Stansberry Research

A Contrarian Bet in the Midst of the Vaping Scare

October 2, 2019

The "mysterious lung disease" is making headlines everywhere.

Already, the U.S. Centers for Disease Control and Prevention ("CDC") has attributed a dozen deaths to this vaping-related illness...

And the emergency is crushing portfolio holding KushCo (OTC: KSHB). Shares of the company, which is a major servicer to the vaping industry, are down 73% since we recommended the stock in March.

No doubt, lots of you look at that number and are ready to throw in the towel on this stock. Resist that urge...

Nothing about our thesis on KushCo has changed. The cannabis sector is currently down, and KushCo's stock price has been unfairly punished. But we remain confident that KushCo is going to be one of the big winners as marijuana legalization expands across the U.S.

So I wanted to take a minute today to explain why we're continuing to hold KushCo in our portfolio. In fact, we believe the selling has only made it a better investment... And if you haven't already established a position in the stock, you may never get a better opportunity.

As I'll explain, if anything, the vaping crisis shows the industry needs more of what KushCo provides – not less.

To review, KushCo is a partner to the major players in the cannabis industry across the globe. It provides custom-packaging solutions, the gases necessary for extraction, and branding and strategy help through its marketing agency, the Hybrid Creative.

Much of the company's decline has come in recent months as the mysterious lung disease continues to claim victims and make headlines.

This decline seems incredibly overdone... So I wanted to see firsthand what was going on and get an update on the company's thinking about the vaping risk.

While traveling in southern California last week, I stopped in and had an impromptu meeting with KushCo's management.

KushCo is a big servicer to the vaping industry. About 70% of sales come directly from its wholesale vape products and parts. Adding to the fire is its distribution agreement for CCell technology – CCell is a high-quality vape company that uses ceramic cells and has become an industry leader. The owner of the CCell technology is a Chinese company called Smoore Technology. This profile doesn't exactly work well with the current vape scare.

The vaping scare notwithstanding, there are four reasons KushCo is a great contrarian buy right now...

First, while the mysterious respiratory illness brought on by vapes is horrible, the current vaping scare will be solved.

Hundreds of people have been impacted and the number of deaths linked directly to vaping stands at 12. Unfortunately, this count is likely to increase, impacting families nationwide. It's a real tragedy.

But put in context, this is a relatively small number.

Five years ago, the CDC found that 3.7% of the entire U.S. population regularly used electronic cigarettes or vaping products. This amounted to more than 9 million people. And academic research suggesting that e-cigarette use was healthier than combustible cigarettes was mounting.

According to the World Health Organization, adult vapers totaled about 41 million globally in 2018.

The illnesses and deaths are certainly a risk to investing in KushCo, or any cannabis stock for that matter. Even Altria (MO), the $75 billion tobacco company that acquired 35% of JUUL in December 2018, has seen its stock fall more than 30% from its April 2019 high, most of that coming in the wake of reports on the vaping illness.

But the relatively small number of cases in the U.S suggests this is a driven by an isolated source, perhaps a bad batch of counterfeit or street-made products.

In fact, just today, NBC's Today Show published the findings of its own investigation. It had several illegal vapes and several legally purchased vapes sent to a lab to be studied. The legal vapes were 100% as advertised. The illegal vapes contained pesticides, vitamin E acetate, and other agents used to cut the active ingredients.

This completely dovetails with our view of the current problem – illegally purchased products.

The widespread media coverage will lead to investment pain and potentially slower sales of vape products in the short run. It will also catalyze needed regulation and push customers toward high-quality products, like the ones made with CCell technology.

Secondly, the vaping scare will drive users to the legal markets and quality products.

One of the most touted practices in recent months is to make sure you purchase only quality products sold by manufacturers or dispensaries you know. Both the FDA and the CDC began this campaign in August. Purchasing illegally may be cheaper, but the user has no idea what he or she is getting.

We believe the daily reports of illness and death will encourage illegal users to switch to the legal markets where available. This in turn will pivot the market toward higher-quality products that have been tested by the regulated states in which they are sold. Both of these moves could actually benefit KushCo over the longer term.

For example, CCell products sold by KushCo use ceramic – not metal – in their vapes. Heavy metal contents, including lead, in vape oils are some of the leading suspects in the vaping-related illnesses. CCell will not leech metal into the cartridges.

Third, customized product labeling will see increased demand...

Quality, tested products will want to give you more information, not less, on their packaging. These include comprehensive labels, barcodes, and microchips to differentiate products.

During the first two quarters of 2019, about 17% of KushCo's revenue came from its Packaging and Labeling products and services. We believe this segment will see increased demand.

Supporting our view of growth, KushCo recently signed an exclusive distribution agreement with De La Rue. This is a provider of authentication solutions that will combat counterfeit products. It will provide the company's labeling business with the ability to track and confirm the products are what they say they are.

This will give KushCo and its customers increased comfort in the products distributed by the company.

Last, KushCo shares are trading at a valuation of less than 1 times sales. In my view, this is being driven completely by the current vape scare impacting the entire cannabis and e-cig market.

Despite this valuation, 2019 calendar revenue is expected to climb 110% and approach $200 million. 2020 estimates capture slowing growth as current consumers figure out what they want to do. This is positive, as the vape market is unlikely to escape the current fear. Even with the scare, current estimates suggest 47% growth.

Said differently, should the 1 times sales multiple hold into 2020, the market cap will increase 47% in line with revenue growth.

While risky (as we don't know the ultimate outcome of the vaping-related illness), diving a bit deeper into some rationale around the business gives us comfort that KushCo shares are a decent bet to make – especially now – in the emerging cannabis market.

KushCo is still a buy up to $10 a share. Use this opportunity to purchase shares if you haven't already.

Happy investing,

Thomas Carroll