The Cannabis Industry Is Booming; Is This Supplier a Buy?

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Few investors are unaware by now of the booming cannabis market. The drug is federally legal in Canada and in many U.S. states, and it looks to be on a path toward federal legalization in the U.S. This commercialization of cannabis has led to a boom in growing the plant across North America. One industry that has benefited from this is hydroponics, which is when someone grows a plant without soil. Many cannabis growers utilize this growing method.

GrowGeneration (NASDAQ:GRWG) is a fast-growing hydroponics supplier that is benefiting from this surge in popularity for cannabis. Does that make the stock a buy?

What is GrowGeneration?

GrowGeneration is a serial acquirer of hydroponics stores across the U.S. According to its website, it owns and operates over 60 retail and distribution centers. The company also offers e-commerce solutions at GrowGeneration.com and Agron.io, the latter of which was acquired this spring and helps commercial growers manage all their hydroponic needs.

In the second quarter, GrowGeneration's revenue increased 190% year-over-year to $125.9 million. Some of this was inorganic due to acquisitions, and it was compared to a slow quarter last year that was impacted by the start of the COVID-19 pandemic. Nonetheless, 190% growth is very impressive for any retailer. One metric investors should consider in evaluating the success of these (or any) acquisitions is comparable-store sales growth. In the quarter, comp sales grew 60% year-over-year, which shows the increased demand for hydroponic equipment and consumables across the country.

Net income was $6.7 million last quarter, so GrowGeneration is profitable even while going through its growth/acquisition phase. However, it only had a 28% gross margin, which will hamper its ability to expand net profit margin down the line. 

Growth opportunities ahead

Given the 1,800 hydroponics stores currently operating in the U.S., GrowGeneration has a lot of acquisition targets out there. With 60 stores currently under management and a goal of 70 by the end of 2021, even if it doubles store count by 2025, it will only have 6.7% of the hydroponics market in the U.S. by that measure.

The company also faces an exciting opportunity to grow its private-label brands, which would be easy to promote through its owned stores and two e-commerce platforms. In the second quarter, private-label sales were 7% of revenue, compared with 1% in the year-ago quarter. This is impressive when you compare it to the pace of GrowGeneration's overall growth, and the segment could help the company expand its gross margin over time. For example, last quarter, gross margin was 28.4% compared with 26.7% a year ago. 

Valuation

GrowGeneration is guiding for $455 million to $475 million in revenue this year. The total hydroponics market in the U.S. was estimated to be $9.5 billion last year and the industry is expected to grow at 11% per year to $17.9 billion by 2026. This gives the company a nice tailwind it can ride in the coming years.

Right now, GrowGeneration has a market cap of $1.8 billion, giving it a price-to-sales ratio (P/S) of 3.9 based on the midpoint of its 2021 guidance. This might seem cheap given how fast the company is growing, but investors should remember that this is a low-margin business and that GrowGeneration has a history of diluting shareholders by using stock to acquire new stores. Its share count has gone from about 20 million in 2018 to 60 million today. This isn't necessarily a bad thing, since the shares are being used to acquire profitable stores, but it will be a headwind for shareholders in the future.

So, is it time to buy?

GrowGeneration seems to have hit its stride over the past few years. Management thinks comparable-store sales growth could hit 25% in 2021. This will likely slow down in the years after, but consistent same-store sales growth even in the single digits is a perfect recipe for a profitable retailer, especially one like GrowGeneration that's growing its store count.

If you believe GrowGeneration can comfortably get to $1 billion in revenue without diluting existing shareholders too much, it might be smart to buy the stock right now; it's currently down about 14% year-to-date. However, investors should be cautious about the stock's valuation. It's possible GrowGeneration is riding a short-term wave of demand from growers that will trail off in the coming years.

Overall, whether this stock is a buy right now depends on your portfolio and risk tolerance.  If you are bullish on cannabis/hydroponics, GrowGeneration could be a great addition to your portfolio. If not, then it's probably best to stay away, at least for now.

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