This week, we gave our viewers the opportunity yet again to select our company of focus for our full analysis. Overwhelming, among the three options presented viewers selected The Hydropothecary Corporation (TSXV: THCX). Admittedly, we knew little about the company when we first presented the option to our dedicated readers. Due to our lack of knowledge on the company prior to our Deep Dive, we had no idea what we were in for.

Within The Hydropothecary, we found a highly polished, professional organization that always seems to go the extra mile. Whether it be assisting the provincial government with draft legislation, or informing shareholders that a product recall is imminent, Hydropothecary always takes that one extra step to provide value above and beyond its competitor. The method in which it lays out information in its investor presentation, or provides informative videos outlining its success speaks to a management team that understands the importance of presentation, yet honors transparency. By the time our research was complete, we were thoroughly disappointed that we hadn’t examined the stock earlier.

The Hydropothecary: The Pride of Quebec

Originally incorporated in mid 2013, The Hydropothecary has become the pride of Quebec when in reference to licensed cannabis producers. As the first to receive its license to cultivate and subsequently sell cannabis in the region, the success of the company has become ingrained in the topic of cannabis within the province. At the present point in time, it remains the only facility in Quebec that can legally sell cannabis product. There are five other operations in existence that are currently able to cultivate within the region.

Corporately, the structure of the company consists of a single wholly-owned subsidiary known as The Hydropothecary Corporation, which is referenced to as “Predecessor THCX” within financial documents. Predecessor THCX then has a single wholly owned subsidiary listed as 167151 Canada Inc. This numbered company is the corporation that initially received the licenses to produce and sell medical cannabis and oil products.

Hydropothecary’s Current Operations

The Gatineau Facility

The operations of The Hydropothecary are located on the outskirts of Gatineau, Quebec within the National Capital Region of Canada. This is where they have been located since initially receiving their license to cultivate cannabis in early 2014. At the time, the facility was 7,000 square feet in size and capable of producing roughly 600 KG per year of dried cannabis flower.

Whereas other corporations in the sector have elected to expand their portfolio through acquiring multiple licensed producers, the Hydropothecary elected to do so by staying true to their roots. To do so, they have continuously expanded their operations at their current facility. At the present point in time, the facility encompasses a total of 50,000 square feet. Within this figure, is roughly 42,000 of canopy space, with the remainder being utilized for warehousing and sales purposes. Current production figures are capped at 3,600 KG, with the company being quoted as stating they are running at full capacity presently.

In anticipation of increased demand with the advent of recreational marijuana, the company has taken an aggressive strategy with regards to expansion. In August 2017, the company announced that it had entered into an agreement for the procurement of a 250,000 square foot addition, with a planned completion date of July 2018. This addition is set to increase the total annual production figure to 25,000 KG of dried cannabis.

With investors being excited about this initial expansion, they were blown away when on December 12, 2017 it was announced that the company had acquired an additional 78 acres of land. With this land being adjacent to their current 65 acres, it brought the total facility footprint to a whopping 143 acres.

In addition to this land purchase deal, it was announced that a new facility would be established on this property. In terms of square footage, it will be one of the largest in Canada – an impressive 1,000,000 square feet. Even more impressive, is the fact that the $80 million building will be funded through the use of cash currently on hand. Further funding will occur through a recent short form prospectus, which will assist in providing $35 million for the state of the art equipment located within the facility. To this end, the company has stated that it was be highly mechanized with the use of robotics throughout. Expected completion of this expansion is December 2018.

With the inclusion of the current expansions under way, the total facility size will be 1,300,000 square feet. This translates into an estimated annual production figure of 108,000 grams of cannabis at full capacity.







Current Product Offerings

Presently, the company offers four lines of product. Of these four lines, two consist of traditional cannabis flower: Time of Day, their signature line of product, and H2, the company’s classic line of product. In the case of the former, the typical price is $15 per gram due to the premium nature of the product. For the latter, prices range from $7.25 to $10.

The remaining two lines consist of proprietary products that are not found elsewhere on the market. The first of these, is Decarb. Decarb was created by the company as an alternative to the options of smoking, vaping, or the use of oils as a means to obtain ones medicine. Through a specialized process, the cannabis is first dried and then the company decarboxylates the cannabis, which activates the CBD and THC. Next, the company mills the product until it is the consistency of flour.

