Description

Elevator Pitch

GRWG is a cannabis-related stock that has been a ~5 bagger over the last year. At >40x ‘21E EBITDA, GRWG is priced to perfection despite the fact that I believe the Company will likely be net loser from Federal Decriminalization of cannabis. Insiders are voting with their wallets with >$85mm of net sales since the beginning of 2020 at an average price ~60% lower than current trading. Consequently, I believe GRWG offers a compelling risk / reward either as an outright short or hedge for other long cannabis exposure.

Company Background

GrowGeneration Corp. (“GrowGen,” “GRWG” or the “Company”) is the country’s largest chain of hydroponic garden centers (the Company likes to think of itself as the “Home Depot for cannabis”). After several recent acquisitions, GrowGen operates 58 stores in 12 states (though over half of the stores are in CA, CO and MI). The average store is ~15k sf.

GrowGen is effectively a roll-up or local hydroponic stores, having acquired 34 of its 58 stores since the beginning of 2020 alone. The Company acquires these stores or groups of stores for ~3-5x EBITDA, typically with a combination of cash and GRWG stock. GrowGen occasionally greenfields new locations as well. In addition to acquiring retail locations, GrowGen has also acquired a number of nutrient brands such as Char Coir and Canopy Crop Management as it has sought to expand its private label offerings and capture additional margin (the Company currently operates at a high 20s gross margins).

The Company’s revenue mix consists of ~60% consumable products (e.g., nutrients and soil) and ~40% hydroponic equipment (e.g., lighting). GrowGen positions itself as a one stop shop cannabis cultivators of all shapes and sizes (though this has more to do with current law than a competitive moat). In 2020, ~25% of the sales were to commercial grow operations (i.e., MSOs and other large cultivators). However, it is no coincidence that the vast majority of the Company’s store footprint is in open license states such as CA, CO, MI and OK (as opposed to limited license states such as IL, OH, PA or NY), as cultivation in open license states tends to be significantly more fragmented with many small growers as opposed to a limited number of scale played.

Short Thesis

1.   Supplier Concentration / Disintermediation

GrowGen’s top two suppliers (who I believe to be SMG and HYFM) accounted for 41% of purchases in 2020 and the Company expects them to account for >30% of purchases in 2021.

2.   Federal Decriminalization / Cannabis Banking Reform Will Hurt GRWG

Due to the prevailing interpretation of the Bank Secrecy Act (“BSA”), large companies that have end customers in the cannabis business tend service them via a two-step distribution model to avoid selling to companies that touch cannabis.

As a prime example, under current law, public companies such as Scotts Miracle Grow (“SMG”) and Hydrofarm (“HYFM”) will sell to retailers, like GrowGen, to avoid the BSA complications. Thus even large MSOs with enormous grow operations who want SMG or HFYM product would be forced to buy these products at retail from someone like GRWG.

Were cannabis to be federally decriminalized, the argument that SMG or HFYM could not sell directly to a cannabis cultivator for fear of losing access to bank accounts would suddenly disappear. While SMG or HYFM might still find some value with having a retail presence to service small growers and hobbyists, it does not make industrial sense for either the MSOs or SMG for GWRG to continue to be a retail middleman that takes ~30 points simply due to the current legal structure.

More likely I believe is a scenario where GRWG can still play an important role for the hobbyist grower while MSOs and other large cultivators buy pallet sized quantities directly from large suppliers. Additionally, I believe that when cannabis is decriminalized, it will spur significant industry consolidation both within and between states enhancing the presence of MSOs relative to small growers. The cumulative effect of this would materially shrink GrowGen’s addressable market.

3.       Current Financials Include Significant Amount of Non-recurring SPend

Roughly ~40% of GrowGen’s revenue comes from non-consumables that a grower typically only needs to buy once before relatively long useful lives. When a state introduces recreational cannabis, new growers must buy new equipment to start growing. This grower capex spend benefits GrowGen when a state ramps legal production replace formerly illicit supply but is one time in nature. This dynamic can be seen in GRWG’s performance in Oklahoma, where 2020 revenue was ~$42mm vs just $0.5mm in 2018 largely on the back of this.

4.       Priced to Perfection

Despite these potential headwinds on the horizon, at ~42x ‘21E EBITDA (or ~48x ‘21E EBITDA – SBC) the market is pricing-in considerable growth.

I believe part of the reason for this GRWG is currently one of a limited number of US-listed ways to play the US cannabis space as most US MSO have their primary listing in Canada. I expect this dynamic to change over time, which could result in retail outflows.

5.   Insider Selling

GRWG insiders have been selling in size over the last couple of years at prices significantly below where the stock trades today.

Risks to Short

1.       Federal Decriminalization Never Happens

If cannabis is never decriminalized, it is likely that GrowGen would continue to hold an important place in the cannabis supply infrastructure similar to a beer distributor in current alcohol supply chain.

2.       Roll Up Arbitrage Persists Longer than Schedule 1 Status

GRWG has been able to arbitrage its currently low cost of public equity capital to execute its roll up strategy. To the extent this dynamic continues before the Company experiences some of the headwinds mentioned here, it is possible that GrowGen could grow into currently stretched valuation.

3.       Non Cannabis Strategic Wants Into the Space

While highly unlikely, in taking a short position, one can never fully discount the possibility that a strategic (perhaps an HD or LOW in the case) blows you up.

Catalyst

Federal Decriminalization

Hawthorne / Hydrofarm selling direct to cultivators

Retail outflows