Description

Introduction

POSaBIT Systems Corporation (CSE: PBIT; and OTC: POSAF), a leading technology company delivering payment processing (debit/credit/crypto solution) and point-of-sale (POS) systems for the cannabis industry, probably shouldn’t be a public company. Certainly, at today’s valuation, if you ask management, they would agree with this sentiment. Even with the recent rally, the shares currently trade at a pitifully low multiple of sales (3.5x FY22E) and reasonable multiples of forward earnings, despite the wild immaturity of the business and putting up 250-300% recent topline growth. I believe shares are worth over $4 today, or >3.5x above the current stock price.

This opportunity exists because the company had no traditional IPO; is listed on a terribly minor Canadian exchange and only recently moved to the OTC boards; and has no street coverage. The company went public through a reverse merger into a Canadian shell company and, simply put, no one is paying attention – as a case in point on the recent blowout 2Q earnings report where PBIT delivered 232% YoY revenue growth and raised annual guidance aggressively, there was not a single question asked on the call – by either sell or buy-side! The forthcoming quarters should constitute a potent cocktail of improved disclosure; better trading liquidity; more investor awareness; and of course ongoing rapid growth in the fundamentals. Importantly, management is cognizant of the valuation disconnect and I believe will pursue a Nasdaq relisting in the mid-term (by end next year).

Company Overview

Based in Seattle, Washington, POSaBIT Systems Corporation (CSE: PBIT) is a leading technology company delivering payment processing (debit/credit/crypto solution) and point-of-sale (POS) systems for the traditionally cash-only cannabis industry (where federal law has heretofore restricted traditional payment companies from operating). The company serves >300 clients for payments (in 14 different states), and 100+ with POS services. PBIT has suggested they will launch in 5-8 more states this year, as well as Canada, and obviously as more of the US legalizes they will roll out their products over time in these new markets as well. Their solution is fully KYC (‘know your customer’), AML (anti-money laundering), and OFAC (Office of Foreign Assets Control) compliant. The company has a decent investor deck (available here) that covers the basics of the business and its value proposition.

PBIT is I believe a  ‘best in breed’ way to play a hyper-growth industry with multiple secular trends, but at a knock-down, value-ish multiple. Unlike many other listed cannabis companies, the business is structurally profitable, has high incremental margins, is capital light, and with high gross margins and a high ROIC at scale. Payments processors are excellent businesses – unlike commodity cannabis production, or many commoditized retail offerings – and thus we should expect to pay a large premium for a high-growth payments processor exposed to multi-year, secular growth trends. Instead, the opposite is true for now: we get to invest at a deep discount to the prices paid for inferior businesses. This disparity probably won’t last.

The company achieved accelerating top line growth of 327% in 4Q and achieved a 79% CAGR between 2018 and 2020. Recently announced 1Q and 2Q results continued this trend – 276% and 232% revenue growth in each quarter respectively, expanding gross margins, positive EBITDA – and the company is likely to crush 2021 guidance throughout the year (which itself was raised at 2Q reporting by >20%). Impressively, unlike most other hyper-growth stocks, the company is EBITDA positive. 

Given the large runway in cannabis and increasing digital payments penetration, I am confident that PBIT can sustain strong revenue growth and drive margins in-line with other payment companies.  Importantly, I believe the unit economics are sustainable even after federal legalization of cannabis and SAFE banking occurs (to be discussed later).  

What does PBIT actually do?

Posabit offers a cashless cannabis payment solution in traditionally a cash-only industry. The company has innovated to legally offer traditional debt, point of banking, credit cards (through a two-step transaction using cryptocurrency), and ACH. The company leads with compliance and an integrated payment portfolio. Most of their competition either offers a closed loop credit card/ACH system or a clunky POB product.

These are the various payment solutions PBIT offers to its clients (cannabis dispensaries and retail stores):

Debit: Traditional debit to the penny. This is what most consumers are familiar with doing when they want to use their debit card at a store. The merchant hands the customer the terminal and the customer enters their debit card PIN #. The customer pays a convenience fee. The merchant also pays a payment processing fee;

Point of Banking (POB): This is the most common payments solution in the cannabis market. It’s inefficient because the transaction is rounded up and it is treated as an out-of-network ATM charge. The customer enters their debit card PIN # and the dispensary gives the customer cash back. If the customers’ bank charges $3-5, they need to pay the bank fee plus the convenience fee so this is a more expensive option overall. This is currently the biggest competition for POSaBIT;

Credit Card: PBIT was actually founded with this transaction as the primary solution. A retail customer will first buy crypto (litecoin/bitcoin) on their payments terminal (they have the ability to walk out the store with just their crypto) and this transaction is written in the blockchain. In a seamless transaction, the user then approves the cannabis transaction. The merchant hands the customer the terminal and the customer needs to accept a convenience fee. The merchant also pays a payment processing fee.

