EDITOR’S NOTE:You know how, when you read an investment newsletter or a promotional piece from a company, you’ll end up with a dozen pages of disclosure notices, telling you that you shouldn’t believe anything you just read because they own stock in what they’re writing about?
Here’s our disclosure:
We own stock in this company. So, while we think it’s great, you probably shouldn’t believe us without doing some further digging.That’s why we pay Braden Maccke, a third party analyst based out of Austin, Texas, to write honestly and aggressively about companies we like, to hold them to account, and to make them earn your respect. If he doesn’t like the company, he’ll say so and we won’t complain. If he does like the deal? That’s because he’s dug deep and come up with glory all by himself. We call his series the Second Set of Eyes.
We set Braden up on a call with CannaRoyalty boss Marc Lustig last week and told him, break it down, keep it interesting and honest, and write til the story is told.
Then we waited to see what would transpire.
Coloring is all the rage right now. Full grown adults are filling themed coloring books and buying new ones when they’re done. And why not? It’s fun and soothing to add color to a line drawing. It doesn’t shut the brain off so much as it peacefully occupies it. Coloring takes attention, but it isn’t taxing.
Coloring books are nothing new, but their resurgence and popularity among adults in 2017 is. While this trend is no doubt good news for Hammermill and Crayola, the companies who are in the best position to take advantage are licensing outfits like Disney and Universal, who own the brands that make the books move. Kitty cat and landscape coloring books can be produced free of licensing fees, so they proliferate to the point that they blend into each other and end up in dollar store bins. A Star Wars- or Harry Potter-themed coloring book, however, sticks out and connects with the consumer. It’s familiar. Years of investment in high-quality, successful content means that a Yoda-themed coloring book can deliver a well-earned dopamine hit to the brain of the shopper right from the shelf, and command a premium price that more than makes up for the licensing fee that the publisher paid to Disney. The consumer carries home the promise of a fresh nostalgia hit with every page and is drawn to the familiarity of the brand they know.
As cannabis continues to be formally commoditized, the business world is making a sport out of coloring in between the lines that various governments are drawing in different states. As regs loosen up with public sentiment, the retail markets continue to mature. Now that the novelty of being able to buy weed over-the-counter has worn off, consumers will likely continue on as they always do – trying different products until they find one they like, and sticking with it as long as it stays consistent.
Inclusion seeking and fear of social exclusion are some of the strongest social motivators, so popularity ends up being parabolic. The top of that popularity curve in any sector is always occupied by a product that built a consumer connection so strong that it borders on compulsion, and they usually earned it. The idea that Coke and Red Bull bought their way to the top of the popularity parabola with enormous ad budgets is a misconception. They advertise like they’re carpet bombing because Monster and RC Cola would happily eat their lunch by creating associations of their own if they eased off on the ad real-estate and gave them a chance. The root of those brands’ success is the fact that consumers like the product.
Coke and Red Bull aren’t as interested in mind control as they are in shelf space control, and the access that comes with it. Their products are in every convenience store and vending machine – constantly available to their loyalists – by the nature of the fact that the stuff sells. They spend big to stay front of mind with consumers in a high-profile way because every impression calls up an association with that familiar and always-available taste. Retailers would drop Coke and Red Bull for something cheaper in a hot minute if they didn’t sell, but they always do, and the grand cycle continues.
The Cannabis Upgrade Space
CannaRoyalty (CRZ.V) CEO Marc Lustig doesn’t want to be in the farming business. He considers cultivation to be crowded and risky. A crop that goes bad can be hard to recover from, and even the best automation can’t always produce a consistent product. There’s plenty of money out there right now paying the best horticulturists to make good use of this new opportunity to find the best and most efficient ways to turn light and water into dope. What is all that product going to do to the market? Lustig is more interested in the notion that marijuana’s newfound respectability will appeal to a crowd of users who never really wanted to get their hands sticky in the first place.
Accordingly, the CRZ asset package is built around upgrade stages that add value in between the grower and the consumer. They envision a market of users who are interested in a pre-rolled joint that burns smooth, an edible product, or an extract product like shatter, delivered through a vape device, or pills, or whatever better delivery system is being developed now. The CRZ portfolio also contains assets in various other kinds of consumer goods like cannabis dog food and massage oil with which they hope to develop consumer followings that pay off with a projected increase in cannabis use.
Lustig and CRZ are also forecasting advances in medical marijuana, and are trying to take advantage of it by investing in patient-side technology. They have an equity position in Resolve Digital Health, a company that makes digital hardware and software that meters cannabis doses to patients, and tracks consumption and effect data through a smart-phone app in a way that they hope will become a standard for patient care.
It isn’t a Mountain, it’s a Mountain Range
The marijuana business in 2017 isn’t like soft drinks or movies. Brands can only reach consumers through regulated outlets. There are only so many of those and the rules of engagement differ from state to state. Almost universally (with Nevada being the outlier), cannabis products sold in medical and retail dispensaries must come from licensed in-state suppliers. Cannabis is still against federal law in the US, so moving product from one state to another is a no-go. That means that any given brand of processed product must come from a manufacturing facility in the state that it’s sold, and an aspiring top brand has to maintain a measure of consistency across those different operations.
