Special Free Report From The Motley Fool

By the Hidden Gems Canada Team

The second wave of cannabis legalization looks poised to hit Canada on October 17, 2019 when the sale of edibles is scheduled to be legalized. That means you could start seeing these cannabis-infused products on store shelves as early as this December.

With industry experts like Deloitte projecting this so-called “Cannabis 2.0” to inject an estimated $2.7 billion into the market, we felt it was “high time” that we call your attention to an intriguing small-cap stock opportunity in the world of cannabis.

You’ll find the results of our painstaking research below with the company we’re recommending for “Cannabis 2.0.”

Without further ado, allow us to introduce you to KushCo Holdings.

To your wealth,

Your Hidden Gems Canada Team

KushCo Holdings

Point to Consider: 

Because small caps can be thinly traded with very little volume—and can pop dramatically when there is a sudden increase in new buyers—we strongly recommend that you use limit orders when buying one of our recommendations. Using a limit order can protect you from paying a higher price due to a sudden (and often temporary) spike in the share price.

Whenever we recommend a company, we aim to hold it for a minimum of three years. Our cost basis—reflected on the Scorecard—will be the stock’s closing price the day of the recommendation.

Introduction

You may already know that I (David here) grew up in California. In Californian elementary schools, it’s customary for kids to learn all about the Gold Rush of 1849, when gold was discovered throughout California. This discovery prompted a rush of individuals heading westward in an attempt to strike it rich by mining for gold.

The funny (or unfortunate) thing is that most of the actual gold miners aren’t the ones who ended up striking it rich. Instead, those who did best were typically the “picks-and-shovels” companies supplying, well, things like picks and shovels, jeans, and other equipment and tools to the gold miners. (Levi Strauss, founded in San Francisco in 1853 to manufacture blue jeans worn by the gold miners, is one of the better-known examples.)

What does this have to do with this Hidden Gems Canada recommendation, you might ask?

Well, with Canada set to legalize edibles on a national level on October 17—and more than half of U.S. states legalizing some form of marijuana—we are likely still in the early stages of a Green Rush with the cannabis industry. It’s no secret that cannabis fever is high as ever (pun totally intended), but we think the Green Rush could see similar dynamics to the Gold Rush.

Cannabis is an agricultural crop—arguably a commodity—and building a thriving long-term business around a crop is a challenging endeavour. In other words, growing and selling cannabis will be a tough (and increasingly competitive) business model that will likely be littered with a lot of failed companies and disappointed investors in the years ahead. However, companies that supply the cannabis industry—the picks and shovels for the Green Rush—should be in a far better position to build a sustainable (and profitable) business in the coming years.

This is why we’re going south of the border this month and recommending KushCo Holdings (NASDAQOTH:KSHB). Read on to see why we think Kush could be the ultimate “picks-and-shovels” player in the cannabis industry.

Supplying the Green Rush 

Founded in 2010, Kush aims to be the go-to supplier for the cannabis industry. The company oversees 12 facilities throughout the U.S., with a sales presence in every major U.S. market (including three facilities in California, Colorado, and Washington). Kush sells and distributes packaging, containers, bottles, bags, vaporizer products, accessories, and branding services to cannabis companies like manufacturers, processors, and retailers.

Put simply, Kush is primarily a business-to-business (B2B) company, essentially servicing the entire cannabis supply chain with products that every cannabis business will need. Whether it’s growers, extractors, manufacturers, retailers, or dispensaries, Kush has something for them. (The company has already sold more than one billion units of packaging and accessories—a number quoted as being around 100 million just last fall.)

Branding and packaging regulations are strict for cannabis products, differing by state (and country, for that matter). With its extensive offering of various child-resistant, tamper-proof, and compliant packaging—which can be customized and differentiated for its clients—Kush plays a key role in the emerging legal cannabis industry. Being able to offer both compliant and custom products—in all major U.S. markets—serves as a moat of sorts for Kush, raising the bar for current and potential competitors.

Kush currently sells to more than 5,000 business accounts, which is up from about 4,000 clients at the end of 2017. The company is also nicely diversified, with no client accounting for more than 10% of revenue. And a bonus is that most of the company’s products all represent repeat purchases … leading to repeat revenue once Kush lands a new account.

Two of Kush’s four co-founders—Nick Kovacevich and Dallas Imbimbo—continue to own about 30% combined of shares outstanding. Kovacevich remains chairman and CEO, while Imbimbo serves on the board of directors. This level of insider ownership is a breath of fresh air compared to most Canadian cannabis companies, where it’s rare to find founders still at the helm and owning more than even 5% of the company.

