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We welcome Ted Ohashi as a guest contributor to New Cannabis Ventures! Ted is an investment professional who has been covering the Canadian cannabis sector on Seeking Alpha and through his own newsletter, and we have admired his work and are grateful that he will be sharing his perspective with us. Readers should be aware that Ted’s views, like those of all of our guest contributors, do not reflect the views of New Cannabis Ventures.
Executive Summary & Recommendation
We believe Organigram (TSXV: OGI) (OTC: OGRMF) merits the consideration of investors and our opinion is affirmed following our due diligence into the recent product recalls. We explain below why OGI remains our favorite among the Canadian Licensed Producers:
- We believe OGI’s recent product recalls have not been well understood and errors have been made in media reports. This creates a buying opportunity for investors we expect the shares to respond positively as information is disseminated to investors.
- Denis Arsenault, CEO, proved his ability in moving OGI forward and especially in the way he has handled the recent product recall. Arsenault wrote a cheque to become OGI’s largest shareholder, hasn’t sold a share and remains the largest shareholder. He has made a long term commitment to the Company and its shareholders.
- Management’s focus is generating net profits and positive operating cash flow which has been done. In the first quarter ended November 2016 with last year’s comparables in brackets, OGI generated over $2,230,671 million in sales ($1,029,376) on 260,291 grams of dried bud (142,790 gr) and 77,200 ml of cannabis oil sold. The gross margin was over 65% (55%)
- An adjustment in fair value of inventory and biological assets of ($499,857) was taken resulting from the product As a result, net profit was ($755,547) compared to ($201,211) last year. EBITDA was $272,839 compared to ($62,072) last year and cash flow was $510,015 compared to $25,844 in the same quarter in 2016. There will be further adjustments in the next quarter.
- OGI is the leading organic producer among public Licensed Producers and we continue to believe their shares will produce above average returns.
- We direct you to our Seeking Alpha reports that can be found at http://seekingalpha.com/ar- ticle/4007536-organigram-win-win-canadian-cannabis-group
- Recently a product recall impacted OGI negatively. It is likely customers and investors will conclude from media reports this damages the company and its We have assessed the situation and conclude the negative impacts will be quickly overcome.
Organigram Holdings was one of the early licensees, approved by Health Canada on March 26, 2014 and together with Bedrocan became the second/third publicly traded Licensed Producers on August 25, 2014 after Tweed Inc.
From the outset, OGI pursued a strategy of becoming a certified organic grower. This plan showed considerable foresight as issues of branding and pricing were all improved by differentiating their product from the pack. The company also focused on operating profitably with the goal of producing a high rate of return for its shareholders. In this regard, it is important to remember Denis Arsenault, CEO, became a major shareholder by purchasing his position. To date, he has not sold a share and remains the company’s largest shareholder. His personal goals are in line with all shareholders.
By the fall of 2016, Arsenault had reasons to be feeling pretty good. The physical plant was built and operating and the company had produced two quarters of net profits and positive operating cash flow. But as often happens in investment management and golf, just when you think you’ve got it figured out, the powers that be provide you with a teachable moment.
November/December 2016 Product Recalls
A press release dated December 30, 2016 came as a surprise when it announced a voluntary product recall. Health Canada reported that on December 28, 2016, Organigram had initiated a voluntary Type III recall on five lots of products. On January 9, 2017, came another press release announcing the product recall had been expanded to include additional products. Health Canada reported this as a Type II recall covering sixty-nine lots of products including dried marijuana and cannabis oil produced between February 1, 2016 and December 16, 2016.
Recalls are defined by Health Canada in the following manner:
“The numerical designation, i.e., Type I, II, or III, assigned by Health Products and Foods Branch…to a particular product to indicate the relative degree of health hazard presented by the product, as follows:
- Type I: a situation in which there is a reasonable probability that the use of, or exposure to, a product will cause serious adverse health consequences or death,
- Type II: a situation in which the use of, or exposure to, a product may cause temporary adverse health consequences or where the probability of serious adverse health consequences is remote, or
- Type III: a situation in which the use of, or exposure to, a product is not likely to cause any adverse health consequences.”
There have been other cannabis product recalls in the past going back to the earliest days of legal growing of medical marijuana. However, this is the first time Health Canada has disclosed the type of recall involved. This is part of Health Canada’s move toward greater transparency and we applaud the change. One benefit is it enables consumers and investors with the ability to exercise some judgment on the seriousness of the event. Not all recalls are the same we have the ability to assess these recalls as not having serious potential health consequences.
What was the Problem and Why?
This event triggered some media reports that generated more heat than light. In fact we conclude some of the negativity was intentional. Here is our assessment of the situation. The materials in question were:
- Myclobutanil, a fungicide used in the production of produce and vegetables under the name Nova40W in Canada and Eagle 20 in the U.S. The product is described as “slightly hazardous” by the World Health Organization (WHO) and of “relatively low acute toxicity” by the U.S. Environmental Protection Agency (EPA). Myclobutanil is allowed in certain food crops but it is not approved for use with cannabis.
