Adastra Holdings (CSE:XTRX): Giving the customer what they want
Adastra Holdings (CSE:XTRX) is a cannabis company located in British Columbia and generating revenues primarily from the Canadian recreational market. Adastra operates a 13,000 sq ft extraction facility with a full suite of capabilities for performing super-critical CO2 extraction, ethanol extraction and hydrocarbon extraction.
The company recently reported third-quarter (Q3) results, showing revenues +119% versus Q3 2020 and gross profit margin increasing to 52% versus 44% in the previous quarter. Furthermore, during the quarter, Adastra completed the 100% acquisition of the Phyto Extractions brand of cannabis concentrates, which provides Adastra with an in-house brand with well-established reputation among consumers.
The Phyto Extraction brand will be the main driver of revenue growth in the coming quarters in our view. The product offering encompasses a range of cannabis extracts, including Live Resin, Terp Sauce, Vape Liquid, and Shatter (popular segments within the cannabis concentrates space). These product categories have been gaining market share as consumers become more knowledgeable about different formats.
Going forward we expect Phyto Extractions to drive additional revenue growth from new products including dried flower, infused dried flower, and pre-rolls, as well as new retail channels and marketing initiatives.
In this report, we examine the positioning of Adastra’s consumer products within the cannabis landscape. We conclude that the company has the right product portfolio to appeal to the evolving consumer base to continue driving market share gain and revenue growth.
Positioning - the growth stream of the recreational market
During 2021 there has been significant share price weakness in the wider cannabis sector. This has been driven, in our view, by the disappointing financial performance from some big names in the sector, which are affected by a high-cost production base and declining market shares. By contrast, we argue that Adastra is well-positioned to deliver strong and profitable growth. We examine these dynamics in this report.
Adastra has targeted sales of C$5mln per month by the end of 2022, and we believe that the company is well-positioned to deliver on this target based on existing revenue momentum, consumer trends, and new growth initiatives. This report examines the outlook for profit growth, summarised in the table below.
We believe that growth in revenue and profits during 2022 can potentially drive significant upside for the Adastra share price over the next 12 months. On p9, we illustrate a peer comparison valuation scenario which would indicate a share price of C$2.18, or 122% upside from the current level.
Drivers for the stock price
Year end Aug 31 · 2020 · 2021 · 2022
Revenue (CA$-000's) · 2,499 · 6,035 · 30,798
Operating Profit · (1,828.0) · (342.0) · 9,335.0
Cash Balance (CA$-000's) · 1,146 · 1,080 · 6,681
Adastra Holdings is a cannabis company developing, producing, and marketing products in Canada for the domestic market.
The company has three operating units:
Adastra Labs specialises in extraction, purification, formulation and manufacturing of cannabis concentrates, operating from a 13,000 square foot state-of-the-art facility in British Columbia built to meet GMP (good manufacturing practice) standards.
Chemia Analytics is co-located with Adastra Labs, offering testing services specialising in analysing impurities and additives that can affect quality.
Phyto Extractions is a 100% owned consumer brand focussed on cannabis concentrates. The Phyto Extractions brand has wide recognition in the Canadian market as a legacy brand and a producer of award-winning extracts.
Through to September 2021 the company has produced revenue through two primary activities — wholesale activities and tolling services related to the production of cannabis extracts and related cannabis products.
Investment summary
Phyto Extractions - a legacy brand with widespread consumer recognition
In September 2021 Adastra announced the acquisition of 100% interest in the Phyto Extractions brand, providing the group with a widely recognised brand and range of proprietary formulations. We believe that the Phyto Extractions product range will be the main driver of revenue growth for 2022. The following table outlines the current product offering and immediate future plans.
Phyto Extractions product range
Source: Proactive Research
Strong revenue growth - 119% in the latest quarter
The company has achieved strong revenue growth over the last 12 months, with Q3 2021 revenues of C$1.5mln showing 119% growth year-on-year. With the inclusion of the Phyto Extractions brand and PerceiveMD business from Q4 2021, we anticipate a further increase in revenues for the quarter and a continuation of strong revenue growth over the coming quarters.
