Description

Recently “reintroduced” to public markets and trading at just 3.3x mgmt’s reset 2020 EBITDA guidance, with a strong balance sheet and negligible leverage, AYR Strategies is one of the few already profitable cannabis companies and they are poised to double revenue and triple EBITDA in 2020.  While mgmt. has historically overshot their skis on guidance (requiring a rebasing in July), the assumptions behind current guidance sound much more reasonable, and the current valuation more than discounts a massive shortfall.

Despite being written up twice on VIC, AYR Strategies remains largely unknown to the broader investment community.  Both previous VIC write-ups were done under different tickers (CSA/A and CBAQF) when the company was still a SPAC.

I think a new write-up is warranted now that the company is no longer a SPAC, has rebranded itself with a new name and new ticker, reset previously optimistic guidance and begun an active IR campaign.  The company reported Q2 results yesterday, reaffirming guidance, presented at Cannacord last week and has recently been doing NDRs is NYC and Boston for micro-cap investors.  Oh, and the stock is down 45% from its highs after de-SPAC’ing at the end of May. Finally, I think this is timely as the company announced yesterday that it is de-listing from its current exchange and listing next week on the CSE, where it will trade among the rest of its peers for the first time.

Background –

AYR is a vertically integrated multi-state operator in the U.S. Cannabis sector with cultivation/extraction facilities and dispensaries in Nevada and Massachusetts.  The company reported Q2 results yesterday and concurrently announced their pending transition to the Canadian Securities Exchange, where they will have exposure to a much broader investor base.  This transition is important, as the company has heretofore been listed on the Neo Exchange in Canada, where liquidity has been sparse (sometimes less than $100k/day), despite the fact that AYR sports a market cap of $500m.

AYR is unique in that despite sporting an enterprise value that’s only a fraction of that of many of its publicly traded MSO peers, it generates among the highest levels of absolute profitability.

Anchor Portfolio –

AYR’s assets consist of cultivation/extraction facilities and dispensaries in Nevada and Massachusetts.  In Nevada, they have 5 recreational dispensaries, 3 cultivation facilities and 2 extraction/production facilities.  In Massachusetts, they have 3 medical dispensaries (with recreational licenses that are pending local municipal approval), 1 cultivation facility and 1 extraction/production facility.

AYR’s facilities are currently operating at full capacity and are unable to keep pace with demand for its products.  For example, at the Cannacord conference last week, the interim CFO disclosed that their production facility in MA had pre-orders for August for roughly twice what they are currently capable of producing on a monthly basis at full capacity.

In order to meet this robust demand, which is similar in NV, AYR is roughly doubling capacity at both facilities and expects to complete this in Q4 of this year (MA) and Q2 of 2020 (NV). 

Sources of organic growth / margin expansion –

On a pro-forma basis, AYR generated 30% ebitda margins off of $100m in revenue in 2018.  The bulk of their business comes from wholesaling product to dispensaries in MA, where they are currently serving 16 of the 29 recreational dispensaries that will be open in MA in the next month.  For comparison, they were serving only 1 of 5 open at the start of 2019.

MA is an attractive market for incumbents because the limiting factor there has been supply, not demand.  Critically, the vast majority of new dispensaries opening in MA are non-vertically integrated, retail-only dispensaries, which means they must purchase all their products from wholesalers like AYR.  So you have the number of overall dispensaries increasing, but the number of vertically-integrated dispensaries remaining flat, leading to an increase in demand on wholesalers without a commensurate increase in supply.  Note that AYR is one of only 3 licenses wholesalers in MA.

This supply/demand imbalance is expected to remain for the near-term because most of the operators of with existing cultivation licenses lack the capital to materially increase capacity and those that do have to submit their plans to the regulator for approval and only a handful have actually done so, to date.

Once AYR receives recreational approval for its 3 MA dispensaries, their wholesale volumes will be directed primarily to their own dispensaries, where the product will fetch prices 20-25% higher than prices for bulk medical marijuana.  That said, the mgmt. claims their wholesale margins are still good because they only sell higher-quality flower, which has retained its pricing power very well relative to lower-quality flower that has not.

