KushCo reserves legacy customer sales, highlights pending write-off risk for sector

KushCo Holdings’ profitability took a huge hit in its fiscal second-quarter earnings report, which included a $9.1 million provision for bad debt expense.

The California-based cannabis packaging company’s exposure to the vape crisis of 2019 makes it a canary in a coal mine for the sector. The ensuing capital drought and COVID-19 pandemic challenges will force other companies with less vape exposure to show write offs, as well, as customers stop paying.

KushCo noted on its quarterly call that these debts are primarily from smaller “legacy” customers, which were $13.8 million of revenue in 3Q19.

In other words, it is expecting to write off 66% of its 3Q19 legacy customer revenue.

While the bad debt has been reserved, it has not yet been written off. Only $2.3 million of the $9.1 million has gone bad already, indicating that most of these suppliers might still be paying a tiny bit.

Put another way, the days sales outstanding on a gross basis (i.e., before the reserve) are flat with November at 76 days, but the net days sales outstanding are down to 51.

Since a rolling loan gathers no loss, as the saying goes, beware of companies that keep extending credit endlessly, as KushCo said it did before taking its medicine in February (see the quote from the CEO below).

More importantly, other suppliers to these same customers likely won’t be paid, either, meaning more write-offs are coming to the industry.

This follows MedMen paying customers in equity and Innovative Industrial Properties’ unpaid lease in January, and it is occurring during a capital crunch where even larger operators such as Acreage Holdings are having trouble raising capital despite extremely high rates (and, in Acreage’s case, low risk to the lenders).

We believe nonpayment of past sales and write-offs of accounts receivables will become a larger issue for the cannabis sector overall.

To put the $9.1 million allowance in additional perspective, it is 33% of total the gross accounts receivable, 30% of the current quarter’s sales and 8% of the trailing nine months sales.

As shown in the table below, the clear signal was the spike in accounts receivable first to 51 days in August and to 70 days in November from only 32 days in May.

KushCo Accounts Receivable Aug ’18 Nov ’18 Feb ’19 May ’19 Aug ’19 Aug ’19 Nov ’19 Feb ’20E
Year Quarter Quarter Quarter Quarter Year Quarter Quarter
Days Sales Outstanding Gross      67.3      43.2      32.3      33.1      52.9      66.2      74.6        76.2
Days Sales Outstanding Net      60.3      37.6      28.9      31.8      50.8      63.6      70.4        51.0
Reserve % of Gross 10.4% 12.9% 10.4% 3.8% 3.9% 3.9% 5.6% 33.1%
Provision % of Current Period Sales 2% 2% 6% 0% 0% 2% 1% 30%
Write-off % of Gross 0% 0% -20% 0% 0% -10% 1% -9%
Net AR % of Sales 16.5% 10.2% 8.0% 8.7% 13.8% 17.4% 19.1% 14.0%
Sales $52.1 $25.3 $35.2 $41.5 $47.0 $149.0 $35.0 $30.1
Beginning Allowance for Doubtful Accounts $0.0 $1.0 $1.5 $1.3 $0.6 $1.0 $1.1 $1.6
Provision for Bad Debt $1.0 $0.6 $2.0 $2.6 $0.4 $9.1
(Write-off for Bad Debt) $0.0 ($0.1) ($2.5) ($2.6) $0.2 ($2.3)
Ending Allowance for Doubtful Accounts $1.0 $1.5 $1.3 $0.6 $1.1 $1.1 $1.6 $8.3
Gross Accounts Receivable $9.6 $11.9 $12.6 $15.1 $27.0 $27.0 $28.4 $25.2
Allowance for Doubtful Accounts $1.0 $1.5 $1.3 $0.6 $1.1 $1.1 $1.6 $8.3
Net Accounts Receivable $8.6 $10.3 $11.3 $14.5 $26.0 $26.0 $26.8 $16.9

KushCo’s shifting sales strategy

KushCo’s new focus on larger customers that can actually pay is a good one – but it’s also a lesser of two evils.

Normally, focusing a company’s revenue base on fewer larger customers increases the risk of price pressure and margin compression because it increases the negotiating leverage of the buyers. Selling to many customers gives the seller more negotiating leverage.

But in this case, focusing on customers who can actually pay is preferable to shipping to those who can’t and never will pay.

This comment by CEO Nick Kovacevich from the earnings call (transcript hereslides here) shows the customer credit treadmill to be wary of and also highlights how tough KushCo’s core packaging business truly is if nonpaying customers simply go to the competition.

“This is a situation that we deal with all the time. We have a legacy customer in … California that’s traditionally purchased a lot through us. They now have an outstanding balance of $300,000 to $400,000. It’s 90 days, 100 days, 120 days past due, they are chipping away, they’re making payments. But I guess what else we have, we have $300,000, $400,000 of inventory with their name on it sitting in our warehouse.

“So now we’re stuck between a rock and hard place. They want the inventory, but they can’t pay down their balance. So do we then give them the inventory, then jack up the receivable? Or do we just sit on the inventory, which is costing us money to store, and try to see if these guys can pay us down?

“And if they can’t get additional credit from us, what do you think they’re going to do? They’re probably going to call one of our competitors and start going and buying from them just so that they can get an additional lifeline and keep their business going.

“So this is the game that unfortunately we’ve been dealing with in a lot of these markets, and we’re sick of it, and to the point where we have outstanding balances from customers up to in the $1.7 million-figure range where, yeah, they’ve been paying us $25,000 here and $25,000 there, and we’re just done with it. We’re taking all the write-offs. We’re doing it all right now.

“And, yeah, we’re going to collect some of that in the future, but we just don’t want to deal with it, and we’re not going to be extending credit to these guys anymore, and we’re going to be focusing just on folks that can actually pay their bills in a timely fashion and get us the money that we deserve for the service and the products that we provide.”

The question is whether KushCo’s write-off risk is now totally behind it, leaving a clean core investment story: linear exposure to increasing cannabis consumption via a non-plant-touching ancillary service.

Even with direct cannabis volume-growth exposure, it is still a competitive business.

If a small bankrupt customer can play hardball on $300,000 of inventory, what will a large multistate operator do when it knows KushCo’s next quarterly earnings hinge on its order?

They’ll ask: “You’re sure you can’t drop the price by 5%?”

And I think we can guess what the answer will be.

Just ask Rayonier Advanced Materials about its pricing power vis a vis Eastman, which was 31% of its revenue, in a contract dispute and one-day 49% stock price decline on Aug. 21, 2015.

Mike Regan can be reached at [email protected].