ACH: Traditional ACH from a bank account. It’s a clunky transaction but PBIT has the capability.  Customers pay a transaction fee, while the merchant pays nothing.

PBIT’s integrated solutions also enable built-in loyalty, discounting, robust back-end reporting, SMS/MMS messaging and other critical operational functionality. Clearly, as more of the cannabis retail dollar moves towards digital payments, these offerings will be enhanced over time (indeed PBIT is already building the organization for this growth).

Massive Secular Tailwinds

PBIT is perfectly positioned at the intersection of huge secular cannabis adoption and the digitalization of cannabis payments infrastructure. We all know cannabis is no longer a taboo topic, nor even a frowned-upon social habit – rather, it is seeing an increase in legalization for recreational use with New York, Virginia, Montana, South Dakota, Arizona, and New Jersey among the recent states to grant approval. At the same time, payment companies have been benefitting from the digitization of payments (cash to card) in traditional industries, but the cannabis industry remains in its infancy with cash maintaining a share of wallet of ~93% vs. 5-10% for traditional retail. PBIT highlights how immature the industry is in its most recent deck:

PBIT should be a huge winner from both the move away from cash, and the gravitation of more retail dollars to cannabis. Indeed, a recent white paper details some of the myriad problems with the cash-heavy nature of the cannabis retail trade today:

Given the legacy of criminality and risk of money laundering that are two of the practical consequences of having a cash-heavy, retail-focused cannabis industry, it is in everyone’s interest to see the rapid replacement of cash by digital/electronic money solutions. Obviously, this would be hugely beneficial to an early adopter like PBIT.

Indeed PBIT’s most recent 2Q report clarifies that merchants see the obvious logic in increased digital payment penetration for many of these reasons. It turns out – as in other retail – consumers simply prefer paying by card, and tend to spend more, and have a better experience, when they do so:

As for the broader market, large listed players expect that US Cannabis retail sales will double between 2020 and 2024 to $34 billion:

That is to say, PBIT is in the fortuitous position of being able to enjoy growing adoption of their solutions – cashless, digital payments-enabling technology – even as the total retail pie grows rapidly. This should set the stage for many, many years of above-trend topline growth as both the broader market, and cashless payments’ share within this market, accelerate.

Fleshing out the financial model

The company’s growth has been nothing short of explosive, with revenues doubling or tripling every year. For 2021E, the company has guided to ~130% growth in revenues, although note that in 2Q they continued to put up eye-popping growth rates (+232% YoY) driven by an even bigger spike in payment volume, so I expect they will beat this guidance quite easily and keep growing from there:

Whilst we are still extremely early in the business cycle for PBIT, it’s important to note that they reached EBITDA profitability for the first time in 3Q ‘20 as gross margins grew to 25% from 19% in the prior quarter. GMs are still 27% in 2Q’21, but FY guidance is now 30% midpoint at the GM level (implying increasing margins throughout the year) and thus the beginnings of operating leverage flowing through the model. Incremental margins are very high for payment processors (far higher than what I am tentatively modeling below), and I would expect a strong margin trajectory in the coming quarters and years:

As you can see, there is no rocket science behind my model – extrapolating the recent trend and baking in some operating leverage as the business begins to scale, this is clearly a solidly profitable business trading at a very low absolute valuation, even extremely early in the business’ S-curve. But the simple truth is false precision is not required here. The fact we can buy this business at ~3.5x next year’s revenue – when it is solidly profitable, already! – fairly boggles the mind. Given the scope of the opportunity; inflecting growth and profitability; and reality of earnings power for at-scale payments processors, I believe this should trade north of 10x FY22E revenue today. If this were a private company or listed on a proper exchange, I expect the multiple would be much higher than this.

Why Does the Opportunity Exist?