With the resulting product being Decarb, the user can then use the product as they wish. Options for consumption include mixing it into food or beverages, or consuming it by itself. For the later, Hydropothecary offers a product called CannaCap, which essentially allows the user to consume the product in a pill format for easier and discreet medication. The use of this product has a longer onset period than other methods of consumption, with the company suggesting users wait several hours before taking a second dose. Decarb is available in several configurations, with prices ranging from $3 to $15.

The final product offered by the company is that of Elixir, an oral sublingual mist. Essentially, it is the companies only current oil offering. The product is intended to be consumed by misting the product under the tongue, providing an onset time of thirty to forty five minutes. The company sets itself apart from competing products through the method of delivery of the oil, as well as the carrier oil used. This carrier oil is peppermint based, which is said to have medical benefits in addition to that of the cannabis contained within.

In terms of product reviews, two things quickly became evident from users: first, is that the packaging and experience of using the product is excellent. The second, is that the products are expensive relative to that of market comparables. There was also a bit of complaint regarding the information provided by the company in relation to the cannabis strains, which makes it difficult to cross compare to competitors.

Overall users discussed the experience the company provides in the use of the product, with some users even refer to it being similar to receiving a gift due to the presentation of the product. This makes it clear that the company is focused on providing a user experience as much as it is on providing medical cannabis. To this end, the same was apparent to us as well based on the effort the company went through to add premium touches to the product, such as the use of glass jars rather than plastic.

Hydropothecary’s Product Recall

Previously, we mentioned that a product recall had occurred for the company. Although not a regular feature of the companies current operations, we felt it needed to be sufficiently addressed. On May 2, 2017, Hydropothecary issued a news release stating that on the evening prior, they had received a notification from Health Canada. This notification was a result of random testing conducted on company product. Essentially, trace amounts of myclobutanil were discovered to be present in certain cannabis products. Due to this discovery, the company issued a voluntary stop-sale of all products immediately.

The company resumed the sale of certain product lots two weeks later on May 16, after issuing an update. Within the update, they also stated that they were issuing a voluntary recall of product. The recall was to cover fourteen lots of product that was supplied between February 1st and May 1st. Two weeks later, this recall was expanded to include a total of nineteen more lots, sold between the dates of July 15, 2015, and March 24, 2017. This was done after the company conducted an investigation into all product ever produced and sold.

Ultimately it was determined that the unapproved pesticide was introduced by a former employee, without the authorization or knowledge of the company. The company went on to state that it was prior to the time of the current head grower and quality assurance team.

Overall, the company handled the recall extremely well. They made an example of themselves by displaying the lengths they would go to in order to ensure customer safety and satisfaction. Although it is highly doubtful that product sold in mid 2015 was still in the hands of consumers, they went the extra step in order to absolutely ensure client safety.







Hydropothecary’s Financials

Revenues

For the most recent quarter, Hydropothecary’s revenues were down year over year. However, in the same comparable time frame, grams shipped was up 50%. The company indicates that this was a result of the introduction of their lower priced H2 line of products. However, we get the sense that it is likely also to do with increased competition in the sector.

Overall, for the previous quarter essentially everything was up on their statement of loss, except revenues. Due to IFRS rules, the companies cost of sales actually recorded as a positive, making the margin more than double that of the revenue. This however was not enough to offset the increased expenses experienced versus the same time period last year. There was also the issue of the revaluation of the companies convertible debentures, which resulted in a significant hit to the net loss figure.

Lastly, in regards to future potential revenues it should be stated that the price per gram figure is slipping. This trend has been prevalent on the wider market, as documented by StatsCan.

However, for the Hydropothecary, this trend has been reversed. To the left you’ll find the breakdown from the last four reporting periods on a price per gram basis. Although this is the direction of the trend at the present time, expect this to begin to turn shortly. This will be the result of the pressure applied by the general market.

The Hydropothecary’s Cost Per Gram

While the revenue per gram is slowly increasing for The Hydropothecary, the opposite is true for its cost per gram. This inverse relationship that is currently being maintained is excellent for the profitability of the company. Within the investor presentation, the company provided this handy chart displaying the decreasing cost of production.