Growth Opportunities

The legal cannabis market in the U.S. is expected to total $20 billion by 2020, and that number becomes substantially larger when you factor in expanding legal cannabis sales in Canada and abroad. Kush, in other words, is dealing with a sizable (and expanding) market opportunity, and the company has the benefit of growth tailwinds for the foreseeable future.

Kush has a unique advantage in the U.S., since it never actually touches the marijuana plant (or anything with THC or CBD) in its day-to-day business. This business model enables Kush to work around the fact that cannabis is still prohibited on a federal level in the U.S. This hands-off approach lets Kush benefit from economies of scale with its distribution facilities—unlike state marijuana growers, which can’t export product outside their respective state—and the company is also able to be listed as a publicly traded company in the U.S.

Kush has three growth levers to pull going forward: new products, new channels (customers), and new geographies. The company has taken advantage of its own currency (publicly traded shares) to make several acquisitions to accelerate this growth.

One recent acquisition that fits into the “new products” category is Summit Innovations—a distributor of hydrocarbons to the cannabis industry. Hydrocarbon gases are used to turn cannabis plants into oils, and this particular acquisition opened Kush to the extraction side of the industry—broadening its product portfolio and customer base and laying the foundation for cross-selling opportunities.

The company most recently acquired a full-service creative agency—Zack Darling Creative Associates—which works with both cannabis companies and other industries (more on this later). This broadens Kush’s product portfolio to include services like brand strategy, design and marketing, app development, and e-commerce solutions. Particularly with so many young companies—many of which are already Kush customers—trying to establish themselves in the nascent cannabis space, these types of brand and strategy services are natural add-ons to Kush’s product suite.

Kush does have some clients in South America and Europe, but the U.S. is still its biggest market in a major way. We’ll look for the company’s international expansion to grab hold moving forward, particularly with Canada’s second wave of legalization coming up later this year.

Risks and What to Watch

We’ll start with what is more of a “heads up” than a risk. Unfortunately, we’ve learned that shares of Kush are not eligible to be purchased in registered accounts (TSFA or RRSP) in Canada. However, you can purchase shares in non-registered accounts. We hope this slightly inconvenient roadblock is removed in the future, but for now you must use non-registered accounts if you want to buy shares of Kush.

Kush is still on the riskier side of the spectrum as far as Hidden Gems go, with the company still unprofitable and operating in what is essentially a brand-new legal industry. Given the market opportunity at hand, however, it makes sense for management to prioritize heavily reinvesting back into the business to fuel growth. The company’s revenue has grown more than 10 times since 2015 to $40.75 million, with revenue climbing 173% in the latest quarter.

The company’s cash burn over the past four quarters topped $13 million—and that would be a bit higher when you factor in acquisitions—but Kush recently raised $32.9 million in a stock offering. This capital raise strengthens the company’s balance sheet and conservatively gives Kush a two-year runway to continue expanding without needing to raise additional cash. Given that insiders continue to own more than half of shares outstanding, we think leadership is aligned with shareholders and will avoid heavily diluting shareholders in the name of expansion.

Kush is also in the midst of an evolution of sorts, which brings both opportunity and risk. In September of last year, the company changed its name to KushCo Holdings. KushCo will oversee three business units: Kush Bottles (cannabis supplies), Koleto Packaging Solutions (FDA-compliant packaging for the pharmaceutical and veterinary industries), and Zack Darling Creative Associates (branding services). While this move is sensible considering how many products and services fall under Kush’s umbrella, the company runs the risk of spreading itself thin and losing focus—particularly as it looks to enter non-cannabis industries.

Since Kush’s primary business is the distribution and sale of physical goods, we’ll keep an eye on how quickly inventory and accounts receivable are rising compared to sales. If we see inventory and/or accounts receivable outpacing revenue growth for a sustained period of time, it could be a yellow flag that Kush is poorly managing inventory and struggling to move product.

In the coming years, we’ll be watching for Kush to gain more clients, enter new territories, and successfully cross-sell new products and services. If the company can check all three of those boxes, we think there are good odds Kush will see margins improve over time and begin generating positive cash flow in the process. Investors should be ready for a lot of volatility and aim to hold for a minimum of three years.

The Hidden Gems Bottom Line

Kush Bottles—soon to be KushCo—is one of the few companies in the cannabis industry both based and publicly listed in the U.S. The company’s business model gives it flexibility to navigate the fragmented U.S. market—and murky legal structure—and supply just about every stakeholder in the cannabis industry.

With a unique first-mover advantage, high insider ownership, and tailwinds of a Green Rush that aren’t likely to subside anytime soon, we think Kush Bottles is the ultimate picks-and-shovel cannabis company for Hidden Gems investors today. Here’s hoping we’ll be seeing a lot more green—of all kinds—in the years ahead!

David Kretzmann owns shares of Kush Bottles. Report data as of July 19, 2018.