PBIT received bad advice to come public through an RTO (reverse takeover). This is a popular method of coming public in Canada and involves taking over a shell company (also somewhat common in Australia), but obviously it doesn’t generate any investor awareness and so RTO often languish, for years, even if the business is growing rapidly (as is the case here). In speaking with management, they thought it would be listed on the TSX Venture Exchange – a small but well-known ‘starter’ exchange for smaller growth companies – but they ended up getting stuck on the Canadian Securities Exchange (CSE). If the TSXV is a bit of a backwater, the CSE is the financial equivalent of a Wild West saloon: no one comes in, no one goes out, and for the most part securities there simply languish in obscurity:

This explains why we are able to buy a dominant payments processor in a rapidly growing niche with a huge runway at 3.5x forward sales. Indeed, today, many US brokers actually can’t even transact in the stock! But of course this is also likely to change, and imminently: PBIT recently graduated to the OTC exchange, and trading volumes have increased considerably in recent weeks. As a result, the name is finally somewhat investable for US investors, and so now is therefore the right time to get up to speed on the name. I expect the valuation to begin to rerate quite rapidly into and around a potential proper uplisting to the Nasdaq and as the topline continues to print >150% organic growth through 2H and into 2022.

Thoughts on valuation: PBIT should be valued 4-5x higher today

There are various ways to cut the valuation, but on any relative or absolute metric the current valuation is absurd. Today, the fully diluted market cap is $137mm, and the all-in enterprise value is $131mm. That’s barely 3.5x EV/FY1E revenues, and mid-20s multiple of EBITDA next year - despite being at the very beginning the S-curve for this business. This is so far below the baseline valuation for the opportunity that exists, it almost beggars belief.

Larger payments names listed on ‘proper’ exchanges generally earn higher multiples for higher growth. I tried to figure out what typical payments investors value most in looking at these stocks, and unsurprisingly there is a very high correlation between expected organic growth and the valuation multiple the market is willing to accord a given name. If you look at the below correlation matrix, you will see there is a ~92% R squared (correlation coefficient) between out-year organic growth and the EV/EBITDA multiple, meaning, simply if PBIT could simply maintain a 30% growth rate – versus its current 230% growth in 2Q – it would imply a ~$2.4 stock price, or a double from here:

I am not trying to be exaggeratory, nor do I expect a microcap on an inferior exchange to earn these kinds of multiples near-term – but this just serves to demonstrate how gargantuan a valuation gap exists versus industry comps.

An alternate method would be simply to comp on an EV/sales basis to ‘high-growth’ cannabis names – even though the economics of cannabis production, or retail cannabis stores, should at scale be far inferior to those of a payment processor, and of course basically all these names are locked in market share wars and losing boatloads of cash. But even on this basis, most of these names trade in the 5x+ forward EV/sales range.

There are other data-points on valuation from private market transactions, but they all lead us to the same conclusion. Basically every high-growth payments/fintech name doing a funding round in the private markets is being valued somewhere north of 10x revenues (see here, or here, or here, or here). I do not think it is worth examining the minutiae of each name there versus PBIT, but I think the overarching point is quite clear. The beauty of this situation is that we don’t need to expend too much energy trying to pinpoint the exact ‘right’ multiple or price for PBIT. What we can say, with confidence, is that the price today appears wrong by standard deviations, and is entirely a function of lack of awareness from investors. To make a huge excess return we simply need the company to promote its story better. Beyond that, to make an absolute killing, we will need to underwrite strong business execution in the coming years. But the first few bags of the multi-bag are, I believe, simply there for the taking.

Catalyst Path – a plethora of value-accretive events

There are several significant catalysts I expect in the coming months. Obviously I expect continue strong topline growth, ongoing profitability, and further inflection in the PnL as operational leverage begins to demonstrate itself. More importantly, the company has recently completed its US OTC listing; and I expect this to be followed by a Nasdaq uplisting when possible (I expect this to be a 2022 event). In conjunction with this potential uplist, I do expect the company to be more proactive on the IR front (they have recently hired an IR firm; have added new board members with more capital markets experience; and are starting to focus on ‘telling the story’ better, so baby steps so far but heading in the right direction).

Further, the company announced an innovative partnership with I Heart Jane, a cannabis distributor, earlier this year – we could see more partnership of the like developed as PBIT extends its reach across new states and to new customers.