As of the latest interim financial report, it is believed that Hydropothecary has the lowest cost of production in the country. Most notably, is that its production cost is lower than that of Aphria Inc’s, who is focused entirely on low cost production.

The reasoning for this consistently decreasing cost of product is threefold. First, is the fact that Quebec has some of the lowest power rates of all the provinces. Second, is that the recent expansion uses curved greenhouse panels, which maximizes the use of sunlight. This inherently decreases power consumption spent providing supplemental light to the plants. Finally, is the process of economies of scale. As more cannabis is produced, certain processes can be streamlined to offer cost savings. This final reasoning is further demonstrated when compared to gram shipment figures.

As can be viewed above, these two charts show an inverse relationship which is the premise behind economies of scale. As production figures increase the individual cost should decrease due to scalability.

When examining this chart, we should also discuss the issue of current production figures. This chart provided by the company demonstrates one of two things. Either they are not at peak production capacity, or they are not at peak sales capacity. With the current 42,000 square feet of grow space under the facilities roof, the company has indicated that on a per annum basis they can produce up to 3,6000 KG of product. Currently, they haven’t hit the maximum stated capacity of their initial 7,000 square foot facility that had a projected annual production of 600 KG.

In order to hit current production maximums, the company needs to hit 900 KG per quarter in grams produced, and a similar figure in grams shipped. Upon this occurring, further decreases in the cost per gram produced should be present.

Private Financing

Although the company has seen relative success in its current line of business, where it has seen exceptional success is its private financing. Within the last nine months, the company has conducted three separate raises, with each being up-sized the same date as the initial announcement. Further to this, the size of the private financing is ever increasing. Here’s a quick glance at the three latest rounds.

July 18, 2017: $25.1 million bought deal of convertible debentures closed. Conversion share price of $1.60 and warrants at $2.00.

November 24, 2017: $69 million bought deal of convertible debentures is closed. Conversion share price of $2.20 and warrants at $3.00.

January 8, 2018: Announcement of $100 million private placement, later upgraded to $130 million the same day.

Investors need to be very aware of Hydropothecary’s terms when it comes to forced execution clauses. Whereas many companies elect to not enforce these terms, Hydropothecary is ruthless in this regard. Of the three raises above, the first two had such clauses for both the debentures as well as their warrants. Here’s how it played out.

July raise: Convertible debentures forced to convert on November 22, 2017. Total unpaid interest amounted to $36.00 per debenture. Warrants accelerated expiry date on January 2, 2018. New expiry date is February 1, 2018.

November raise: Forced conversion of debentures on December 15, less than a month after the closing. Interest earned on units amounted to $2.92.

It is not believed that the warrants on the latest raise have such a clause. However, private investors need to be aware of the tendency of Hydropothecary to exercise these acceleration rights.

Share Structure of Hydropothecary

When it comes to the share structure of The Hydropothecary, this is where their transparency truly shines through. We have gone over countless company share structures by this point in time. In the vast majority of cases, we’ve had to go digging for the proper information. For some cases, such as one company we looked at last week, it took us hours to gather all the appropriate data. In the case of The Hydropothecary, we didn’t even have to produce our typical graph.

Given the amount of financial raises that have occurred over the last year, we were slightly nervous to look at the share structure. What we had seen from the company up until this point in time had impressed us, so we were certain that there would be a catch. There wasn’t. At least not in regards to their share structure.

In short, this chart provided by the company goes above and beyond what is the norm for small cap players. The simple fact that they provided expiry dates on this chart blew us away, as this simple item is such an uncommon thing. Our only gripe with this chart, is the management ownership figure. While they have accounted for future dilution from the currently open raise, they haven’t accounted for the recent dilution caused by the forced conversion of debentures.

With regards to the current outstanding warrant and options, investors need to be aware of the scale of these. All are long ago in the money, with the exception of the warrants to be released in this latest raise. At some point, this derivatives will provide some selling pressure as they get closer to expiry. Expect these to come in to play should the share price start to falter.

