof.
Table 3 shows some current valuation ratios. I've also calculated enterprise value excluding lease liabilities, given that much of this is offset by subleases, or could be subleased in the event of a store closure.
Table 3: Current Valuation Multiples
To get some forward-looking ratios for Aegis in year 2022, in Table 4, I've made the following assumptions for bullish, neutral, and bearish scenarios:
Second Cup sales decline by 15%, 20%, or 25%, respectively, based on a combination of same-store declines, and store closures.
Bridgehead does sales of C$850K, C$750K, or C$650K per store.
Hemisphere does sales of C$1.25M, C$1.0M, or C$0.75M per store.
Bridgehead and Hemisphere have an EBITDA margin of 12%, 10%, or 6%, versus about 6% for the Second Cup (based on adjusted EBITDA for 2019).
Additional debt of zero, C$3M, or C$6M, to survive the rest of the pandemic, on top of the recently announced C$4M line of credit.
This abstracts from additional growth initiatives, e.g. new Hemisphere locations or acquisitions, of which the latter would likely require additional capital.
Table 4: Hypothetical Valuation Multiples, FY2022
Getting back to x3.5 EV/sales in the neutral case would give a share price of C$1.40, a gain of 52% versus the C$0.92 close ($0.72 USD) on December 31st (C$0.89 close on Jan. 6th). On the other hand, the EV (ex-lease)/Sales in the bearish scenario is slightly above the current multiple.
Another way to look at the current valuation would be to observe that recent transactions for cannabis dispensaries, e.g. from Fire & Flower and High Tide financial statements, are in the ballpark of C$1M per dispensary. If that’s representative of what Aegis could receive for Hemisphere, then C$7M for seven locations, plus C$10M for Bridgehead (given that it arguably has some growth potential), would get close to the current market cap, valuing the Second Cup brand at only around C$6M, assuming the credit line was already fully drawn. In other words, a sum-of-the-parts approach could suggest that one is getting the Second Cup for *almost* nothing (at least compared to its market cap years ago).
Concluding Remarks
The caveats are significant. Hemisphere is still in the early innings, and the pandemic continues to put strain on both the company and its franchisees. I would be most concerned with The Second Cup's performance through the pandemic and in the long-term, given its secular decline. 2020Q4 and 2021Q1 will be affected by the recent lockdowns, as well, possibly leading to financial numbers somewhere in between those of Q2 and Q3, and some more downward pressure on the stock, if the market has not anticipated that.
But the pivot to a new strategy focusing on a portfolio of brands gives a plausible way forward for Aegis. Prior to the pandemic, the Second Cup brand already had declining sales for many years, in the face of increased competition. The risks are high, but an economic recovery, and traction with Bridgehead and Hemisphere, should lead to gains in the share price.
Analyst's Disclosure: I am/we are long SCUPF, FFLWF, HITIF, INSHF.
I'm not a financial adviser/advisor, and this post is only intended to express my own opinions. This is not a comprehensive assessment, and while I endeavoured to reasonably characterize my understanding of the potential risks & rewards, I could have overlooked key facts and/or risks. Furthermore, these positions represent only a small part of my overall portfolio, and my views could change at any time, not least because of new information that might become available. The suitability of an investment depends on your own personal circumstances and risk tolerance. You are responsible for your own due diligence.
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