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GrowGeneration (GRWG) is a chain of hydroponics stores that mainly serve the cannabis industry. GRWG reported strong growth in 2019 that has managed to continue into 2020, which has led shares to deliver multi-bagger returns this year alone. Can the outperformance continue? In this report, I give my verdict on the valuation and my forecast for improving profitability or lack thereof. I remain skeptical that comparable sales growth can continue beyond the pandemic, at least to the point that would justify the current valuation.

The Home Depot Of Weed

GRWG is the largest chain of hydroponics stores in the USA, with 28 stores spread over 10 states. Most of its stores are located in states which have fully legalized cannabis:

(Investor Presentation)

GRWG can be considered a “picks and shovels” type company for the cannabis industry, as it sells supplies ranging from nutrients & additives to lighting:

(Investor Presentation)

GRWG has delivered stellar top-line growth in the triple-digit range in 2019 as well as this year. While much of the gains were driven through external acquisitions of new hydroponics stores, GRWG has also delivered strong same-store sales growth:

(Investor Presentation)

This year has seen an unprecedented rally in “software as a service” technology stocks which have been bid up due to recurring revenues. GRWG breaks down what it believes to be recurring revenues as “consumables” which include things like nutrients & additives, growing media, and storage containers. GRWG discloses that consumables made up 60% of its revenues in 2020:

(Investor Presentation)

Insider Ownership

As of the beginning of the year, insiders owned a substantial chunk of the company, totaling over 13% for officers and directors:

(2020 Proxy)

High insider ownership can suggest that management is aligned with shareholders due to having substantial “skin in the game.”

Blistering Valuation

There are 53 million shares outstanding for a market cap of $1.2 billion. Annualizing the latest quarter’s results, GRWG generates $174 million in revenues and $46.4 million in gross profits. Shares trade at 7 times revenues, but I prefer to use gross profits because gross margins are low at around 25%. GRWG trades at 26 times gross profits, which is a lofty multiple. Is that reasonable or bubbly? That depends on your outlook for future profitability, which I discuss below.

Potential Red Flags

With companies growing as fast as GRWG and trading with such a high valuation, the most important question is: can the growth continue? Or more specifically, will the growth justify the current valuation? One thing that concerns me is that roughly half of the growth is coming from the acquisition of new stores:

(Investor Presentation)

Such a strategy seems inherently unsustainable: for one, if GRWG keeps reporting high comparable sales growth numbers, then wouldn’t new acquisitions come at higher and higher prices? If the hydroponics business is such a good business, then why are stores willing to sell to GRWG at all? A reduction in the accretiveness of external acquisitions would force GRWG to rely on internally generated growth for future growth levers.

On that point, what is the competitive advantage or “moat?” There does not seem to be any reason why Home Depot (HD) could not sell hydroponics itself (in fact, it does).

Analysts asked the company about potential competition on the conference call. Analyst Glenn Matson asked:

“Just curious if you’re seeing any new entrants from below or above on the competitive landscape?”

GRWG President Michael Salaman responded:

“Hey, Glenn, we have not at all. There’s – that we’ve seen zero.” (2nd Quarter Earnings Transcript)

Moving forward, I’m uncertain that’ll be the case.

Second, I suspect that much of the comparable sales growth seen in 2020 is due to the coronavirus and may not be repeated or even sustained in 2021. Many of the states that GRWG operates in have already legalized recreational cannabis for some time, meaning that the one-time “legalization boost” has already happened.

All these factors bring me to my last point: why isn’t the company more profitable than it is, and can it really increase profitability moving forward?

In spite of triple-digit top-line growth, net income has actually declined from $1.3 million to $480 thousand year to date. The main culprit appears to be a 10 times increase in share-based compensation to $5.3 million in 2020, amounting to over 25% of gross profits.

Now, coming back to my discussion of the valuation, GRWG trades at 120 times the last quarter’s earnings annualized. In order for earnings to grow enough for the P/E multiple to decline to 30, a more reasonable multiple, GRWG would theoretically need to see comparable sales growth of approximately 68% (assuming no change in the 26% gross margin and that all gross profits flow to the bottom line). Whether or not that is possible depends on GRWG’s ability to grow upon this year’s results even after the pandemic. Call me a skeptic.

Finally, Hindenburg Research has released a very critical report of the company. In the report, Hindenburg Research notes the executive management team’s histories with failed penny stocks and pump & dump schemes. The company, as far as I can tell, has not refuted these claims.

Conclusion

Before I make a purchase of the stock, I’d like to see a meaningful improvement in operating margins. While GRWG has delivered impressive results, I am skeptical that comparable sales can continue in 2021 and onwards once we move past the pandemic. Because shares have run so far so fast, GRWG would need to deliver approximately 68% comparable sales growth in order to justify the current valuation. Further, prospective investors should keep a close eye on share-based compensation as that number needs to decline moving forward. GRWG appears to be a solid stock that is benefitting from the growth of the cannabis industry, but in my eyes still needs to prove itself to justify my investment.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.