Hello, Gumshoe friends! I’ve been off the grid for a little while, but it’s good to be back — and it’s nice to see the pile of hot, steaming teaser pitches that have larded up my inbox over the past couple weeks.
So… which one to look at first? I’ve had a lot of requests for an answer to Matt McCall’s “Royal Gold of Marijuana” pitch, so I guess we’ll get things going there… after all, if there’s one thing I love it’s a nice royalty investment, the best of them can become a perfect passive income stream for a lazy investor (the worst of them, not so much… but lets be open to some optimism to begin the week, shall we?)
Here’s how McCall tries to get us excited in his pitch for his new service called Early Stage Investor ($1,999/year “on sale” at the moment):
“Few chances like this will ever come along in your investing lifetime… and if you act before July 18th you could watch a small stake grow into a massive fortune.”
And he gets us on his side by admitting that looking for the next huge penny stock boom in pot is a loser’s game…
“The odds of you finding the next marijuana penny stock that goes from $1 to $30…or building a big pot business from scratch are pretty slim, and very risky.
“So I’ve got a much better idea for you…
“A third type of investment has just opened up in the red-hot marijuana markets…”
That is, of course, royalties… the notion that you pay up front for a perpetual share in something. Here’s more from McCall…
“You see, what I’m about to share with you is an incredibly rare phenomenon. It’s only occurred a small handful of times in the past few decades, in other industries….
“But on many occasions, it’s resulted in an explosion of wealth so incredible, the numbers almost seem made up:
“The first time we saw it was in 1983 when it returned early investors as much as 45,300% gains.
“The next time it happened was in 1992 when it showed early investors a whopping 297,900% gain.
“Then it happened again in 2004 for 1,700% gains.”
Then he gets more specific about the Royal Gold (RGLD) connection, which started with a failed explorer run by a guy named Stanley Dempsey… who had an oil and gas company that faltered in the early 1980s when oil prices collapsed, then switched to gold exploration, and then, after the market crash in October 1987, turned to partnering off its gold projects… which ended up being the mostly passive, royalty-receiving business that ended up working for them, much as it did for Franco-Nevada (FNV), the other early pioneer of royalty-based financing in the gold market. Here’s a bit of McCall’s spin on that story…
“You see, Dempsey took what little money he had left… and rather than spend it to have his own company explore for more gold… he offered it to other, more knowledgeable and experienced folks in the gold mining industry…so they could explore. And in return… Dempsey’s company would receive a percentage of whatever gold the mining companies found and sold… in the form of huge royalty payouts.
“In other words, his new company didn’t explore or produce gold. They didn’t own drills, or trucks, or any of the other incredibly expensive trappings of the mining business either.
“They simply paid other folks to find gold for them and took a percentage of the profits in return.”
So that’s pretty much true — though it took decades for the huge riches to build and compound, and there were certainly hiccups along the way for Royal Gold (and the other precious metals royalty companies)… but what does this have to do with marijuana?
McCall says Dempsey had a couple key strategies that made Royal Gold work…
“Dempsey knew the key to making this work was to stack the odds in his favor.
“First, he only worked with the most knowledgeable and experienced miners in the industry — in short, the guys who knew where the gold was.
“And second, he spread his capital across a wide variety of projects…
“This way he maximized the probability of finding a ‘winner’ — if even one of the mining operations he funded discovered gold, he’d receive royalty payments for years.”
Those are both “duh” strategies, of course — at least for a financier. It’s obviously key to work with companies and people who you trust, and to diversify. And certainly royalties on a few good mines make up for all the money you lost by buying royalties on properties that never had a real discovery or on mines that never got built.
Royalties are by far my favorite way to invest in mining… but compared to a lot of other industries, investing in gold mining royalties is still a very high-risk business that requires you to guess about the future not only when it comes to things no one can control (gold prices, drilling results, geological surprises) but also about management acumen in managing a massive permitting, construction and development project. That’s why these deals make a lot of money when they work out, because a lot of the time they don’t work out.
OK, so now we get into more specifics about this “Royal Gold of Marijuana” … here’s a bit of a sum-up from McCall…
“You see, the key to making a fortune in royalty companies is to get in at the very beginning… you want to be there first.
“As you’ve probably guessed, a brand-new royalty opportunity has just opened up… only this time it’s in one of the newest and fastest-growing industries in the world today…
“I’m talking, of course, about the red-hot marijuana industry.
