Sproutly: Game Changing?

Summary

Sproutly has developed a water-soluble format with potential applications in the cannabis beverage industry
The previous 12-month period reports widening losses to circa $12m for full year 2018
Oversupply in Canada reduces the favorability of the production segment, with long term capacity expected to exceed demand for the foreseeable future

Company Overview

Founded in late 2015, Sproutly is a relatively new entrant to the market specializing in processing cannabis into a water-soluble format that has potential applications in the cannabis-based beverage industry. The Infusion brand was added to the company portfolio in late 2016, and forms the basis for commercialization of water-soluble cannabis. With 161,792,272 shares outstanding, Sproutly boasts a market cap of $140m CAD.

Key Takeaways

  • Losses widened from $993k in the nine months ended 2017 to $9.56m in the comparable 2018 period. Sproutly is now starting to scale up, forming part of the cost burden in addition to a $3.8m spend on listing expenses and circa $1m in financing costs. • The technology behind Sproutly does work as intended, however the patent application is still pending and competitors already possess the technology to create cannabis-based beverages in a commercial way.
  • Licensing this tech to major manufacturers and brands is in the author’s opinion the only viable way forward for Sproutly.
  • US rights to the technology are not owned by Sproutly, and is fully owned by Sproutly founder, Dr. Arup Sen. This raises multiple concerns moving forward.
  • Sproutly remains unproven in its abilities to scale up effectively, with particular concerns over the length of time it takes to process cannabis into a water-soluble format compared to methods used by competitors.

Short-Term

Growing Losses

While growing losses are common in the industry, from an investment perspective it hurts long term shareholder value in absolute terms (it’s still a loss) as well as relative terms as share issuances may be utilized as the tool of choice for additional fundraising activities, thereby diluting existing shareholders.
As detailed below, the macro economics fail to provide optimism for short to mid term outlooks moving forward.

Production Facility

As well as operating within the cannabis beverage market, Sproutly maintains a 16,600 sq ft production facility near Toronto with a 1,400kg potential annual production capacity.
The strategy is to deliver dried cannabis to Toronto users via a same day delivery service, essentially segmenting the business into two parts: APP water soluble technology and the traditional vertically integrated production and distribution business involved in supplying cannabis to the end user.

 Demand-and-Capacity-Fundamentals-of-Sproutly

(Source: Sproutly, 2019)

Generally, this author remains skeptical as to the short and mid term viability of taking production on internally. Competitors are generally willing to sell at a loss to sustain and grow volumes while Sproutly has little added value in terms of branding and marketing. In the authors opinion, this segment of the business is of minor concern, and serves primarily as the center of R&D efforts and not as a profit center, at least with short to mid term horizons in mind.

The Macro Environment

As this report examines a company in a high-growth industry, investors are interested in potential market size 10, even 20, years out from today. Below is a chart provided by Statista.
Forecast legal cannabis spending worldwide from 2016 to 2024
Forecast-legal-cannabis-spending-worldwide-from-2016-to-2024
(Source: Statista, 2019)
The table below projects out to 2030 and 2040 utilizing the same methodology as found in the Statista research and chart above.

Year

Market Size

2020

$29.5 billion

2030

$199 billion

2040

$1,339 billion


This data is, in the author's opinion, somewhat optimistic - very few industries grow at 20%+ per year over the course of 30 years. Yet it remains the primary allure to investors and provides the basis for current elevated valuations across this sector.

Long-Term

Scaling Up

The first step towards full commercialization is proving that this technology is both effective and cost efficient at the scale required to meet aggressive increases in demand. To date this has not been verified, and the company continues to undertake R&D efforts to prove an acceptable level of scalability. Part of this involves basing Biosciences APP technology at the production facility, but as of January 2019 this is yet to be approved by Health Canada.

Patents

Once (or perhaps if) scalability is achieved and meets the criteria set out above, the technology on a comparative basis will need to provide a competitive advantage compared to the methods used by competitors such as Tilray. This will likely be in the form of cost efficiencies, that the process used by Infusion retains the quality of comparables at a lower production cost than that of competitors. 

While it would provide substantial competitive advantage to be the sole company able to process cannabis into beverages, this is highly unlikely to be the case. The announcement of partnerships between the likes of Tilray and Anheuser-Busch InBev is indicative of stiff competition ahead, as these companies pour tens of millions of dollars directly into R&D efforts for developing a similar end product. This is a material headwind to Sproutly and direct competition would likely prove excruciatingly difficult.

Licensing, Distribution & Branding

Meeting the above criteria successfully would allow Sproutly to negotiate from a position of relative strength with major producers such as Coca Cola and other various producers of alcoholic and non-alcoholic beverages. Partnership with a company such as Coca Cola a few years down the road would de-risk Sproutly from the inherent complexities and difficulties in producing and distributing beverages on a quasi-global scale. Quite frankly, this is a notoriously competitive market that a company such as Sproutly would find extremely difficult to operate in alone.

Balance Sheet

Furthermore, the balance sheet shows an entry for intangible assets of $63.12m in November 2018 up from $6.2m in the same 2017 period. This single item forms the majority of book value this company holds, with intangible assets being especially difficult to value accurately. Encapsulating brands, IP, trademarks and patents it is an easy metric to inflate beyond reasonable worth and is a common entry for write downs as expectations meet reality. It forms an especially concerning headwind, and investors should carefully deliberate on the commercial value of the items mentioned above.
However, the company retains circa $11m in cash which is sufficient to cover all short-term obligations. This amounts to a total of $8.8m providing sufficient liquidity for the company over the next 12 months. Previously, Sproutly has engaged in share issuances as a source of financing and this appears set to continue over the next 48 months as the firm burns through its existing cash pile with no clear path to profitability.

Conclusion

This is first and foremost a play on the underlying technology of Infusion, with the Toronto Herbal Remedies segment a bolt on to the core value proposition. The long-term success of this beverage-based technology relies on a number of factors occurring favorably over the next 12-24 months, and this remains far from certain. It is therefore a high-risk high reward scenario, with extremely favorable upside should the caveats mentioned above be overcome.
The global environment remains favorable, but continued over supply across Canada is having a material impact on the profitability of production and this exposes Sproutly to further financial headwinds.
In the authors opinion an investment in Sproutly is not to be undertaken by the faint of heart, as substantial volatility and various hurdles to success will provide a roller coaster ride over the next 12-24 months.

All statistical and quantitative information used in this article is sourced via Annual and Quarterly Reports released by Sedar on behalf of Sproutly.