Is This The Most Undervalued Stock in Canadian Cannabis?
It's a micro-cap and you've probably never heard of it
Decibel (TSXV: DB) is a little-known Canadian cannabis Licensed Producer with a fully diluted market cap of C$70MM.
The company is flying under the radar of most investors because it’s coming off a low revenue base. Growth is accelerating but Decibel has no sell-side coverage and is thinly traded, thus making it difficult for investors (mostly retail) to update their views on the stock. There’s basically no discussion around Decibel on platforms such as Reddit, Twitter, or Seeking Alpha.
Decibel reached break-even in the last quarter and most of its capital investments are behind it. With all of the company’s facilities coming online in 2021, Decibel is poised for growth.
Based on my estimate for 2021 revenue, the stock is trading at ~1x sales, a 70% discount to peers. As Decibel grows sales through 2021, this valuation gap will close. I think the stock offers a +100% upside with the potential for becoming a multi-bagger.
Company Background
Decibel was born in December 2019 when We Grow, a private company, merged with Westleaf. We Grow owned Qwest, a brand with one of the highest average selling prices in Canada. The transaction was a way to bring We Grow into the public market and use Westleaf’s infrastructure (cultivation & manufacturing facilities + a six-store retail network) to leverage the value of the Qwest brand.
We Grow had a premium brand but limited cultivation and manufacturing capacity. By merging with Westleaf, We Grow was trying to scale faster.
This scale-up strategy is showing tangible results. Here’s what happened in 2020:
Keep in mind that 2021 will be Decibel’s first year of normalized results. In 2020, the company was integrating operations, finishing the construction/expansion of its facilities, and obtaining the necessary licenses from Health Canada. Q4/20 saw a step-up in net revenue as Decibel started selling vapes and concentrates.
If you’ve followed my previous write-ups, you know I like to invest in companies when they’re undergoing a transformation or approaching a turning point.
I think this is the case with Decibel. The company reached a turning point and the market has some catch-up to play.
Profits, At Last
In Q4/20, Decibel produced positive free cash flow for the first time. With ~40% gross margins and quarterly operating expenses running at ~C$5MM, Decibel breaks even at C$45MM in sales per year.
Let’s think about this number. The recreational cannabis market in Canada should approach C$3.5BN in retail sales in 2021. Excluding excise taxes and a margin for retailers, the addressable market for Canadian LPs would be C$1.5BN to C$2.0BN. Decibel’s C$45MM per year implies a ~3% share of that market1.
This is a low watermark and Decibel has already achieved it in the last quarter. Industry sales should continue to grow at a minimum of 15% per year over years to come, so I doubt Decibel’s sales will drop below the $45MM level again.
Industry growth is a tailwind, but there are other reasons why I think Decibel will continue to grow. The company just finished expanding its cultivation capacity by 5x (from 1,800kg to 9,000kg), and 100% of its assets will come online in Q2/21. The demand for Qwest products outpaces supply. Higher supply will lead to more sales with limited price compression, thus helping the company maintain high margins.
Quick math: assuming 6,000kg produced per year, sold at a net price of C$7/gram (last quarter it was C$8.60), Decibel would generate over C$40MM in sales from dried flower alone. Sum that up with C$40MM in sales of vapes and concentrates and $15MM from Decibel’s retail stores, and you have a credible path for C$100MM in net revenue.
The Most Undervalued Company in Canadian Cannabis
The Canadian cannabis market isn’t a good place to invest in. It’s too competitive and fragmented. Canadian LPs are known for stripping shareholders to the bone with excessive dilution and terrible capital allocation.
Even in this unfavorable environment, there are companies that are worth investing in. I like Decibel because it has:
A premium brand with pricing power, which gives the company leeway to play with increased volumes vs. margin compression.
An established infrastructure with cultivation, extraction, manufacturing, and retail. Importantly, the bulk of Decibel’s capital spending is behind it and the current capacity should be sufficient for generating C$100MM in annual sales.
A lean cost structure with ~$20MM in operating expenses a year.
A sustainable business that has reached profitability.
With 100% of its assets coming online in 2021, I think Decibel can generate C$55MM to C$60MM in net sales this year. That means the stock is trading at ~1x 2021 sales.
This is a 90% discount to large-cap LPs trading at ~15x sales, and a 70% discount to mid-cap LPs trading at over 3x sales. Consider that most Canadian LPs are unprofitable and don’t generate positive EBITDA vs. Decibel which was FCF positive in Q4.
Here’s an even clearer picture of how Decibel is undervalued: TGOD, which is expected to produce only $41MM in sales over the next twelve months, has a market cap of $150MM. Aleafia Health, which is expected to produce $68MM in sales, has a market cap of $180MM.
If the market cap of these LPs serves as a benchmark, Decibel’s stock has at least 100% upside from here, and the potential to become a multi-bagger.
Catalysts
I think the valuation gap will close as Decibel increases sales through 2021. The company is coming off a low revenue base and the market has yet to update its views. Decibel has no sell-side coverage and no relevant discussions on social media (Reddit, Twitter, Seeking Alpha). The investor base is composed mostly of retail, hence the company’s low multiples aren’t immediately clear for investors. As Decibel reports good sales numbers, the stock can’t go anywhere but up.
Another catalyst is a potential acquisition. Acquiring Decibel would be accretive to any large or mid-cap LP. M&A is heating up in the sector, as demonstrated by the Aphria and Tilray merger, the acquisition of Supreme by Canopy, and the acquisition of Zenabis by HEXO.
Risks
Competition: The Canadian market is overly competitive. This environment could pressure Decibel’s sales, rendering my forecast useless. This risk is mitigated by the value of Decibel’s brand, its lean cost structure, and its imminent profitability, coupled with the growth rate expected for the overall industry.
Dilution: Decibel has only ~$4MM in cash in its balance sheet. While most of the company’s capital spending is behind it, Decibel may need additional working and investment capital. There’s a good chance Decibel will have to raise equity. Given the stock’s large upside, this is a risk I’m willing to take.
Key Metrics to Watch
Net sales and margins. The first half of 2021 will provide a good idea of how operations are going and if Decibel is marching towards my net sales estimate of $55MM to $60MM.
Disclosure: I’m long Decibel.
This is a conservative calculation. Approximately 30% of Decibel’s sales come from its six brick-and-mortar retail stores. Taking that into consideration, Decibel is likely to need a ~2% share of the recreational market to remain profitable.