- Bifenazate (Floramite) is a pesticide used to control mites in growing grapes for wine, apples, nuts and more. Health Canada describes it as “unlikely to affect your health when used according to label directions.” Bifenazate is also allowed in food crops under specific conditions but it is not approved for use with cannabis.
In addition, the amounts detected were very small, the equivalent of 1 part in 14,285,714 and as little as 1 part in 20,000,000. The likely culprit was fertilizer, in other words, it was not an instance of Organigram using non-approved substances as pesticides or fungicides and trying to hide that fact. It was the introduction of these substances in an unexpected and/or accidental fashion.
Also the recall of a consumable product going back to February 2016 is not a completely straightforward issue. Little physical product is likely to be returned. However, Organigram has focused its efforts on customer satisfaction so other to deal with customers are open.
In conclusion, if myclobutanil and bifenazate were banned substances found in amounts dangerous to humans, Health Canada would have issued a Type I recall and there would be nothing voluntary about the offender’s response. But as explained, both myclobutanil and bifenazate are used in specific aspects of human food production but they are not approved for cannabis and the amounts at issue at around 1 part in 14,285,714 were miniscule.
How did unapproved chemicals enter OGI’s production processes?
After extensive investigation, management concluded the contaminants entered via the fertilizer but other possible sources include soils, coco coir (a growing medium) and peat moss. At the time of my most recent contact, there were further test results that had not come in but the work to date seemed fairly conclusive. In other words, fertilizer is likely the source but that could change.
One rumor is that a rogue employee or competitor sabotaged the company. Although it may be impossible to completely rule this out, it doesn’t seem likely. One would have to question how and why they would introduce such a small amount of foreign matter. This was initially a Type III recall and later upgraded to a Type II but in either case not a serious threat to human health. If you really wanted to damage the company and its reputation, a much larger quantity of something more toxic could have been used. An insider would have known or been able to find out these materials were not particularly dangerous and OGI, as an organic grower, does not use pesticides or fungicides.
Another possible source could be the water. An Oregon based nursery operator suggested that in a farming region, such chemicals can and do find their way into the local water supply and stay there for a long time. In Oregon, for example, trace amounts of fertilizer is present in the local rivers and streams. It could have been introduced by buckets and pails not properly cleaned.
The one thing that seems evident is this was not a case of OGI attempting to secretly use these chemicals deal with a problem. If this was the case, one of Health Canada or Ecocert would probably have released that information and this would be a far more serious matter.
As Arsenault says, “I think what the industry has to realize is that we need to also test what’s coming in to our facility not just test what’s going out of our facility.”
The issue of maintaining organic certification through this period is being dealt with by management in conjunction with Ecocert Canada. Ecocert is a leader in organic certification and provides Organigram with its organic certification. When myclobutanil and bifenazate were first detected, management of Organigram led by Denis Arsenault, CEO, undertook a complete review of operations that resulted in the introduction of new procedures and testing regimes. A key corporate objective is to minimize the possibility of a recurrence in the future. OGI’s Director of Operations has been and is working actively with Ecocert and the company is hopeful their status as an organically certified grower will be sustained. Factors in OGI’s favor include the fact they were not using the substances in question to control fungus or pests and the amounts detected are extremely small. Although a final decision is pending, we believe certification will not be interrupted.
The product recalls will have a financial impact on Organigram. But what is important is whether the company will be able to maintain its financial goals of profitability and positive operating cash flow. Initially, the financial effect will be on the cost side. In the first quarter ended November 2016 compared with last year’s results in brackets, OGI generated over $2,230,671 million in sales ($1,029,376) on 260,291 grams of dried bud (142,790 gr) and 77,200 ml of cannabis oil sold. The gross margin was over 65% (55%)
A reduction in fair value of inventory and biological assets of ($499,857) was taken resulting from the product recall. As a result, net profit was ($755,547) compared to ($201,211) last year. EBITDA was $272,839 compared to ($62,072) last year and cash flow was $510,015 compared to $25,844 in the same quarter in 2016. There will be further adjustments in the next quarter.
From a revenue point of view, the registration system means it will take a month if an existing customer wants to change suppliers as a result of the recall. Uncommitted customers can choose a different supplier at any time. In my opinion, the underlying cause of the recall is not serious enough to cause large changes on the revenue side. So with the possible exception of one fiscal quarter or an overlap between two quarters, we think OGRMF will be able to continue to meet its goal of profitability and positive operating cash flow when management has completed its co-operative and collaborative response to Health Canada and Ecocert.
We believe the response of customers, Health Canada and Ecocert will be a reflection of management actions led by Arsenault with the help of employees. He says their entire focus since the problem first came to light has been on customers and employees. Arsenault is effusive in his praise and appreciation of the efforts of his employee team during this vital period. This was a serious, disruptive event to a young and growing company. But the company responded in a proactive, cooperative and collegial fashion. When all the issues have been dealt with Arsenault’s ‘glass half full’ view is the Company will emerge stronger and better than it was before. We agree. Everyone prefers it didn’t happen in the first place but there are unexpected benefits that can arise from facing and successfully dealing with a challenge such as this. Organigram can find a place in every long term investor’s portfolio.
Disclosure: The author has no position in OrganiGram and has received no compensation from the company or any other party.
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