Australis Capital — Company update on Folium and Cocoon

On the conference call, the company provided additional detail regarding the background of the Folium merger and the reasons for its termination. The company revealed that there was a competitive process surrounding Folium (including the participation of a major US investment bank), but that the reverse merger process pursued by Australis was proposed as an alternative to a direct take-out. The company confirmed that management was aware of potential red flags at Folium (presumably its ongoing legal troubles with former employees), but that it was confident in the strength of the underlying business at the time.

As far as the reasons for the termination, the company cited the drop in CBD prices as a significant contributing factor, as we initially suspected. However, Australis did not provide any additional detail regarding what was found during its due diligence of Folium that has been previously cited at the cause for the termination. Australis suggested that it still believes that Folium has the potential for success, but that in light of the lower CBD prices and these undisclosed factors, it was not willing to ‘go all in’ on the merger. Australis has consistently highlighted its conservative approach to reviewing assets, and the process with Folium was no different.

In additional news, the company announced on 26 February 2020 that it received the first orders for its Cocoon self-service technology. The Nevada dispensary chain THRIVE ordered 32 CocoonPod kiosks to service the company’s eight current locations and potential future expansions. THRIVE has a four-year exclusivity contract with Australis, in which Cocoon will be the sole automated service platform used at the dispensary chains.

Australis stated that it expects revenue from these units to be US$1.4m for the first year and US$7.1m over the term of the agreement. This translates to an initial yearly revenue per kiosk of approximately US$44,000, increasing to over US$50,000 over the four-year period. The company has not released the precise terms of its revenue share agreement, but we expect it to be in the single-digit range. Additionally, the company will generate revenue from the sale of the CocoonPod capital equipment, which we estimate in the range of US$15,000 per unit, similar to that of an ATM. Based on the tracking of new dispensary licenses, there are an estimated 7,180 dispensaries operating in the US. This corresponds to an addressable market for Cocoon of approximately US$360m in recurring revenue, assuming an average of one kiosk per store, and similar usage compared to Australis’s estimates.

The company also provided some small details regarding its other ongoing programs. The company provided a brief update on the Green Therapeutics deal, in which it signed in Q219 a definitive agreement to acquire GT’s cultivation and production business and brands. The company stated that the moratorium on the transfer of licenses in Nevada has prevented the closing of the deal. The moratorium on transfers appears to be in part politically motivated following the revelation that foreign interests were attempting to buy their way into the market. We will be watching the situation closely, and although there can be no guarantees regarding timing, we expect the moratorium to be lifted in due time to allow for the market to continue to develop. The operational costs to Australis for the project are very limited before the closing of the deal, and there is little financial pressure on the company at this time, so we expect Australis to be able to weather these delays. If the deal needs to be terminated, the parcel of land that Australis acquired in North Las Vegas for the expansion is saleable. However, it is worth noting that Australis has already issued almost 8m shares associated with the transaction, although we assume that if the deal falls through there are provisions for their return.

Additionally, the company provided some minor details regarding its recent acquisition of Paytron. The company noted that the value of the transaction was US$120,000, and that the primary purpose of the deal was to acquire the talent at the company (namely Marc Ruben, cited in the initial press release).

We have added Cocoon to our model because it is expected to imminently generate revenue through the agreement with THRIVE. We arrive at an initial valuation for this program of C$13.43m. We arrive at this valuation using a DCF methodology of three different scenarios, which we risk adjust. In the best case scenario, the Cocoon product line gains significant commercial traction, and cannabis is federally legalized or decriminalized. For the purposes of this scenario we expect federal legalization or decriminalization to reach full effect in approximately 2023. We assume that the total number of cannabis dispensaries will approach 30,000 in 10 years, which is roughly equal to the number of specialty coffee shops in the US. We assume that the company will be able to achieve 2% penetration in this market (in terms of units per dispensary, encompassing multiple placements). We include C$2m in fixed selling costs and 15% variable selling costs. The DCF for this scenario is C$74.16m and we estimate at 15% probability of its occurrence. We use a 10% discount rate (our standard for commercial products) and a 1% terminal growth rate.

We also include a scenario in which federal legalization or decriminalization does not occur. All of our assumptions for this scenario are the same as the best case scenario, except we expect total dispensaries in the US to approach 15,000. The DCF for this model is C$33.30m with a probability of 15%.

Finally we include the scenario in which Cocoon does not gain commercial traction (either with or without legalization). In this model we do not include revenue outside of the current THRIVE agreement. The DCF for this model is negative C$2.16m, with a 70% probability.

The net value we calculate for Cocoon based on these scenarios is C$14.61m. We expect to adjust these probabilities following developments in the company’s commercial rollout of the product and any changes in the regulatory landscape. This brings our total valuation of the company’s portfolio to C$75.98m, roughly twice the company’s market valuation.

As we expect near-term revenue from Cocoon, we now include this in our financial forecasts. We include C$2.55m in revenue (US$1.8m, US$1.4m from recurring sales and US$400,000 from capital sales) for FY21. We have also included C$3.08m in cost of selling for the same period as we expect the company to expand its sales efforts to promote the CocoonPod product.

Although we no longer expect the Green Therapeutics deal to close in FY20, the company has already invested C$10.89m in the project, which is reflected in the balance sheet (although we have adjusted our cashflow accounting to match Australis).

The company reported a net loss of C$6.89m for Q3 FY20 ending on 31 December 2019, which is a slight increase over the previous quarter (C$5.20m), largely due to one-off items. The operating loss was C$4.2m in Q3 FY20, versus C$3.9m in the Q2 FY20. The company ended the period with C$19.47m in cash, which should be sufficient for its near-term operational goals, but the company may issue more stock or take on debt for future transactions.