“Right now, you have the rare opportunity to get in at the early-stages of this brand-new royalty opportunity… what I’m calling the ‘Royal Gold of Marijuana.'”
What makes gold royalties work? Mostly two things: Finding and producting more gold than was initially expected, and than was predicted in the models you used to judge the price of the royalty, which happens pretty often (there’s no financial incentive to “define” reserves beyond what is required to make the mine feasible enough to get financing, but mines often expand dramatically and produce for more than twice as long as the initial assessments predicted); or enjoying leveraged exposure to higher gold prices. You can make a lot of money either by producing gold for many years beyond the “break even” point (when the money you invested for the royalty is paid back), or by seeing the price of gold soar far higher and thereby speeding up the repayment of that initial investment and getting to those “profit” years.
That’s pretty much it — there’s no magic, and since you’re not exposed to operating costs you don’t care how profitable the mine is as long as it is profitable enough to keep operating… all you care about is whether your share of the production can be bigger than expected or continue for longer than expected, or whether the produced volume of whatever the commodity is will be more valuable because the prices in the future are higher. It looks like magic when it works well, partly because, when it comes to gold, higher prices also meant that the mines produced for longer because it was worth producing the lower grade stuff, or allowed miners to invest heavily in expanding the mines, so you got a bit of double leverage that way… but it’s not magic.
Why does McCall see riches for this royalty-style company in the marijuana space?
“… according to Business Insider 85% of marijuana consumers haven’t moved into the legal market yet.
“That means a huge underground demand is just waiting to be unleashed in the legalized world.
“Gold, on the other hand, has been around for centuries. By the time Royal Gold began mining, there was already an established market…and they still handed investors a fortune.”
Unlike gold, of course, marijuana production is not at all constrained in any physical way — it doesn’t have to be found, it just has to be grown, and with hydroponics you can build a plant in a year and produce several harvests a year soon after. Gold production does not respond nearly as quickly to increased demand, which is part of what helps prices to rise (and what has historically made gold a pretty good currency, given the naturally limited supply).
And we’re told that this market has made some huge royalty deals possible…
“Gold royalty businesses often typically receive about 2-5% of revenues from gold extracted from a mine…
“Compare that to the ‘Royal Gold of Marijuana’ which already has deals in place that deliver 30-50% of the total cannabis sales from several different growers.
“Bigger royalty deals in a much more profitable industry? Add it all up and it’s not hard to believe how this tiny marijuana company could ultimately outperform even Royal Gold’s outstanding returns.”
The flip side of that, of course, is that if things turn out to be less exciting on the income statement than a marijuana company predicts, then having 30-50% of their top line committed to a royalty company could be a major drag on the company’s operations, endangering their ability to survive a downturn. Royalties that are too big to handle and screw up the economics of the underlying business aren’t good for anyone.
But I’m putting the cart before the horse here again, that 30-50% could be a significant exaggeration… so let’s see what this company actually is, shall we?
“… these larger royalty percentages mean it has the potential to receive tens even hundreds of millions each year from several royalty partners.
“That’s a far cry from Dempsey’s most lucrative royalty stream that paid out around $10 million annually.
“Of course, the truth is, even if this marijuana royalty stock only does half as well… or even 1/4 as well as Royal Gold, it could still turn an investment of just $1,000 into $100,000 or more.”
And we’re also told that these can be very long-term royalties… which is certainly good news, it’s often after that first 5-10 years that a royalty really starts to generate dramatic profits.
“In the gold business, royalty deals typically last for the life of the gold mine… which is usually around 10-25 years.
“With cannabis, it’s a completely different story.
“As a renewable resource… it can never ‘run out.’ Because of this, the ‘Royal Gold of Marijuana’ has multiple deals set up that pay out lucrative royalty streams for up to 99 years!”
And the pitch says that these are also very good deals, with some examples:
“For example, this company has a royalty stake in what will soon become the single largest marijuana indoor grow facility on the planet.
“It’s a former KRAFT food manufacturing plant. Currently under renovation, this state-of-the-art facility will be the size of more than TEN football fields.
“With more than 600,000 square feet of grow space, it’s going to be the Madison Square Garden of the pot industry.
“When completed, this gargantuan facility will churn out more than 40,000 pounds of marijuana per year.
“And the best part? The ‘Royal Gold of Marijuana’ gets a cut of the revenue. And I’m not talking table scraps, either. They’ve negotiated a massive 50% royalty deal on all the pot produced at this facility — for — get this — up to the next 99 years!”
