Investing in Hydroponics with Hydrofarm Stock

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If you happen to live in Arizona and exercised your right to vote, some people owe you a debt of gratitude. That’s right, we’re talking, of course, about the legalization of recreational cannabis in the State of Arizona. As a result of your votes, the prosecutor in Arizona’s largest county is dropping all pending charges for recreational marijuana use by adults. It’s the same sort of relief you get when waking up in the drunk tank and realizing the county isn’t going to press charges.

The only thing the Americans seem to like more than political pissing contests is puffing the magic dragon. When the dust settled following the elections, Arizona, Montana, New Jersey, and South Dakota all voted to approve cannabis for adult recreational use. Since cannabis companies cannot transact across state lines, this means a whole lot of new grow rooms will be coming online soon. One company that stands to benefit from all that growth is Hydrofarm.

Our leadership team often refers to Hydrofarm as a “40 year-old start-up”

Bill Toler, Chairman and Chief Executive Officer of Hydrofarm

About Hydrofarm Stock

Click for company website

Founded in 1977, Petaluma, California’s Hydrofarm is the nation’s oldest and largest independent wholesaler and manufacturer of hydroponics equipment and grow lights. While black-market growers have been using their products for decades, it wasn’t until 2017 that the company began taking in funding and growing by acquisition. In 2019, Bill Toler came on board following his role at Hostess Brands where – at least according to the MBAs at UBS – he was the driving force behind the company’s success. Now, he’s come out of retirement for an opportunity that’s unmatched – the convergence of cannabis and controlled environment agriculture (CEA). Let’s talk about cannabis first.

The Growth of Cannabis

One of the most popular topics we’ve ever covered here on Nanalyze is cannabis. Our first piece on How to Buy Marijuana Stocks for Dummies garnered over 15,000 shares, and that’s when we realized we could leverage our brand to help newbie investors avoid the pitfalls of investing in cannabis – and get some free smoke during the process. In speaking with institutional investors, we found that most shy away from any “plant touching” investments. Instead, they look for the pick-and-shovel opportunities such as growing equipment, something that’s often referred to as the ancillary cannabis sector.

Indoor growing ain’t easy – Credit: Hydrofarm S-1 Filing

For those of you who have never grown cannabis in your closet, hydroponics is the farming of plants using soilless growing media and often artificial lighting in a controlled indoor or greenhouse environment. As all these new states come online, there will be a boom in sales of growing equipment. (The North American cannabis industry is expected to approximately double over the next five years.) Many of the experienced black-market growers will pivot into growing cannabis legally, and there will be a flood of supply on the market. At this point, all the capital expenditures on grow room equipment will fall off a cliff and companies will need to depend on consumables to thrive.

Consumables as a Service

That’s where Hydrofarm shines. Approximately two-thirds of their net sales are generated from recurring consumable products including growing media, nutrients, and supplies. Their distribution footprint in the U.S. can reach approximately 90% of the population in 24 to 48 hours, and their two distribution centers in British Colombia and Ontario can provide timely coverage to the entire Canadian market. As long as growers are growing cannabis – legal or not – they’ll need supplies. In California, black-market growers are actually stealing market share from legal dispensaries. That’s a non-issue if you’re selling the equipment that both types of growers need which has resulted in revenues growing at a compound annual growth rate (CAGR) of +17% over the past 15 years.

Credit: Hydrofarm S-1 Filing

Hydrofarm believes that a majority of the CEA equipment and supplies they sell to customers is ultimately purchased by participants in the cannabis industry, though they do not sell to participants in the cannabis industry directly. This may change as indoor farming – also referred to as vertical farming – is used for something that’s lower on Maslow’s Hierarchy of Needs.

CEA and Indoor Farming

Indoor farming, vertical farming, call it what you will, this category includes all indoor growing operations that don’t involve cannabis. Unlike other companies we’ve spoken with, Hydrofarm is more forthcoming about the extent to which “a majority” of their 6,000 different products are being used by cannabis farmers. That customer profile may change as companies are now focusing on growing food closer to where it is consumed.

Though it has recently slowed, venture capital funding has been pouring into indoor farming startups, the economics of which remain unclear. Sure, they use 98% less water, a fraction of the land footprint, no pesticides, and less fossil fuels are used to transport products.

Credit: Sarah Hughes

But similar to the alternative protein thesis of Beyond Meat, the costs need to come down enough so that your average Joe can afford them. The availability of fresh fruits and vegetables at price points less than traditional farming methods might actually encourage more healthy eating, especially in the most obese nations of the world.

As we learned in business school, you should always take other people’s hard work and summarize it. Then, you can appear to be a thought leader without having to do any of the heavy lifting. With that in mind, we found a lovely lady across the pond named Sarah Hughes who produced a very accessible report titled “Vertical Farming: Does the economic model work?” In that report, she talks about her travels around the world to study the various methods of indoor farming and how they’re being used. Similar to our findings in Nauru, each application needs to be assessed independently to determine economic viability with each variable modeled such that the benefits can be determined. You start with the crop first, the location second, and then you start to look at the various methods of growing that crop. In her words:

There is an exciting future for controlled environment agriculture and Vertical Farming, but it may not be in the crop areas which are hitting the headlines now.

Credit: Sarah Hughes

In summary, we’re not entirely convinced that vertical farming is going to displace traditional farming anytime soon, so we’re largely focused on Hydrofarm as a play on the cannabis growth thesis. It also happens to be where the company is reaping the most rewards at the moment.

To Buy or Not to Buy

We’ve largely avoided the entire cannabis thesis because of all the hype surrounding it which increases volatility and consequently risk. There’s also some significant regulatory risk when you consider cannabis remains illegal at the federal level. Still, the trend is our friend, and we can only expect that legalization will continue until it reaches a federal level.

There aren’t many pure-play investment opportunities for cannabis and indoor farming equipment. The last time we looked at Scotts Miracle-Gro, about a fifth of revenues could be attributed to the growth of cannabis and indoor farming. Hydrofarm is a pure-play stock with an experienced executive at the helm along with six more executives he’s hired to get the job done. A fresh management team is what a 43-year-old company needs to get out of the “we’ve always done it this way” rut. Since the hydroponics industry remains highly fragmented, there’s plenty of room to grow through acquisition.

Many IPOs today are subject to hype because of the Robinhood weekday warrior types. Hydrofarm is exactly the sort of company that these morons would salivate over, so we’re certainly not going to consider getting involved until the dust settles following the IPO.

Conclusion

It’s not often you can invest in multiple themes using a single pure-play stock. There’s no reason to believe that any administration – one driven by donkeys or elephants – will slow the advancement of cannabis legalization, especially when state coffers start to fill with cash. The economic viability of indoor farming remains to be seen, but the farms in operation now will continue to need consumables to operate.

Given the majority of their revenues come from consumables, Hydrofarm is an attractive stock for anyone wanting to play the cannabis theme without taking on regulatory risk.

If the IPO takes place as planned, shares of Hydrofarm will trade under the ticker “HYFM.”

Pure-play disruptive tech stocks are not only hard to find, but investing in them is risky business. That’s why we created “The Nanalyze Disruptive Tech Portfolio Report,” which lists 20 disruptive tech stocks we love so much we’ve invested in them ourselves. Find out which tech stocks we love, like, and avoid in this special report, now available for all Nanalyze Premium annual subscribers.

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