Q2: Cannabis sales up 78% QoQ with flat OPEX
ZENA reported Q2 results that were slightly below our expectations but still showing strong growth.The company also increased its guidance for annual production capacity by 35%. Total gross revenue was $26.5mm vs. our expectations of $27.8mm, including$7.3mm in net cannabis revenue, up 78% QoQ. ZENA mentioned a strategy of lowering prices to obtain greater RECmarket share, along with some logistical issues, where it had more optimistic expectations for cannabis salesin Q2. The strategy has early indicationof working with ZENA taking#1 marketshare recently by volume in Nova Scotia and New Brunswick.Q2 Adj. EBITDA of ($6.3mm) in the quarter compared to our estimate of ($5.5mm) and it was encouraging to see flat OPEX.Overall, ZENA appears to be on the path to meet our expectations, while the capital structure continues to be cleaned up.We are also comforted by the exceptional partner feedback received on ZENA, giving us conviction on the name.ZENA continues to trade well below most peers at ~7x 2020EBITDA. BUY
Opportunity to become a top five LP:
ZENA nowhas licensed production capacity of 54,000 kg and a goal to increase capacity further to 143,200 kg in 2019 with construction and licensing progressing at its Langley facility. ZENA expects the cultivation cost per gram to be $0.50 at Langley and the Atholville facility was disclosed as $0.78 in cost, down $0.32inQ2. Continued outperformance in production and lowered cultivation costs should lead to significant value creation. Also, the expansionaheadcould position ZENA as a top five CanadianLP supplier with one of the lowest production costs. Although, most LPs have aggressive expansion plans, our ZENA forecasts reflect conservatism to what it is capable of achieving with Dutch horticultural expertise. We are also comforted with the fact that ZENA’s partner ecosystem is highly supportive and a strong entrepreneurial team will be flexible in pricing to move high quality product.
Propagation business supports value creation with added stability:
As part of the creation of ZENA, Bevo Agro and SunPharm merged through an RTO deal in Jan. 2019. Bevo is a plant propagation business (seed to seedling) that has monopolistic characteristics, good growth and a history of value creation. Bevo will contribute ~$35m in sales and ~$8m in EBITDA with what we estimate to be ~$100m in EV to ZENA. This also highlights a low EV of ~$200m attributed to cannabis or ~7x multiple vs. peers at ~20x,in part from a complicated capital structure. However, most dilutive ZENA securities have much higher strike prices and the capital structure is in the process of being cleaned up.
Our $3.25 target is based on a 12x EBITDA multiple for propagation and 15x for cannabis. We see ZENA as becoming a top five CanadianLP supplier. BUY.
We see ZENA as becoming a top five Canadian LP with its shares substantially undervalued at ~7xEBITDA, in part from a complicated capital structurethat is being cleaned up. We spoke to several of ZENA’s partners, including government contactsat the distribution levelin different provinces and the feedback was unanimously positive. Contacts described ZENA’s quality of operations as one of the best when compared to other LPs andspoke to the high ethics of management and solid relationships in place. This bodes well in an industry going through rapid transition, where we see competitive advantages in high quality producers with strong reputations and partnerships. We are also comforted with the strength of ZENA’s team at multiple levels, including the founders, management and growers. The hands-on teamis well aligned at ~53% insider ownership andgenerally haveentrepreneurial backgrounds with multiple successes in a variety of industries.ZENA will also be flexible on pricing to move a high-qualityproduct, important in our view as the industry matures
Partner feedback and scuttlebutt
We try to differentiate our research by speaking to as many customers, industry experts and contacts that we can about a company. Each process is unique, depending on the industryand market dynamics but we find that this type of primary research helps us in better understanding businesses and ultimately picking good stocks. Cannabis presented challenges in our research process as a relatively new industry with a very broad set ofcustomers. We therefore focused on reaching out to ZENA’s distribution partners and government contacts familiar with the company and operations. This level of research is far more encompassing than our own opinions and we were very encouraged, given the exceptional feedback received on ZENA. We highlight our key findings:
Quality facilities: We were told that ZENA “passed with flying colours” in regards to thequality of facilities. One partner said that the facilities are far beyond the requirements put forth by Health Canada, important for the medical business. A government contact also said that quality facilities usually lead to quality products and is animportant criteria in determining who to request supply from.
Best in class operators: Our contacts all spoke of how great it was to work with the ZENA team, including several governmentcontacts. Feedback included that ZENA was “very easy to work with”, “hashigh integrity”, “receptive to feedback”, “willing to find solutions” and “quick to respond”. One contact simply said “amazing experience”. We put high weight in this type of feedback as it should lead to long-term benefits in an industry going through rapid transition, where all companies may not survive. We also heard of less favourable feedback for other LPs, including that some seem to only be “focused on their stock price” and not product quality.
Innovation: One large commercial partner told us that part of the reason for selecting ZENA was its ability and history of innovation with Bevo. Inwhat seems like a simple business, Bevo has had substantial innovations in its growing processes and automation.A good example of this was the spin out of a proprietary vertical farming technology, now commercialized by CubicFarm Systems that had a ~$100m valuation. ZENA has extraction technology on-site and is investing in considerable R&D capabilities with several PhD resources.
Capacity to expand: Most partners also mentioned that it was important to see the expansion capability when selecting preferred suppliers. ZENA expects to expandproduction to 143,200 kg this year, supporting this criteria.
Product quality: We heard good feedback on ZENA’s quality of products and growing practices. Partners mentioned that ZENA had superior growing methodologies, which may be in part from its food expertise with Bevo. There were also no concerns mentioned for the types of products used in ZENA’s growing process. One contact referred to ZENA’s offering as a “premium product”, supported by online end customer reviews.
How we buy: A governmentcontact spoke to reasons for selecting certain LPs and supply that include the track record of meeting sales goals, customer pull-through, willingness to drop price to not take up inventory and general receptiveness and ability to problem solve. ZENA was again rated very high for this criteria and one of the best when compared to other LPs.
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