C21 Investments (CXXI) - A Fresh Perspective
C21 Investments (CSE: CXXI) released Q3 results at the end of December and showed consistent performance along with some solid improvements across many key metrics.
While the origin of the CXXI story carries significant baggage, we felt it was time to take a fresh perspective on the story, starting with an operational review.
Right-Sized Operations Yield Cash Flow
Unlike many cannabis companies, C21 Investments has right-sized operations. As of last quarter, they started generating both positive EBITDA and operational cash flow after a significant QoQ reduction in SG&A.
The following table summarizes CXXI's financial performance over the last three quarters.
2019 Financial Metrics (000's)
Q1
Q2
Q3
Revenue
$7,757
$9,859
$10,577
Gross Margin
43%
44%
42%
SG&A
$2,865
$6,227
$2,212
Operating Margin
($780)
($4,038)
$1,161
EBITDA
$452
($1,856)
$2,212
CFO
($752)
$1,679
$2,256
Net CF
($6,053)
$335
($1,175)
Notably, topline growth slowed significantly last quarter. This may have been affected by the short-lived vape ban in Oregon and the negative news around vape products.
However, we believe a more significant cause was the reduction in SG&A. Management often has to choose between growth investments or profitability. Given the pending debt obligations and low cash balance ($2.02 million), focusing on cash flow is a disciplined approach.
Further, Oregon sales actually saw solid growth (25%) in the quarter compared to Nevada, which was flat.
2019 State Revenue Contributions
Revenues (USD Million)
Q1
Q2
Q3
Oregon
$0.66
$1.57
$1.96
Nevada
$7.10
$8.28
$8.62
The next few quarters will be very telling as it relates to the state of CXXI's operations.
The company needs to see a significant growth in cash flow to cover pending debt obligations. If they can't grow revenues without overpaying on SG&A, their solvency will come into question.
Further, there are significant questions about the value of their Oregon operations. While revenues are growing, certain assets are clearly struggling (as discussed below). After making a series of costly acquisitions, it remains to be seen whether they will yield the ROI that management and investors are hoping for.
Looking at CXXI's 2019 Q3 performance annualized, the valuation metrics are favorable compared to large-cap companies and small-cap peers. Their EV/EBITDA is sitting at a healthy 9x, while price/sales is 0.95x.
Investors should expect CXXI to trade at a discount relative to its large-cap peers given the company has significantly less growth potential as a two-state operator. However, these comparisons still provide context and demonstrate CXXI's operations are generating solid results.
However, looking beyond the income statement to the assets on the balance sheet, investors start to see some concerning numbers.
Oregon Oversupply Weighing on Balance Sheet?
While it can be difficult to attribute the value of a growth-asset in its early days, it's clear some of CXXI's Oregon acquisitions are not paying off as desired.
The Eco Firma Farms acquisition, completed in June of 2018 for consideration of $7.85 million, has seen some write-downs. In January of 2019, $5.16 million of goodwill was written down, while in October of 2019, an asset impairment of $4.14 million was charged.
At the very least, they have taken the opportunity to minimize tax payments.
Looking at the Swell acquisition, while no formal write-downs have been made, there are still ongoing negotiations regarding remaining payments. Management is trying to reduce the cash consideration paid to make the deal more favorable for shareholders.
While investors should be pleased to see CXXI push for a better deal, it's another sign of an acquisition that isn't paying off.
Finally, CXXI's Phantom acquisition, completed in February of 2019 for a total considering of $10.54 million, is also being revisited.
Specifically, there are ongoing negotiations around the valuation of the properties associated with Phantom's cultivation facilities, which are being purchased for an additional $8.01 million. This is another sign that operations in Oregon are not paying off as expected.
While we have heard positive anecdotal evidence that the Phantom acquisition was a smart move, the ROI is unclear at this time. Given the oversupply challenges facing Oregon operators and the EFF halt, CXXI's operations in the state may weigh on overall performance.
As of the end of Q3, 74% of CXXI's total assets were comprised of goodwill and intangibles. The total value of goodwill was $50.9 million or 58%, almost split evenly between Oregon and Nevada operations. Considering above 25% is high for a normal business, investors should be cautious.
While bulls and bears can argue over whether various acquisition prices were fair, our biggest red flag is the insider ownership of CXXI's debt.
Of particular note is the secured promissory note owed to Sonny Newman (President and CEO of C21 Investments) for the Silver State acquisition. The original terms of the debt were for $30 million with an interest of 10% per annum, for total interest payment of $4.5 million to Mr. Newman over one and a half years.