Our revenue growth forecast for 2022 is driven by the introduction of new product lines, including dried flower and pre-rolls, new retail channels, and sales force expansion. The company has targeted C$5mln of revenue per month by the end of 2022.
The following chart summarises our near-term revenue expectations for Adastra.
Our growth forecasts - driven by continued momentum plus new products
Revenue outlook
Source: Proactive Research
We argue that our forecast is conservative in the context of Adastra’s existing growth trajectory. For Q1 and Q2 we are making a conservative assumption of 32% quarterly revenue growth, which is actually slower than the historic performance in spite of the expected new product introductions. So, although we are forecasting dramatic growth in revenue and profit, we believe that our assumptions are very realistic for Adastra.
Timeline – how the business has developed
Over the last three years, the company has achieved strong overall corporate development and growth in revenues from a low initial base; however, we argue that Adastra has only really developed a fully rounded revenue base during the last 12 months, with new management and new assets acquired during 2021.
The following timeline outlines the progress
Timeline
Source: Proactive Research
With the manufacturing and marketing capabilities that are now in place, we believe that Adastra has all the elements in place for a sustained period of revenue growth in the coming years.
Cannabis market
Since the legalisation of recreational cannabis in Canada in 2018, sales of legal product have grown continuously. The first products to receive authorisation from Health Canada were dried flower (unmodified plant materials), followed by concentrates (extracts), and then edibles, including candy and beverages. The main focus for Adastra to this point has been concentrates.
The following chart shows how the recreational cannabis market in Canada has evolved since legalisation.
Canadian recreational cannabis sales
Source: Health Canada
The psychoactive ingredient in cannabis is tetrahydrocannabinol (THC), and concentrates can be formulated to give consumers their preferred concentration of THC for a satisfying cannabis experience. Some consumers also place a premium on a balanced range of Terpenes, which are a family of organic compounds that give cannabis its natural flavour.
Industry's 1st generation products did not meet consumers' expectations
During the initial period after legalisation a common complaint among cannabis consumers was that the dried flower products were of low quality. These products lacked the levels of THC that consumers expected to experience. This led to a situation where, in spite of legalisation, the trade in illegal cannabis continued to exceed the legal market.
The following diagram illustrates:
Legal cannabis consumption versus illegal - Canada
Source: Statistics Canada
As a wider range of cannabis products have come to market through the legal retail channels, more consumers have switched from illegal products to legal ones.
However, we argue that some of the first generation of legal recreational cannabis companies have still not caught up with the preferences of the consumer. This may be a factor in the poor performance of cannabis stocks in aggregate during 2021. Some of the biggest stock-market listed cannabis names have continued to lose market share, with revenues declining during 2021 even as demand growth for the industry remains positive.
The following chart shows the revenue trajectory of two of the biggest names:
Some big names have continue losing market share
Revenue for two of the big cannabis stocks
Source: Proactive Research
We note that there are also big cannabis companies that have reported positive revenue growth over this period. For example, Tilray has produced 40% annualised growth over the last year; however, this company’s revenues include the benefit of a number of acquisitions that make it difficult for us to extract a like-for-like figure.
Overall, this topic has been widely covered in the specialist press, with a widely held view that ‘Big Weed’ has been losing market share over the last year.
Adastra has been gaining market share at the expense of the 1st generation cannabis companies
Against this backdrop, Adastra has continued to enjoy strong revenue growth, with revenues for Q3 2021 up 119% versus the same quarter in 2020. We argue that this is partly due to Adastra’s focus on concentrates, which have continued to grow faster than the overall cannabis market. Also in part, we believe that Adastra’s overall product offering is better aligned with consumers’ preferences, when compared with the first-generation legal cannabis products. Anecdotally, low THC dried flower has been losing market share, which includes many of the first-generation legal cannabis products.
Looking forward
Adastra has further opportunities to expand its product offering and to capture more market share. In particular, the company has plans to introduce dried flower products. These will include high-THC dried flower, which we believe is consistent with the Phyto Extractions brand position. Although the dried flower segment in the market is growing less rapidly than the concentrates segment, dried flower remains the largest product category in the market in absolute terms, and therefore represents a significant opportunity for Adastra.
