The Valens Company Inc. (VLNS)

[FUNMAN]

See Red & Blue Highlights --->>>Valens Company: Arming The Rebels In Cannabis 2.0

Feb. 26, 2021 12:16 AM ET

Read the article at this link to see the graphics:

https://seekingalpha.com/article/4409262-valens-company-arming-rebels-in-cannabis-2_0

Summary

* Valens is pivoting its business away from fee-based tolling services for LPs to focus on white label agreements with royalty and revenue share.

* Despite a significant drop in tolling revenue in 2020, Valens has successfully scaled up its white label manufacturing business.

* We are confident on Valens' shares as tolling could recover while white label keeps growing; attractive valuation and decent balance sheet limit potential downside after hitting a trough in 2020.

The Valens Company (OTCQX:VLNCF) is a leader in the Canadian third-party extraction sector. We have covered the company since early 2019 when Canada was looking to legalize 2.0 products one year after the initial federal legalization of dried cannabis products. Back then, we had identified Valens as the leader in contracted extraction and white label manufacturing; its business was just primarily focused on tolling for other LPs.

However, COVID has wreaked havoc on the tolling business but Valens was quick to pivot towards its white label business. While its competitors are reeling from the damage caused by the industry-wide oversupply, Valens is arming the rebels by providing an end-to-end solution to cannabis brands and non-LP companies looking to offer 2.0 products (concentrates, edibles, vapes, extracts).



(All amounts in C$)

Market Leader

Valens was the first-mover in the contracted extraction and white label manufacturing business in Canada. Since then, it has dominated the market with the largest customer base. After the wholesale market crashed due to market oversupply and a disappointing (again!) rollout of 2.0 products, it became apparent that Valens was more nimble and had a much stronger white label business than its closest peer MediPharm (OTCQX:MEDIF) whose revenue collapsed 90% due to challenges in the wholesale market.

However, it is worth noting that Tilray did not renew its agreement after the initial agreement finished which reflects the challenges facing the tolling business. As more LPs build out their internal manufacturing capabilities, there is potential for more customer losses. While MediPharm is struggling to find new revenues outside tolling, Valens has successfully pivoted towards a white label business model by working with non-LP clients on developing new 2.0 products.



(Source: IR Deck)

Recall that Valens mainly provides third-party extraction (tolling) and white label manufacturing services to its partners. The tolling agreements are fee-based and Valens simply processes the dried flowers and hemp into crude resins which are then shipped back to customers for manufacturing into end products. Valens has no revenue share and is only earning a markup by renting its equipment and services to LPs.

In 2019, tolling was the primary revenue source for Valens as it accounted for over 70% of 2019 revenue. For 2020, tolling's share of revenue has decreased to 30% while total revenue grew over 40%. The business has since transformed to focus on white label custom manufacturing which is different from tolling in that Valens provides an end-to-end solution including manufacturing, packaging, and distribution for its partners.

Since completing the pivot to third-party manufacturing, Valens has seen more stable revenue; however, profits have been hurt by continued investments into new capacity and new product lines. EBITDA turned negative in Q4 2020 as a result of capacity expansion and inventory adjustments. For Q1 2021, management is forecasting $19 to $23M of revenue which would represent significant growth from the previous three quarters.



(Source: Filings)

You might find that white label sounds awful like that Valens is doing all the work. So how is it different from tolling or in-house brands? If you look at the customer list below, you will see that most LPs are simply using Valens as a tolling service provider because they have in-house manufacturing capabilities. They simply need Valens to process raw materials into crude resins and they will manufacture end products themselves. This part of the business is shrinking fast for Valens due to oversupplied market and growing in-house capabilities among LPs.

On the other hand, you have white label customers that are mostly brand companies without their own manufacturing and cultivation capabilities. These companies do not want to engage in asset-intensive manufacturing and Valens provides a comprehensive and efficient solution to enter the market. Valens typically strikes a royalty agreement that could include base fee and revenue share which provides more upside. More importantly, the company is mitigating the declining revenue from extraction tolling contracts by partnering with brand-focused upstarts that are gaining market share in the market.



(Source: IR Deck)

As the Canadian market continues to evolve, cannabis cultivation will become increasingly commoditized and handled by low-cost producers such as Village Farms (VFF) and outdoor growers. - The later is very good for another of my holdings, ALEAFIA. - FUNMAN Meanwhile, brand companies like TREC are partnering with Valens to introduce new products into the market despite being subject to marketing restrictions imposed by the government. Valens is able to offer competitive pricing because it can achieve better utilization of manufacturing capacity by working with multiple parties and better manage supply chain and throughput.

The extracts market in Canada remains saturated at the moment as inventory held by LPs and provincial sellers has remained ~7x monthly sales. Unless sales improve dramatically, the market will remain highly competitive as LPs compete with each other for market share. Price compression has hurt all players and Valens is no exception but we think the industry is slowly improving.

Valens estimates that it produced ~15% of all vapes sold in Ontario which is the largest extract product segment. Beverage and edibles are smaller product segments but Valens is positioning itself early on including acquiring an edibles kitchen LYF Food for $25M in January. Valens is dominating the space and we think its competitive advantage over MediPharm and Neptune (NEPT) continues to grow.


(Source: Health Canada)

Valuation

Valens currently has a market cap of $240M and trades at 3.5x EV/Sales based on Q4 2020 results annualized. The stock had $20M of cash at the end of November and it raised another $35M in January, most of which will be used to pay for its LYF acquisition. The stock is trading at a discount to other mid-cap Canadian LPs such as OrganiGram (OTC:OGI) trading at ~10x EV/Sales and HEXO (OTC:HEXO) trading at ~16x EV/Sales.

Valens is, however, trading slightly below MediPharm at 4.5x despite the extremely depressed 2020 revenues reported by its struggling competitor. Therefore, we think Valens has an attractive valuation considering its successful pivot away from tolling while building a growing white label business. The resilience demonstrated last year and its momentum working with a growing list of white label customers means that 2021 could see improvement in its financial performance. The company is also well-capitalized with no immediate need for capital infusion.



(Source: Bloomberg)

Conclusion

One of the key risks we highlighted in our October 2019 analysis of Valens was a slower-than-expected rollout of 2.0 products across Canada:

"If the market demand proves to be well below initial expectations, we could expect an oversupply and price compression in these new product categories leading to reduced orders for manufacturers. Valens and MediPharm will surely be affected by any potential oversupply..."

However, Valens has reinvented itself during the course of 2020 by expanding its white label and custom manufacturing portfolio and working with cannabis brands and non-LP companies. While tolling revenue declined substantially as LPs cut back on spending and built out their in-house capabilities, Valens is becoming a partner for anyone else that wants to enter the cannabis 2.0 market.

We believe there is a place for Valens to thrive as the cannabis industry continues to evolve and more non-LP brands enter the scene. Contracted manufacturing offers multiple benefits to clients including lower upfront capex investments, end-to-end services, and better pricing due to higher utilization by pooling multiple contracts and leveraging product development and manufacturing know-how across different SKUs.

Valens is no longer dependent on LPs and is instead arming the rebels as the cannabis 2.0 market continues to grow in Canada. We are positive on Valens' growth outlook and its cheap valuation further supports our thesis.