I move to the sidelines as the company invests more heavily in its cannabis 2.0 future.

Not Exactly What I Signed Up For

In the confusion and panic surrounding the early part of this coronavirus epidemic, I bought Valens. As the virus put the fate of many companies in question, I believed I was finding the best values in some of the sectors that had been hit the hardest. As a result, my portfolio was filling up with a worrying number of turnaround plays, not typically my favourite type of investment. To offset this exposure, I was looking for some good, old-fashioned “growth at a reasonable price” style investments to provide some balance. I was hoping I had found just such a beast with Valens. This company had been on fire the last few quarters, raking in the cash as they extracted the oils from cannabis plants on behalf of the large marijuana growers. These oils could then be used to concoct a dizzying array of enticing, cannabis infused products. With the recent legalization of these cannabis 2.0 products, the future looked potentially bright for this company; a profitable young company in a rapidly growing new industry.

Unfortunately, things didn’t turn out as well as I had hoped. There were rumblings when I bought it that prices were falling in the extraction space as over capacity met with lackluster demand. But nothing’s ever perfect. I hoped that any decline in revenues on the bulk extraction side of the business could be offset by strong gains in the white label, cannabis 2.0 manufacturing side of the business and that this would increasingly be the growth driver for the business going forward.

To a large extent, that dynamic has played out, albeit much more quickly than I had anticipated. Extraction revenue has plummeted and made up only 17% of total revenues in the most recent third quarter while their white label manufacturing business has taken over, generating 83% of total sales. The company is charging ahead in this sector and is currently the largest Canadian manufacturer of white label cannabis products. They continue to aggressively grow this side of their business and seem destined to become the dominant player in the sector. 2021 promises to bring a spate of new products including such things as lip balm, CBD infused honey, gummy bears and many more weird and wonderful pot-based products. Valens is going to be involved in all of that.

There is just one problem. All those delightful profits the company was generating with its lucrative, but boring, extraction business have evaporated. At first, I gave the company a pass on their disappearing profitability thanks to the covid epidemic. No one was in the stores buying anything, including CBD-infused  iced tea or massage oils. But as we move now into recovery mode, I am less willing to be magnanimous. In the most recent quarter, the company again posted a sizable loss. The company has ramped up expenses across the board to fund its growing white label manufacturing business. They’ve added staff and increased the amount they fork out in management and professional fees. Their depreciation expenses have climbed as they have added manufacturing capacity (under-utilized at the moment) and they continue to dole out large dollops of options to their employees which further eats away at their bottom line. They lost a few million dollars in both Q2 and Q3 and disappointingly, Q3 didn’t really seem to show much in the way of sequential improvement on this front.

Going forward, they say they will continue to ramp up expenses as they launch new products and expand production capacity even more. I suspect that profit margins will remain under pressure as they make these investments in their future.

There is nothing to say that there is anything wrong with this or that this isn’t the right strategy from a corporate standpoint. I wish them all the luck in the world. But this isn’t the company I thought I was buying. I bought a company that I thought had a nice, stable and most importantly, profitable business extracting cannabis oils, with the sweetener of potential future growth from their white label manufacturing business. We’ve still got the white label business and that continues to be exciting, but the profitable extraction business is drying up much more quickly than I had anticipated.

There are lots of smaller companies out there with exciting ideas. Some will make it, some won’t. Every investor has their own area of comfort and expertise. The money-losing start-up isn’t mine. I will leave that to other investors. If Valens can grow its way back to profitability then I will once again look at it with a keen eye to making an investment, but until then, I am moving to the sidelines.

Full Disclosure: I do not own shares in The Valens Company.