And sums that up…
“That means, when completed and at full production, this tiny royalty firm could rake in as much as $220 million per year for multiple decades… all from a one-time $120 million initial investment.”
And he says they’ve got lots of other deals in place as well, including one with a pharmacy chain…
“… this ‘Royal Gold of Marijuana’ has landed the deal of a lifetime — think CVS or Walgreen’s, only the Canadian version.
“In short, it’s secured the rights to the sales of high-quality medical-grade pot, with the potential to be sold in 40 pharmacies, with as many as 1,500 locations across Canada.”
So we’re getting an abundance of clues here… and I’ll throw just one more on the pile to make sure the Thinkolator has plenty to work with — the ad cites the connected leadership team as one of the reasons why marijuana companies will want to make royalty deals with this little firm:
“… the CEO of this company is a veteran of the marijuana industry…
“He’s already founded another hugely successful cannabis company, called Canopy Growth Corp (which I mentioned earlier this presentation)…
“He took that company public in 2014 for just $3 a share…
“Today, it’s the largest pot stock in the world, in terms of marijuana produced.”
McCall also throws out a couple catalysts to entice possible subscribers — one, of course, being the impending recreational legalization of marijuana in Canada, which has been on the lips of every marijuana investor for over a year now as the turning point that will bring massive fortunes (and, of course, that’s also the reason that all the big marijuana companies in Canada are investing heavily in increased production).
And the other is that their first royalty will soon start paying, so they’ll actually have some revenue to get people excited. Here’s how he puts it:
“… as early as July 20th this tiny company is looking to receive its first major royalty stream—as much as $1.7 million—is scheduled to come online, according to our more conservative estimates.
“And this is just the beginning…right after that another royalty payout is lined up.
“This one is even bigger—roughly $3 million.
“Again, when these big revenue streams start pouring in, big institutional investors could take notice and begin to pour billions into this tiny stock…”
And then next year more royalties start pouring in…
“2019 is when this company will really start to cash in on their deals. During the first half of the year, our analysis shows royalty streams of $5 million, $7.5 million, and even a big delivery of $40 million are scheduled to come in….
“All told, over the next 18 months, this tiny company is expecting to reap the benefits of over 90,000 lbs of marijuana …an amount which could exceed $90 million.”
So who is it? Well, part of the reason why it may still be somewhat “secret” is that they keep changing their dang name, but the Mighty, Mighty Thinkolator says the company being touted is Auxly Cannabis, formerly Cannabis Wheaton (XLY.V in Canada, CBWTF OTC in the US).
Auxly was started last year as a streaming company for marijuana, which is where the “Wheaton” name came in (Wheaton Precious Metals, previously Silver Wheaton, was the pioneer of the “streaming” business model, where companies were paid up front and the streaming company received a large chunk of ongoing production, usually at an ongoing price far below the current market price), but apparently this name change to Auxly is meant to emphasize the fact that they’re going beyond streaming to be “immersed in all aspects of the cannabis value chain” — so it sounds like they’ve at least hired some more MBAs to get their business gobbledygook-speak up to par.
Why is this a match? Well, the CEO and founder of Auxly, Chuck Rifici, was indeed a founder of Tweed, which later became Canopy Growth… so that’s a match. As are a couple of the specific deals, including that “single largest” grow facility in a former KRAFT plant (that’s a deal with FV Pharma, which does indeed give them 50% of all cannabis cultivation, excluding the existing cultivation, for 99 years), and the $55 million they’ve invested in ABcann to get 50% of production from a newly constructed indoor cultivation space for 99 years, starting late this year.
So I’m convinced that the Thinkolator is right on this one… but is Auxly a great investment? For that we have to look beyond the ad pitch and think for ourselves.
So far, it’s been a disappointment if you bought during the initial enthusiasm, when lots of talk about what was then Cannabis Wheaton becoming the first great royalty company in Cannabis drove the shares up for a little while in the Spring of 2017 to about $1.50, then more dramatically back in December, when the stock surged to over $2.50 (Canadian) on the impending “legalization” news that sent pretty much all Canadian pot stocks bonkers over the winter. Now it’s around $1.10, though the market cap has surged to close to C$600 million now because they’ve raised so much money (the share count has gone from about 50 million when they were first becoming a “streaming company” early in 2017, to about 566 million shares outstanding now according to the Toronto Exchange numbers).