There is also the possibility for accretive M&A, if or when the stock begins to reflect the value in company more appropriately. PBIT has a very large, fragmented market to penetrate, from a position of strength, and M&A is proceeding apace within the cannabis industries as growers, dispensaries, and retailers all look to get more scale. to capitalize on their industry position and accelerating fundamentals. Indeed, a peripheral competitor, The Dutchie, recently merged with Greenbits and LeafLogix at a $1.7bn valuation, highlighting both the opportunities and sky-high valuations in the space (I have heard that the combined companies have much less than $100m in revenues, implying a 20x+ revenue multiple for the transaction). Note, of course, that 20x sales for PBIT would imply a $4-6 stock…

The key risk – what happens post federal legalization??

As with any investment, particularly microcap/early-stage companies, there are risks. In this case, I believe the main risk relates to federal legalization, and what happens if (or perhaps when) much larger banking and payments players can enter the cannabis market post this (likely) law change in the coming years. I spent a significant amount of time diligencing what could happen to the unit economics for cannabis payments should federal legalization occur.  My tentative conclusion is that cannabis would remain a ‘high risk’ industry – which should enable PBIT to maintain its current unit economics while increasing digital payments penetration. If cannabis were indeed to remain a high risk industry, then the incremental business opportunity would likely not be worth the heightened regulatory scrutiny, for massive financial institutions and payments players – leading to a maintenance of, if not the status quo, then something akin to it (and still highly profitable for the likes of a PBIT).

The key learning here is that even for federally-legalized, ‘normal’ industries, if you are deemed a ‘high risk’ industry you operate in a different banking (and payment) paradigm than traditional industries. If you run a business with a higher risk of chargebacks and want to process credit card transactions, you need a high-risk merchant account. A high-risk merchant account is a payment processing account for businesses considered to be of high risk to the banks. As high-risk businesses are more prone to chargebacks, they come with the need to pay higher fees for merchant services. Examples of high risk industries include: airlines, pornography/adult-related, antiques, casinos/gaming, cigarettes/tobacco, collection agencies, dating, drug paraphernalia, fantasy sports, health and wellness products, hypnotists or self-hypnosis services, nutraceutical, online gaming, timeshares or time-share advertising, and vitamin and supplements.

Note that I have italicized many of the above examples – these industries overlap with cannabis, meaning that even post federal legalization it is quite likely that cannabis remains categorized ‘high risk’ by the banks (as per many of these other industries which are for the most part federally legal throughout the whole country and thus have no technical limits on banking federally).

In the table below, you can see payment processing charges for high risk industries. Note that, interestingly, the current PBIT take rate (~5%) is lower than the high risk mid-point.  This gives me confidence in the sustainability of PBIT’s unit economics in a post-federal-legalization environment:

It is also worth mentioning that I expect PBIT’s take rate to come down, over time, due to competition and increasing scale (note that I model 4.5% take rate next year, for example, vs 5%+ realized so far this year). Should this occur there would, theoretically, be even less pricing risk versus other, federally-legal ‘high risk’ industries in a few years when the federal legalization takes place.

The other positive corollary of federal legalization would be a massive acceleration in digital payments adoption. With legalization, we would expect to see cash’s share of wallet decline from 70% to sub-30%, or lower, in-line with the rest of traditional retail. This means the transaction volumes through PBIT would explode, almost overnight (2.5-3x if cash share dropped to simply 30% from 90% today), while their unit economics would inevitably decline. Still, that is a tradeoff I would be very happy to make!

The other main risk: liquidity

The principal other risk concerning me is, of course, liquidity – always a key concern with microcap stocks. I do expect liquidity to improve as awareness increases. As mentioned, the company recently hired an IR firm and is beginning to tell the story; I am hopeful the OTC listing is a prelude to a Nasdaq uplisting, though, speaking to the company this is probably only a 2022 event. As always, liquidity in microcaps tends to be reflexive with valuation, such that as the valuation improves, liquidity will also improve (PBIT is already beginning to demonstrate this). There are a number of US-based shareholders that initially funded the company that could take some chips off the table as the stock rises, helping to improve the liquidity (even though management/insiders own 37% of the company and will not be sellers).

Catalyst

Quarterly earnings, continued strong organic growth

Graduation from OTC to Nasdaq

Graduation from CSE to Venture and/or TSX main board

Potentially acquired by another payments and/or cannabis firm