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The Flowr Corporation (OTC: OTCPK:FLWPF) is an excellent play on the cannabis market. This exposes investors to a market with huge potential that’s still in its early stages of growth. However, this still is a small operation relative to competitors, and its first large production facility is yet to come on-line. Also, the company appears to be overvalued due to its large market cap and minimal sales. Nevertheless, upon closer inspection, FLWPF appears to have enough potential to justify its premium. In this article, I’d like to take a more in-depth look at the company’s business prospects based on publicly available information.



Source: Daily Marijuana Observer. Flowr offers consumers a premium quality cannabis product.

Business overview

Through its subsidiaries, the company produces premium quality cannabis. Its primary market is adults who use marijuana for recreational purposes. FLWPF does have products available for medicinal uses, but it’s not the company’s primary focus.



Source: MarketsandMarkets. The cannabis market will provide strong secular tailwinds to FLWPF’s operations.

In 2018, it posted revenues of $1.81 million, and this was the company’s first year of sales. However, this is a drop in the bucket compared to its whopping valuation of $458 million. So, it is natural that most investors will think that FLWPF is incredibly overvalued. After all, it’s hard to argue against a 253 price-to-sales ratio.

Financing and production

So far, the company has relied on raising funds through the capital markets, mostly in the form of equity. This is why FLWPF has very few liabilities. In fact, FLWPF’s assets-to-liabilities ratio is a very healthy 8.84.

Moreover, 41% of the company’s total assets are in the form of cash and short-term investments ($20.29 million). Thus, it’s fair to say that it has more than enough cash on hand for now.

However, FLWPF has a negative free cash flow of $11.55 million (based on 2018 figures). This is why it’s possible that the company might need to raise additional capital in the future. After all, if sales don’t pick up significantly in 2019, then its cash reserves will drop to dangerously low levels.

(…) construction of the K1 Facility by the end of the third quarter of 2019. When complete (…) the K1 Facility will produce in excess of 10,000 kilograms of premium cannabis flower on an annualized basis. (…) the corporation also anticipates beginning construction of its larger Kelowna 2 facility (the “K2 Facility”) during the second half of 2019 and projects that facility to produce in excess of 40,000 kilograms on an annualized basis after its completion (…) targeted for the end of 2021 (…)

– Source: Flowr’s investor relations, 2018 annual information form.

Fortunately for investors, I think that FLWPF will manage to ramp up its production capacity significantly by the end of this year. This will probably boost revenues and provide some much-needed cash flows.

Still, I believe that even if FLWPF runs into cash issues again, it’ll merely raise additional capital through another equity issue. Naturally, this would cause further dilution in the shares. However, so far it seems that investors believe in the company’s future. Thus, FLWPF will probably be able to rise without any difficulty, if needed.



Source: International High Life. The figure shows the different prices for one ounce of legal marijuana.

Niche market

Unlike other cannabis producers, the company is specializing in the premium end of the market. It’s challenging to have a precise figure regarding how big this market is. However, we do know that the Canadian cannabis market is probably around 1 million kilograms per year. Assuming only 10% of that is premium, that would imply 100 thousand kilograms per year.



Source: The Motley Fool, plus author’s annotations. The Canadian market has a total demand of roughly 1 million Kg/year.

My research suggests that premium cannabis products are about 1.5 times more expensive than “regular” marijuana. Still, it’s tricky to benchmark prices because most companies offer a unique spin on their cannabis products.



Source: Ontario Cannabis Store, plus author’s annotations. In this case, FLWPF’s product sells at 1.69 times the cost of its competitor.

Market opportunity

Currently, it seems that the market is undersupplied. This is why the market opportunity looks so appealing right now. Let’s assume that the Canadian market yearly demand is about 1 million kilograms per year. This means that FLWPF’s estimated 2019 production (by the end of the third quarter of 2019) of 10K Kg/year is just 1% of the total Canadian market.

Even the K2 facility’s capacity of 40K Kg/year is a drop in the bucket compared to the overall size of the market. Keep in mind that K2 is expected to be operational by year-end 2021. Thus, I think that FLWPF is going to be supply-constrained for the next couple of years, which is a nice problem to have, but a problem nonetheless.



Source: FLWPF’s investor relations.

This promising new market has already attracted many competitors. Most producers are ramping up their production capacity. It’s likely that the sudden spike in supply will cause cannabis prices to collapse. This could have a disastrous effect on the company’s growth story.

However, it’s also worth mentioning that Canada’s eventual excess supply will fuel exports to other companies. So, even if Canada becomes oversaturated with cannabis, companies will still have large markets that are virtually untapped.



Source: The Motley Fool. Cannabis producers are racing to build up production capacity. By 2020, total capacity should be about 2.3 million Kg/year.

Potential game changer

Going forward, Portugal is going to play a crucial role in the company. You see, FLWPF recently acquired 19.8% of Holigen. This acquisition will allow Flowr to amplify its production capacity to a whopping 500,000 Kg/year. Moreover, Portugal’s outdoor cultivation should translate into lower production costs.