And that, really, was my primary concern about Auxly when I first started looking at them a little over a year ago. I love royalty companies and streaming companies, the business model takes a lot of the risk off the table and provides for possible long-tail returns that can be phenomenal… but they are also primarily financing companies, which means that they have to first raise the money to fund these deals they’re making, and should be valued at something like the amount they’ve invested in those deals. There can be valued added by a great management team, and it’s certainly possible for a financier to make great deals that are worth twice what they paid — but if you’re assuming the company is worth more than twice what they’ve invested in future income streams, then you’re making a huge leap of faith.
Of course, leaps of faith are nothing strange in the marijuana space, which has been fighting it out with the blockchain sector when it comes to attracting speculative capital and providing bubblicious daydreams to individual investors. The folks who dreamed about the next big gold mine a decade ago are now dreaming about the next huge cannabis brand.
Here’s what I wrote to the Irregulars about Cannabis Wheaton when it was facing a bit of selling pressure last Summer…
“The streaming deals they have so far look terrible, honestly — the ones I’ve looked at where they’ve provided some specifics are based not on current economics, but on some hypothetical world where prices rise dramatically for legal marijuana in Canada. That might come, but this is going to be a regulated market that might even have strong price controls, and I suspect a bank wouldn’t lend based on those estimates… a streaming company trying to expand quickly apparently will, and perhaps that’s why the streaming company hasn’t raised the $500 million they need to fulfill their end of the streaming deals they’ve made… and, it seems, is having some trouble raising even a tenth of that amount. Which, in turn, could mean that some of their streaming deals won’t close, because the deals that I saw described in detail were contingent on Cannabis Wheaton raising money.
“I do kind of hope that this one hits a rational price as disenchantment continues, and they did bring in a new executive this week, presumably with some hope of righting the ship and restoring some credibility, but we’ll see — it’s quite possible that they missed their chance now. If you intend to build a long-term successful business, it’s short-sighted to be raising this money with junky convertible debt and warrants when there’s a lot of interest in marijuana equities, they could perhaps have set themselves up for a much healthier business if they had just sold a big slug of equity right away and kept expectations a little more in check… but, of course, that would have driven the price down a bit more, at least in the short term, and it seems to me that many of the marijuana market participants who are starting or listing companies in the public markets seem to be quite enthusiastic about getting their windfall profits quick before the story or sentiment changes. That’s probably a word to the wise for us all: Investors can obsess over share prices and have wild mood swings, but when companies themselves are focused on the short term stock price movement instead of on building a sustainable business, things can get ugly quickly.”
So if you had listened to me back then, you would have missed that 150%+ run into late December, but also avoided the belly ache of the 60%+ drop since the highs early this year. The price per share of Auxly is now within about 5% of where it was back in early June of 2017, when I wrote those words, though the market cap has risen 300% and they’ve also added about $90 million of debt.
But that’s all in the past… what’s the story now? Is Auxly now appealing after this long drop in 2018?
It’s certainly not an unknown stock, it has been profiled by lots of the free pundits out there (including the Motley Fool here), and it’s been teased a few times by various newsletters (including Jimmy Mengel starting last year, and the Casey folks this year).
They do have more deals now — you can see some of them outlined on their “Partners” page here, though they don’t talk much about what they paid for these deals or what their ongoing obligations are (my concern a year ago was that Auxly, then Cannabis Wheaton, was being valued as if they had already paid for the deals they had made, when in reality they hadn’t even raised the money to pay for those deals yet). The total production is indeed impressive, more than 200,000kg of marijuana is due to Auxly from its partners when all the operators are producing at full tilt, though that could be many years into the future.
As of last quarter, Auxly reported that they have sufficient capital (about $200 million) to cover their obligations over the next twelve months — so that’s good (the money came from their accelerated warrant conversion process once the stock hit its highs over the winter, plus $100 million in convertible debt sold this year). That means these deals that are currently in progress, the growing facilities being built, etc., can actually be paid for… a good starting point.
The share count will likely continue to balloon, even if they don’t raise more money, because they’ve been aggressively using their shares to acquire more companies — including several relatively small acquisitions made just since the end of the March quarter, which could serve to dilute the impact of any near-term cash flow from their streaming deals that are expected to start generating revenue… so that’s a concern, as is their continuing predilection to act like a junior mining company and issue lots of warrants and convertible debt instead of plain old equity.