The company is also developing infused dried flower products. These consist of dried flower that has been infused with cannabis extracts to give a more intense experience to the consumer.
Furthermore, Adastra is developing a range of pre-rolls - cannabis products rolled in paper ready to smoke. Pre-rolls have been a growth segment over the past year, and we believe that this trend is set to continue in 2022 and 2023.
The following chart shows the growth rate for pre-rolls compared to loose flower.
Pre-rolls growing faster than the overall legal cannabis market
Growing demand for pre-rolls
Source: Proactive Research
Regarding future growth, we anticipate a continuation of strong revenue growth for Adastra. Factors supporting this expectation include:
- Phyto Extractions has well-established brand recognition and is known for its products in the growing market for concentrates
- The Phyto Extractions brand was acquired by Adastra in September 2021. Adastra has plans in place to expand the retail channels and to invest in new marketing initiatives.
- We believe that Phyto’s brand reputation will carry across to dried flower products and pre-rolls, and the addition of these product lines will contribute additional revenue growth
The acquisition of PerceiveMD gives Adastra a route into medical cannabis and psychedelics
Other businesses
In September 2021 Adastra announced the acquisition of PerceiveMD, a multidisciplinary centre for medical cannabis and psychedelic therapies, for C$2.3mln. The business combination will allow PerceiveMD to leverage Adastra’s high-capacity lab facilities, and will give Adastra exposure to potential new revenue streams.
The use of medical cannabis in Canada is well-established, having been legalised in 2001. The acquisition offers a new route for Adastra to become a provider of cannabis products for therapeutic applications.
The use of psychedelic drugs in therapeutic applications has been a rapidly emerging area of focus for academia and for drug developers in recent years. Compounds such as LSD, Psilocybin (a psychedelic from mushroom), and Dimethyltryptamine (DMT) are being evaluated by a range of different organisations, for the treatment of disorders including anxiety, post-traumatic stress, and addiction disorders. We believe that potential legislative change in Canada in 2022 could allow more patients to gain access to psilocybin in particular.
Through PerceiveMD, Adastra now has a vehicle for exploring a wide range of potential medical applications of cannabis and psychedelics. We do not expect the company to make substantial additional capital commitments at this stage. Instead, we believe that Adastra will keep all options open, and commit more resources to the psychedelics space as and when there is more visibility on what types of therapies can become commercial.
Financial outlook
We are forecasting strong revenue growth for Adastra in Q4 2021 and through 2022, with the company on course to meet its revenue target of achieving C$5mln per month in sales by the end of 2022. The following chart illustrates our revenue and gross profit forecasts.
Revenue growth to be directly reflected in gross profit
Revenue and gross profit per quarter
Source: Proactive Research
We are forecasting a continuation of gross profit margins in the 45-50% range going forward. We expect some increases in SG&A and other operating expenditure (opex), in support of further revenue growth, but with the overall opex increasing at a much slower rate than the gross profit. This leads us to forecast sharply increasing operating profit in 2022. Our financial forecasts are summarised in the table on p1. The following chart illustrates the increase in operating profit margin.
Operating profit forecast - turning positive in 2022
Gross profit and operating profit margins
Source: Proactive Research
Investment conclusion
We believe that Adastra Holdings offers a compelling growth opportunity for investors, with profits moving positive in the coming quarters and a positive cash position.
Some of the key differentiators for Adastra within the cannabis space include:
- A product portfolio that is aligned with the growth segments in consumer demand
- The Phyto Extractions brand having strong resonance with consumers
- New product lines and marketing channels to sustain revenue growth
- An economical cost base, allowing the company to move to profitability in the near term
We believe that the current market cap of C$42mln offers significant upside potential for stockholders as the next phase of revenue growth is delivered.
The following table compares the ratio of enterprise value (EV) to revenues, using consensus forecast revenues for the peer stocks from the Financial Times.
Source: Proactive Research, consensus from FT.com
Valuation discount is hard to justify
We recognise that some degree of small-cap discount is likely to persist for Adastra relative to those larger peers; however, we note by way of illustration that even if the discount narrowed such that Adastra traded on a 3x EV/Sales multiple, this would amount to a stock price of C$2.18, or 122% upside to the current share price.