Still, Holigen’s main contribution will be opening the European market for the company. This is a vast market of 741 million people, which is 20 bigger than Canada. By 2028, Europe’s medical cannabis market is projected to grow to over $84 billion.

You see, cannabis for recreational use still isn’t widely legalized in Europe. However, the EU is mostly open to cannabis for medical purposes. Therefore, Holigen gives Flowr three advantages: 1) access to a nascent European cannabis market, 2) a logistical foothold that gives Flowr distribution channels across 35 countries, and 3) lower production costs due to Portuguese outdoor cultivation licenses.



Source: Reddit. Europe still has ways to go in terms of legalization of recreational marijuana, but medical uses of cannabis are widely accepted.

Valuation model

In my valuation of the company, I will initially exclude Holigen because there isn’t that much data available on it. Hence, first I’ll estimate FLWPF’s value (excluding Holigen), and then I’ll add a 20% premium. In my view, the 20% premium is a conservative estimate of Holigen’s value for FLWPF. After all, this acquisition gives the company a vast gamut of alternatives for future growth. Hence, I think this will produce a reasonable ballpark estimate of its fair value.

Also, keep in mind that Holigen roughly equates to 100,000 kilograms of annual production for FLWPF (19.8% of 500K Kg/year). This figure doesn’t include the production capacity of the company’s K1 and K2 facilities. In other words, FLWPF’s stake on Holigen equals two times its eventual in-house production capacity (K1 plus K2 facilities).



I calculated the average selling price of the company’s products and used 50% of that value for the model. I did this to account for the likely price drop in cannabis due to higher aggregate production across the industry. So, I think this gives the model a conformable margin of safety.

After that, I made some assumptions regarding gross margins, operating expenses, and taxes. I looked at other comparable cannabis producers as inputs. I used a 50% gross margins, which is in line with the average of its peers. Still, it’s probable that production costs will drift lower over time due to better technology and incremental experience. After all, the industry is still very young right now, so there’s still ample room for improvements. Lastly, I added a 20% premium to the valuation to account for Holigen’s massive potential.

Thus, when you put all these factors together, the result is a 17.2% potential upside from current levels. I found this surprising because I expected FLWPF to be grossly overvalued. However, after looking at its prospects in-depth, it’s evident that future growth justifies the current premium to a great extent. Still, I don’t think the shares are significantly undervalued either. After all, FLWPF still is a highly speculative company.

FLWPF focuses on the premium segment of the cannabis market. Premium products generally have better margins. Thus, it

Source: Independent.ie. The US could also become a big market for FLWPF at some point. However, the company’s main focus is on Canada and Europe at this point.

Risks

Finally, I want to quickly point out a few key risks that I think investors need to keep in mind:

  1. The cannabis market is highly competitive. There are many competitors currently ramping up production. This will likely drive down cannabis prices over the long term.
  2. FLWPF is a small cannabis company compared to its peers. The company will only have the K1 production facility operational in 2019. Thus, its estimated production of 10,000 Kg/year is peanuts compared to the likes of Canopy Growth Corp. (OTC:CGC) or Aurora Cannabis (OTC:ACB).
  3. Cannabis does allow for some product differentiation. However, it’s inherently a commodity-type product. These types of businesses usually have lower margins. Also, it’s challenging to build sustainable competitive advantages with little product differentiation.
  4. Legal and political issues can always become a headwind. Also, licensing delays or countries failing to legalize cannabis can potentially hamper the industry’s growth.
  5. FLWPF relies on the timely construction of its K1 and K2 production facilities. Any delays here could have a detrimental impact on the company’s value.
  6. FLWPF trades over the counter. These types of stocks generally have additional risks due to the lack of liquidity and disclosure requirements. However, FLWPF is a publicly traded stock in Canada, so I believe this risk isn’t as dangerous in this case.

Conclusion

As a whole, I have to say that I am surprised the company carries as much value as it does. At first, I thought I thought it was massively overvalued. However, upon closer inspection, I’m starting to see that there’s indeed potential for the stock.

In my view, Europe, not Canada, is FLWPF’s most significant upside catalyst. You see, Holigen is a much bigger operation. It offers lower production costs and taps into a potentially much bigger market than Canada. Still, FLWPF depends on further legalization across Europe.

Also, the price of cannabis poses a significant risk for investors. If a production glut occurs, then the price of marijuana could suffer dramatically. I think this would disappoint many investors, and sentiment could shift very quickly. Still, my model accounts for a 50% price drop already, which gives my valuation a reasonable margin of safety.

What keeps me from pulling the trigger on FLWPF is the fact that I don’t see any significant competitive advantages right now. I do think that the company’s prospects look good, but I fear that the ever-increasing competition can eventually chip away at FLWPF’s promising prospects. Still, if the stock drops low enough, I’ll probably pick up a few shares as a speculative play.

Thank you for reading, and good luck.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.