There is actually one sell-side analyst with estimates out for Auxly, predicting two cents of earnings per share in 2019 and 18 cents in 2020, based on the dramatic rampup from $7 million in revenue this year to $570 million in 2020. We shouldn’t base much on the estimates of a single analyst, particularly because it’s probably a company that’s doing business with Auxly (there’s not much other reason for an analyst to cover a company this small), but it’s a start.
So I am forced to stick with accounting on this one, given my lack of interest in reading the details of each of the deals Auxly has made with royalty or other partners, and the accounting says that as of March they had $206 million in cash, $14 million in product receivables (marijuana they’ll be paid in exchange for money lent), $19 million in long term investments, $4 million in property, plant and equipment, and $30 million in “intangible assets”. That totals up to C$273 million, not including another $4.5 million in “goodwill,” which is what they’ve paid for some assets in excess of their value.
They’ve made a few deals since then, but they don’t change the makeup of the company dramatically — so that’s what the accountants believe that Auxly is worth, they have about $200 million in cash and they’ve bought stuff that’s worth about $70 million so far. We can argue about whether they’re valuing those assets fairly or not, but since it was all acquired during the past year I assume there shouldn’t be major differences between what they paid and what the assets are worth — these aren’t hidden assets that have been depreciated over the years, or brand names that are worth far more than the price paid, these are business deals that they made in a competitive environment.
So my base case assumption, having not scoured through the details recently but having been generally unimpressed with the early streaming deals last year, is that a well-connected management team is worth a premium price when managing deals in a nascent sector like this — but since it’s a commodity business still, without clear brand leadership and without any clarity on regulatory pricing, I wouldn’t want to pay more than a 100% premium.
I don’t like the idea of betting on higher marijuana prices, because I don’t think there’s much to be gained by betting on the price per gram of marijuana rising dramatically over the next couple years — part of the reason for legalization is to squeeze out the black market, and if prices are much higher than the $7-10 per gram that Canadians currently pay the black market can undercut the regulated and legal market… particularly since it would be almost impossible to identify whether a person is carrying legal or illegal marijuana.
The continued existence of a large global black market and the massive increase in regulated and legal production in Canada will do plenty to keep prices in check, I think, and I suspect that Canada will have price controls that keep the legal stuff pretty cheap — though once edibles and drinks are legalized, anticipated next year, it will get a lot tougher to control prices as the variety of products explodes. I could be wrong on that, but that’s my base assumption that gives me caution about Canadian marijuana stocks — it will be a booming market in terms of revenue and production, but I’m not sure whether it will boom in terms of profits because I think per-gram pricing will probably fall.
So in that environment, with Auxly’s odd web of distribution and production deals and partnerships and streaming/royalty agreements, I’d be willing to consider paying a price that assumes their deals are worth twice what they paid for them. To get to that number we double all the assets other than cash, and add in the cash, and that gets us to just under C$350 million. That’s the price where I’d start thinking that I can invest in Auxly without making wildly optimistic assumptions — perhaps if I knew the deals or the marketplace better in Canada I’d be willing to pay more, I don’t know, but I don’t find a C$566 million valuation all that compelling.
That doesn’t mean the stock won’t rise, of course — it is a great business model in the abstract, though we will have to wait to see how it plays out given Auxly’s costs and assumptions (the company is not just a passive partner, and these are not primarily passive royalties but are mostly streaming deals that give them a share of production at a cost — either a fixed cost, or a joint venture obligation to help with marketing, development, distribution or other expenses… more like joint venture deals).
And it’s certainly possible that the stock will rise again in a manic spike when marijuana headlines about the first legal recreational sales hit newspapers… I just don’t want to speculate on that happening, so I’ll hang back and will wait to see if this risky but interesting stock gets cheap enough to consider buying. I love royalties, and I have some general appreciation for the way Auxly is developing a large financing operation that’s sort of like a royalty business for cannabis, but I don’t like the price investors are asking me to pay for the shares right now.
I must close by also stating that I could just be a boring old fuddy-duddy, and I have problems with the valuations of pretty much all the marijuana stocks I’ve looked at — so perhaps I’ll just miss the fun, and I can live with that. So I’ll turn it back over to you, dear friends and readers: Think I’m missing out? See a great future ahead for Auxly (or your own favorite marijuana stock)? Let us know with a comment below.
Disclosure: I own shares of Franco-Nevada, which is mentioned above. I don’t own any of the other stocks mentioned, and will not trade in any covered stock for at least three days after publication, per Stock Gumshoe’s trading rules.