The numbers –

Before AYR de-SPAC’d, their prospectus contained lofty guidance that few thought they could achieve.  When mgmt. gave a business update call in July, they took down this guidance – some were surprised by the magnitude of the reduction, but I think this reflects mgmt’s desire to build in a fair amount of conservatism so as not to have to reduce guidance a second time.  They have since outlined the assumptions underlying their new guidance and they are not heroic:

1) mid-late 2020 recreational approval in MA

2) 500 transactions/day in MA once receive recreational approval even though NV locations currently doing 900/day

3) completion of in process capacity expansions on time (totally in control of mgmt. and tracking on time) 

New guidance is:

2019 Pro-forma revenue of C$160m and EBITDA of C$45m (at mid-points).  2020 guidance is for revenue of C$315m and EBITDA of C$145m (at mid-points). 

This puts AYR currently at 3.3x 2020 EBITDA, which is way too cheap for a business growing the top line at 100% with mid-40s EBITDA margins and a strong balance sheet that allows them to fund this growth internally with no need to tap capital markets. 

Importantly, the majority of this guidance is based on the on-time completion of their capacity expansion projects in order to meet current, existing demand, and mgmt. is confident they can complete these projects on time.  The second largest assumption embedded in this guidance assumes municipal approval of recreational sales at the 3 MA dispensaries only comes in the back half of 2020 (1 store in May; the other 2 in Sept). This strikes me as conservative, but even if approval never comes at all, mgmt. claims only 10% of rev and 5% of EBITDA in the guidance is at risk.  But let’s say it’s more like 30%. Less than 5x EBITDA still feels quite cheap for these assets. There are thoughtful arguments for why AYR might deserve to trade at a premium or discount to some of its comps (I recommend reading the other write-ups for more detail), but I don’t really care about where peers are trading (they all trade at a massive premium to AYR).  I think the stock is cheap enough on an absolute basis.

Additional optionality around M&A –

AYR intends to create additional value via disciplined M&A.  Mgmt has said there are only 10 states they are looking at and would restrict themselves to locations that represent the majority of share of wallet across the country, targeting companies that are EBITDA positive with best-in-class operators in limited license states.  With capital markets now effectively closed to cannabis companies, deal flow has increased and asset prices have come down, providing more attractive consolidation opportunities.

Management –

This industry tends to attract sub-par management teams, but the team at AYR is one of the best in the space, including the former global CMO at AB-InBev, as well as a former MD at Goldman and the CEO, who served as President of Bank of America Securities and founded a multi-billion dollar asset manager.  These aren’t a bunch of potheads…

Also worth pointing out that several executives were buying stock in the open market throughout July after their guidance reduction.

In sum, I expect this company to receive much more attention in the coming weeks, as they have now rebranded themselves, started attending investment conferences, reported Q2 results, and will being trading on the CSE on August 19th.  Once more investors become aware of the company and recognize the growth on what is already a profitable business, I expect AYR to see significant multiple expansion to reflect its competitive position within attractive markets, its ability to fund all growth internally, and the minimal execution risk associated with achieving its targets.

Risks:

- Mgmt was previously optimistic about guidance and could be too sanguine again.  This is mitigated by the current valuation, which I believe is already pricing in a material shortfall.

-  MA recreational approval for the 3 dispensaries could take longer than anticipated.  This is another version of the risk factor above.

-  The company is currently searching for a CFO.  The interim CFO has been the COO since the company’s founding and I expect a new CFO will be found shortly.

-  The CEO is currently sponsoring another cannabis SPAC.  Optically off-putting, but his day-to-day is at AYR and ultimately he is aligned with us as he owns 6 million shares and is the company’s largest shareholder.  Note he is restricted from buying more shares on the open market by Canadian law.

Note:

1) For share count, I am using 17.2m subordinate & multiple voting shares, 7.9m exchangeable shares, 16.4m warrants (strike price at $11.50), and 1.4m rights.  Treasury stock method gets you 30.3m fully diluted shares outstanding.

2) The warrants also trade, expire in December 2021, and are even more attractively priced than the equity.  At the current quote, they are available at only a 2% premium to their intrinsic value, implying the market thinks this stock will be exactly where it is now in over 2 years from now, even though EBITDA will likely have tripled by then.  Mgmt initially planned to accelerate the expiry of the warrants, but has since announced they will not be doing so anytime in 2019.  They would consider doing so sometime in 2020 but only if the stock price meets a C$18 threshold based on a rolling 30 trading-day reference period beginning Jan 1, 2020.  That is 25% higher than current prices.

Catalyst

Listing on the CSE August 19th

Municipal approval of recreational licenses for AYR's MA dispensaries

Completion of capacity expansion in MA in Q 2019

Additional sell-side coverage (currently covered by Cannacord Genuity)

Continued reports of strong organic growth