Since the original deal, the terms have been renegotiated twice, generally in favor of CXXI. We believe a third is likely imminent unless shareholders take action.
As of the release of the financial statements (December 30th, 2019), $8.2 million had been paid (when including the month of November), along with interest. In the most recent version, Mr. Newman has reduced the interest amount to 9.5%, which means he will only make $4.125 million from the loan, assuming CXXI can pay off the $18.2 million that will be due on July 1st, 2020.
As you may be able to tell from CXXI's financials, their operations are not sufficient to cover this debt obligation. They appear to have their hands full with the interest payments and small monthly principal payments of $600,000 they currently make.
Moving forward, management appears to have three options:
Debt Renegotiation
New Debt Issuance
Equity Financing
We breakdown the options below.
New Debt Terms with Sonny Newman
Given CXXI's proclivity to renegotiate the debt terms in the past, we believe this is a very likely option. However, we do not think this would be in the best interest of shareholders.
The loan as-is will already yield a massive return of over $4 million to Mr. Newman at the cost of shareholders. A renegotiation will likely result in additional interest payments, further benefiting the debt holder over investors.
Few serious investors will buy into the company so long as this conflict of interest exists. Investors should leverage what power they have to ensure this option is not selected.
New Debt Issuance
The option that would benefit shareholders the most would be the issuance of new, non-dilutive debt. Unfortunately, given market conditions and CXXI's poor financial health, we do not believe this is a viable option.
While it may be possible to issue convertible debentures, sweetener warrants will likely be required, leading to further dilution. A debt overhang will also remain, with no guarantees that CXXI will be able to pay off the new debt in time.
While the ideal option, this seems unrealistic, leaving only one option that benefits shareholders.
Equity Financing
Management should look to equity financing options to pay down the debt obligation. Within this option, there are two routes.
The first requires Sonny Newman to believe in the long term value of the company and covert the promissory note into shares.
In order for this deal to occur, it would likely need to be at a discount to the current stock price. Further, Mr. Newman would have to feel he is receiving fair value for his money. This is where the above-mentioned conflict of interest becomes a problem - this deal may or may not be in Mr. Newman's best interest.
As of the most recent financials, net equity for CXXI is $30.77 million. That includes $50.9 million in goodwill, and $14.7 million in intangible assets. Given the challenges facing their Oregon operations, Mr. Newman may not believe the assets are fairly valued.
The following graph illustrates Mr. Newman's profit/loss if he were to convert the final debt payment into shares as a function of the accepted discount to the current share price. We look at three scenarios:
He believes assets are fully valued
He believes a 25% write-down of goodwill and intangibles is fair
He believes a 50% write-down of goodwill and intangibles is fair
Sonny Newman's Debt Conversion Profit/Loss
Source: Company Filings, Capital 10X Estimates.
The implications of the above scenarios are summarized in the following table.
Scenario
Stock Price Discount
Shareholder Dilution
Zero Write-down
n/a
45%
25% Write-down
10%
56%
50% Write-down
37%
113%
Ultimately, if Mr. Newman converts his debt into equity at par, he will make a $3.9 million profit assuming believes assets are fairly valued. However, he would have to have serious conviction in the growth potential of CXXI, and be willing to accept significant capital risk. This is where he becomes conflicted as both creditor and President/CEO.
Looking at the second option, management could complete a public offering or at-the-market equity raise to pay down their debt.
The following graph illustrates the total shareholder dilution assuming an average discount price for the equity raise.
Shareholder Dilution for Equity Raise Discount
Source: Capital 10X Estimates.
Obviously, no investor has a crystal ball, so it's not possible to predict how the market would react to a dilution event. The above calculations assume the stock price remains at debt conversion levels.
Based on the debt overhang and negativity associated with Mr. Newman's insider debt ownership, we believe equity financing appears to be the best viable option.
Either having Mr. Newman convert his debt at some modest discount or completing a public offering appear to offer similar levels of dilution to current shareholders.
As the debt repayment date looms closer, we believe a lack of clarity will only weigh on the stock price, making an equity financing more dilutive.
If we were a CXXI shareholder, we would be actively pushing management to complete an equity raise or issue new debt to move past these current challenges. If you believe in the long-term growth potential of the business, this would allow C21 Investments to continue developing its operations while using cash flow to fund growth initiatives.
If Sonny Newman's debt is carried forward, we believe it will continue to dampen CXXI's outlook and ultimately starve the business of much-needed cash.
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