Supreme’s physical assets are positioned to help it become profitable quickly
SmallCapPower | November 9, 2016: With the decision from Health Canada pending, and votes for legislative reform for marijuana in nine States south of the border, there certainly is no shortage of catalysts for Supreme Pharmaceuticals Inc. (CSE:SL) (“Supreme”) and its stock price. However, besides the effect that market sentiment will play in the value of the stock over the next few months, is Supreme Pharmaceuticals in a position to continue the upswing that it has been on since August of this year?
Projected Operational Efficiency
A major problem that producers are facing right now is profitability from operations. Although Aphria Inc. (CVE:APH) has started to turn a profit in the last three quarters, producers like Canopy Growth Corporation (TSE:CGC), by far one of the largest growers, and Aurora Cannabis (CVE:ACB) as well as all other marijuana producers have yet to hit that milestone.
Although Supreme hasn’t started commercial production yet, its physical assets are positioned to help it become profitable quickly. When you compare Supreme to the largest and well-known producers, Supreme’s expected square foot per kilogram produced after full build out, is significantly less. With plans to build a campus that is 300,000 square feet to produce 50,000kg of dried cannabis per year, it puts Supreme as one of the most efficient growers needing just 6 sqft/ kilogram. Compare this to Canopy Growth Corporation, which has by far the most licensed capacity currently at 595,000 square feet of growing space, yet only expects to produce 30,000kg of dried cannabis when it is fully operational, putting its sqft/kg of cannabis just under 20. Figure 1, breaks down four producers’ sqft/kg of dried cannabis based on future production area and expected yields.
Figure 1: Projected Square Foot need per KG of Marijuana Produced.
Currently, Aphria is the benchmark for production costs as in Q1 of 2017, its all in costs per gram (g) dropped to $1.80, making it the best in the industry in Canada, compared to Canopy Growth Corp’s cost of $2.66 in Q1 2017, and Mettrum Inc.’s (CVE:MT) about $2.00/g. Supreme is estimating an initial cost of $2.50/g as it ramps up production but is aiming to be a $1/g producer by the time 2020 rolls around. As Supreme is a 100% greenhouse grower, just like Aphria, if management can continue to reduce and manage its costs as it has over the past year, once its sales license is received and commercial ramp-up achieved, you should see Supreme have a similar cost structure to Aphria.
Business Model
As the first producer to focus on the business-to-business wholesale market, Supreme Pharmaceuticals is certainly a trailblazer in that respect. By focusing on wholesaling to business under long-term contract, Supreme will have more certainty in demand patterns. This will enable Supreme to better control costs by optimizing its supply chain and operations to minimize inventory holding costs and further drive down the all in production cost per gram. As marijuana is a light and bulky product, storage costs will certainly add up once producers are at full capacity.
Figure 2: 34 kilograms of Marijuana
Figure 2 shows 34 kilograms of marijuana in garbage bags that was confiscated in New Brunswick, with a motorcycle across the back for reference. Now imagine how much storage space would be needed to store 5,000 or 10,000 kilograms of dried product? By reducing the need for storage space and optimizing grow cycles to match delivery dates, Supreme could become a very lean producer.
One potential problem we see with this model, though, is the margins that the Company will receive from these contracts. As Supreme has contracts with six licensed producers, which will sell to consumers, with current prices in the $5 and $12/g range depending on the strain, we imagine that the price Supreme will sell to its distributors will be significantly less. However, this could also prove to be a very minor difference and the efficiencies realized by bulk sale could save more than it costs in revenue, but we won’t know until they either release specifics for the Letters of Intent or revenue figures are posted.
Financial Performance and Positioning
With the sale of its first batch pending, the financial position of Supreme is quite positive, as it continues to keep its cash burn rate under control. As of its most recent financial statements, Supreme Pharmaceuticals had a cash balance of $3.7 million and only burned $2.2 million in operations for all of 2016. This is a good indicator of the Company’s ability to control costs because, compared to Aurora Cannabis’ cash burn for its year end in June 2015, just after it received a license to cultivate, it used over $3.3mm in its operational activities. Although not an exact apples to apples comparison, both companies have similar facility sizes, have the same year end, and received their producer approvals at a similar time in their fiscal.
Having raised just shy of $15mm in a three tranche financing deal that closed on August 30, 2016, Supreme also has more than sufficient cash flow to continue operating, and funding the expansion of its greenhouse complex in Kincardine, Ontario. The 80,000 sqft expansion, which is currently under construction is only expected to cost an addition $7.6mm-$8.6mm as of the end of fiscal 2016, leaving Supreme with sufficient working capital to ramp up its operations. The Company is also expecting the facility to be completed by June 2017, right after legislation for marijuana’s legalization is supposed to be introduced in Canada’s House of Commons.
With a strong cash position boasting little debt and an interest-only mortgage it signed in August, Supreme is well positioned to move forward unimpeded by financial woes. Having an interest-only mortgage is very beneficial to Supreme as it saves more than $300,000 per month in payments. This money can then be redirected into operational expansion and development over the coming months, as revenue begin to be generated before it has to pay back the $4,000,000 principle in August 2017.
Forward-Looking Valuation Multiples
With an EV to forward revenue multiple of 13.3x for the next 12 months, assuming that they receive the Health Canada sales approval, it puts Supreme Pharmaceuticals in line with other major producers such as Canopy Growth Corp and Organigram Inc. (CVE:OGI), which sit at 13.4x and 11.1x, respectively. Supreme’s is also much less than the emerging west coast’s Aurora Cannabis’ multiple of 18.8x. Although this valuation is resting solely on the ability of Supreme to receive the OK from Health Canada, once that is achieved, Supreme has agreements with six licensed producers to sell a large majority of its 2016 crop of 250kg of marijuana and 70kg of trim, which will catapult Supreme Pharmaceuticals’ top-line growth.