This impediment to centralization presents a barrier to entry at the brand-development stage. As long as it’s unclear if or when the various state and federal laws are going to make shifts that allow for easier scaling, the products will continue to come in ziploc bags with laser-printed labels. Pot consumers are used to the home-made look, so the stuff moves regardless. But the much larger segment of potential cannabis users – the ones that represent the truly large revenue possibilities – want something a little bit more tailor made, a touch more corporate. And they want it consistently good.
It’s an Unconquered Mountain Range
To CannaRoyalty CEO Lustig, this fragmented consumer goods market with no real playbook and no clear leader represents and enormous opportunity.
“I don’t think I’d be here unless I though that [the retail cannabis industry], as a sector, could be bigger than the tobacco and spirits businesses.”
As the name suggests, CannaRoyalty’s model is to create residual income from companies and operations without exposure to business costs going forward. This model has been a successful model in the resource sector for companies like Franco Nevada (FNV.T), Royal Gold (RGL.T), and a variety of oil royalty trusts. Sector-agnostic royalty businesses like Alaris Royalty Corp (AD.T) are darlings of income investors in the periods that they are able to produce consistent dividends, and appeal to value seekers when the share price falls behind a cut dividend. Those are mature royalty companies built meticulously over time. The Cannabis sector is too new to have any of those.. yet.
Building What Can’t Be Bought
In the cleanest of their deals, CannaRoyalty is able to acquire a royalty through a simple purchase. Their agreement with AltoTerra – a Washington State company that owns a high tech cannabis processing facility – entitles them to 30% of the property’s gross income in exchange for about US$750,000 and some property and equipment.
Of course, the transactions aren’t always that clean.
In most other cases, CRZ has taken an equity position in a small, growth stage company either by direct purchase of some or all of the company’s stock, or through a loan that can be converted into stock. Lustig says CannaRoyalty is providing back-end support and management services to the companies they’re incubating, with the idea being that the right kind of guidance, oversight, and focus will help the technology, while brands making up these companies’ assets will grow with the sector, leaving CRZ in a position to divest themselves of the equity and step into a license fees or royalty arrangement.
By developing relationships with their portfolio companies and fostering their growth, the company will be able to take advantage of in-network synergies and develop an understanding of this complicated consumer market that could end up being priceless.
An investment that CRZ made last year in Eureka Management Services, operators of Oakland, CA based Magnolia dispensary, gave Eureka the funding to build a test kitchen at the Magnolia site. The dispensary has been serving legal Oakland patients for many years and its proprietors are notable and well-liked members of the community who have been fighting for legal use since furnishing people with cannabis medicine was a form of civil disobedience.
By creating an opportunity to test new products with seasoned users in a top market, CRZ has put themselves in a position to refine formulas, packaging and branding quickly. They’ve also associated themselves (and their brands) as a partner of a local establishment with deep community roots. That seems positive, given their target demographic.
Let’s See What We’ve Got Here
Brand assets can be tough to value, especially pre-revenue. The answer is usually a function of the size of the addressable market and the ability of the brand’s managers to address that market. So far, the market has a high opinion of CRZ’s collection of Cannabis brands. The 36M share company is trading around $3, for a $143M market cap.
That isn’t a bad number for a collection of assets that Lusting and his team appear to have developed for around $8 million in cash and stock.
This valuation has been freshly validated with a recent $15M bought deal financing. Those assets are unencumbered by long term debt, and the company has a strong cash position.
Curiously, SEDI filings and the company listing document show that no director or officer of CRZ are currently shareholders, and the company stock options plan has yet to award any options to executive officers. Conventional Howe St. wisdom is that management whose compensation depends on the equity price is better for a company’s market cap, but we doubt that that’s ever been shown empirically. Besides, any company that can raise 1/10 of it’s market cap in a bought deal may be better off paying management in cash.
By contrast, Canadian cannabis giant Aphria Inc. (APH.V) is in the farming business, and they are also a CRZ shareholder. They’ve grown to a $500M market cap by vertically integrating their harvests and creating consumer products that focus on consistency. Aphria has an 8.3% stake in CRZ, and had a right of first refusal on CRZ equity financings which expired when they didn’t participate in this last bought deal. Whether Aphria is interested in any particular CRZ asset or if they’re simply hedging is anyone’s guess, but the attention and participation of a market leader like the big Canadian licensed producer makes it look like CRZ must be doing something right.
Growing these brands from the ground up isn’t just the cheap way or the hard way, it’s the only way. But that doesn’t make it easy. There aren’t any national pot brands yet and, if there were, they wouldn’t be for sale.
At CRZ, all of the pieces are there. The company has a hard-working and knowledgeable team that is putting all of their assets in a position to succeed. As long as the cannabis market continues to benefit from the tailwinds of deregulation, CRZ is hoping that they’ll have made the early consumer connections that put their brands in position to become household names.
— Braden Maccke
FULL DISCLOSURE: CannaRoyalty is not an Equity.Guru marketing client, but we hold an equity position in the company and will directly benefit from any long term price rise in the stock.