High Tide: Immense Upside If Margins Can Be Lifted (NASDAQ:HITI)

High Tide (NASDAQ:HITI) operates as a cannabis product retailer in Canada, the United States, as well as other countries. As Canada’s legalized cannabis, High Tide has begun to grow its retail network under the Canna Cabana brand, bringing value through the retail chain’s discount club. As of January 29th, Canna Cabana operates 163 retail stores.

In addition to the Canadian cannabis retail chain, High Tide owns 80% of three separate cannabinoid brands, operating in the United States, United Kingdom, and other countries. The company also sells cannabis-related accessories through multiple ecommerce sites.

After becoming a publicly traded on the NASDAQ after priorly trading on the TSXV exchange in Canada for a bit, High Tide’s stock has lost the majority of its value despite aggressive revenue growth.

A Strategically Growing Retailer

High Tide has started to grow its revenues very significantly with the legalization of cannabis in Canada. Starting from almost no operations in 2018, the company’s revenues have grown into 487.7 million CAD in FY2023 with continuous quarterly increases. In FY2023, revenues grew by 36.7% year-over-year.

While the current growth rate is still impressive, High Tide’s revenues have grown much slower in recent quarters and look to continue the trend into FY2024. The slowdown is due to High Tide’s temporary change in strategy as told in the Q4 earnings call – as capital markets have tightened, the company has shifted its focus on generating better free cash flow for the time being instead of aggressive new store openings. From 2019 to 2022, the company has opened up stores at an annual rate of around 35-40, but in 2023, only twelve stores were opened. High Tide plans to accelerate the store openings again and expects to open around 20 to 30 stores in 2024, up significantly from 2023. I believe that the slower growth in store openings is seen in revenue growth with a lag, as new store openings only gradually start to pick up traction – I expect that the FY2024 growth will be significantly lower than the previous growth rate but will pick up slightly afterwards.

Great KPIs

Canna Cabana’s discount club strategy seems to have worked exceptionally well. In the past two years, the chain’s same-store sales have grown by 110% compared to a national retail sales growth of 28% in the same period. Over 90% of store revenues are generated by loyalty club members, providing Canna Cabana with a highly sticky customer base, with over 1.28 million members as of January 29th.

Due to the highly competitive retail offering, Canna Cabana clearly outperforms the competition in same-store sales. In the January 2024 presentation, High Tide displays that the brand’s same-store sales are over double when compared to competitors – the retail chain clearly has a competitive advantage with the discount club that attracts a high number of customers. High Tide plans to utilize the great market presence by launching and expanding the company’s white label offering in the retail stores, providing a path for greater margins.

A Need for Profitability

In my opinion, stronger margins are clearly needed. Weak profitability is the main concern with High Tide’s financials. High Tide’s gross margin for FY2023 stands at 26.9% and has decreased from 37.0% in 2020 seemingly due to lower pricing for the discount club members – while the program increases volumes, it evidently decreases the gross margin. I believe that the company needs to increase the white label products’ share of sales for this reason to balance good value for customers and a sufficient gross margin.

The company’s GAAP EBIT margin for FY2023 stands near breakeven at -0.5% and has only scaled into profitability in the second half of the fiscal year with a Q4 EBIT margin of 0.9% – despite a thinner gross margin, High Tide’s growing revenues provide the company with operating leverage that increases the total operating income. On an adjusted EBITDA basis, High Tide has been able to scale from 4.09% in Q1/FY2022 into 6.58% in Q4/FY2023.

As told, growing operational scale and white label initiatives could scale the margin into a healthier position. Due to High Tide’s previous acquisitions, the company’s cash flow generation is partly clouded in the EBIT – in FY2023, High Tide had 11.1 million CAD in amortization from previous acquisitions. High Tide generated 6.9 million CAD in free cash flow in FY2023 and expects to continue operations with positive cash flows. Still, the overall profitability is quite weak, and an improvement looks crucial and potentially very valuable for investors.

High Upside Potential

To estimate a rough fair value for the stock, I constructed a discounted cash flow model. In the DCF model, I estimate High Tide to have a lower revenue growth than historically in FY2024 with an estimate of 10%. Afterwards, as High Tide is beginning to ramp up new store openings again, I estimate the growth to accelerate into 16% in FY2025, and to slow down gradually afterwards into a perpetual growth of 2.5%. Altogether, the growth estimates represent a CAGR of 8.8% from FY2023 to FY2033.

Due to the growing scale and other initiatives, High Tide should be able to scale profitability. I estimate the company’s EBIT margin to rise from nearly breakeven in FY2024 into an eventual level of 4.5%, representing a good amount of operating leverage and white label penetration. Due to amortization, High Tide generally has quite a good cash flow conversion.

With the mentioned estimates along with a cost of capital of 10.01%, the DCF model estimates High Tide’s fair value at $3.54, around 102% above the stock price at the time of writing. It must be noted, though, that the model’s margin assumption varies the fair value very widely. The estimate of 4.5% takes into account a good improvement in profitability despite a generally falling gross margin.

The used weighed average cost of capital is derived from a capital asset pricing model:

High Tide had 2.7 million CAD in interest expenses in Q4/FY2023. I believe that most of the interest expenses are related to leases, which I’ve already accounted for in the cash flows – as such, I estimate the financing-based debts of 37.5 million CAD to have an interest rate of 6%, with a long-term debt-to-equity ratio of 15%. For the risk-free rate on the cost of equity side, I use Canada’s 10-year bond yield of 3.51%. The equity risk premium of 4.60% is Professor Aswath Damodaran’s latest estimate for Canada, made on the 5^th of January. Yahoo Finance estimates High Tide’s beta at a figure of 1.16. Finally, I add a small liquidity premium of 0.5% and an ESG addon of 1.5%, creating a cost of equity of 10.85% and a WACC of 10.01%.

Takeaway

High Tide has been able to grow its Canna Cabana cannabis retail chain in Canada very well through a differentiating discount club offering that provides customers with great value. Although the company slowed down new store openings in FY2023, the company still has a great road of growth ahead with industry leading KPIs. The main factor in the investment case is High Tide’s profitability, though – with the growing discount club, High Tide’s gross margin has been pressured lower with the company’s EBIT currently near breakeven. Operating leverage has provided the company with a better overall profitability, though, and High Tide’s white label opportunity could scale the profitability into a better level. The current valuation reflects an intriguing investment case with the DCF model estimating a fair value over double of the current stock price. Due to the elevated risk level with a risky and competitive industry & thin profitability, I only have a buy rating instead of a strong buy rating despite the high upside.