At the current point in time the latest financing has not closed. However, as we always do, we’ll include these numbers in our figures and assume they are fully subscribed. With 157,466,172 shares outstanding, based on the closing price of $4.49 on January 26, 2018, Hydropothecary has a market valuation of $707 million. On a fully diluted basis, this figure jumps to $981 million.

Due to the current raise that is ongoing, we elected to not cover insider ownership just yet. Management has tended to buy in to the private financing of the company in the past, so it would be inappropriate to calculate a percentage ownership at this time. Once the financing closes, we’ll deliver an article that identifies current ownership figures for members of management.







Potential Valuation

Short Term Valuation

Placing a valuation on a cannabis company that is still gearing up for production can often be quite difficult. In the case of The Hydropothecary, although they currently have a maximum annual production figure stated at 3,600 KG per annum, they are nowhere near these figures. However with that being said, the company just recently stated that they are at full production now in regards to their 50,000 square foot facility.

As a result of this, we’ll build our short term valuation assumptions on the following premise:

3,600 KG produced for 2018

Although the 250,000 sq ft expansion is to come online in mid 2018, it is not being factored in due to the life cycle of the plants. The current facility saw an expansion come online at a similar point, and the difference was not notable as of yet.

Sell price per gram of $9.00

Cost per gram of $0.90

Through the utilization of these assumptions, we land on a revenue figure of roughly $32.4 million. Assuming 10% of this figure is allocated to cost of goods sold, it leaves $29.16 in gross margin to cover associated expenses with this product.

We realize we’ll take some flak for this one, but the reality is is that the company as of yet has not achieved maximum output on its production line as of yet. Even with the recent expansion, it still can’t seem to reach figures estimated originally for its 7,000 sq ft facility. Due to this, it’s possible that this revenue figure is actually high.

Long Term Valuation

The long term valuation of a cannabis producing company is slightly easier when they are only focused on the production and sale of dried cannabis flower and oil. In this instance, without any pharmaceutical divisions to try to factor in things are much more clear cut for investors. Rather, we have to just put blind faith into the estimated production figures that are supplied by Hydropothecary.

Assumptions for this napkin-scratch valuation are:

Three year outlook (mid ~2020)

Current production estimates of 108,000 KG are met

Price per gram of $7.00

Cost per gram of $0.70

In this instance, we’re taking a longer outlook so as to account for the time required to get the new one million sq ft facility fully operational. In addition to this, it can be assumed that over this time frame the price per gram of cannabis will decrease significantly as more suppliers obtain licenses. This market saturation will undoubtedly drive down the price of cannabis. We’ve also accounted for the anticipated reduction in cost per gram as a result of the economies of scale involved.

Based on these assumptions, estimated revenue for the Hydropothecary is $756 million. On a gross margin basis, this figure dips to $680.4 million. Associated expenses at this production level are currently difficult to estimate based on the lack of current comparisons. Based on the current market valuation of the Hydropothecary, this is the term likely being utilized by investors.

Closing Remarks

Ultimately, we have become semi-bullish on The Hydropothecary Corporation after our Deep Dive in to the company. Their emphasis on transparency and customer experience is what in our opinion sets them apart from the competition. When combined with their strong ties to the province of Quebec, they currently have an advantage that others in the market simply don’t have as of yet.

Speaking to their ties to Quebec, one last thing we didn’t mention is the work that they have done with the provincial government. To this end, they have assisted the government through providing consultation services on the creation of Bill 157. The Bill is focused on the control and use of cannabis and cannabis products in the province of Quebec, and will provide the basis for the related legislation. Going forward, this will likely be a major benefit to The Hydropothecary, which remains the only fully licensed producer in the province, and the only producer headquartered within the region.

This year aims to be a significant year for The Hydropothecary, as well as the sector in general with recreational legalization looming. Provided it can sort out its low production figures, this could be a banner year for the company. With two expansions scheduled to be completed before this time next year, many changes will be coming to the company. The only question is, are they up to the task? We’d like to think so.

Find companies with a competitive advantage. Determine their viability. Dive Deep.

Information for this analysis was found via Sedar, TMXMoney, SEDI, StatsCan, MarketWired, and The Hydropothecary Corporation. The author has no securities or affiliations related to this organization. Not a recommendation to buy or sell. Always do additional research and consult a professional before purchasing a security.