No one knows for sure how big the global cannabis market will get, but one thing is certain: It's growing fast, and an ecosystem of businesses that serve it is forming before our eyes. Most companies in the space are foregoing profit to grab market share, build brands, make alliances, and carve out sustainable niches. The result is a bewildering number of companies with rapidly expanding businesses but uncertain futures.

KushCo Holdings (OTC:KSHB) is a wholesale supplier to companies serving the marijuana industry, primarily in the U.S. The company doesn't deal in marijuana or cannabis derivatives itself, but sells supplies such as vaporizer parts, solvents, pre-roll papers, packages, and labels to customers throughout the cannabis value chain. It's a small company based in California, but it has put up breathtaking sales growth numbers for three years. Can its stock make you rich?

Marijuana leaves, money, and upward graph.

Image source: Getty Images.

Although the company started out selling packaging solutions, that segment has diminished in importance -- it comprised only 14% of revenue in the latest quarter, and its sales actually declined from the previous quarter. KushCo's growth is now coming from its largest segment, vaporizer parts, which supply 69% of revenue, and from energy and natural products, which supplies extraction businesses with solvents and oil bases and contributed 11% of revenue last quarter.

Torrid top line growth

KushCo's pivot to vaporizers and solvents for producing extracts is paying off brilliantly, as the U.S. market for concentrates is growing much faster than the market for marijuana flowers. While growth has gone negative in the company's original two categories, the two segments supporting the concentrate market are on fire. In the most recent quarter, vape grew 383% year-over-year and 58% sequentially. The company's energy and natural products category essentially didn't exist a year ago, and had sales growth of 69% over the previous quarter.

Bar chart of revenue by category, illustrating dominance of vaporizer category.

Chart by author. Data source: KushCo Holdings.

Put that all together and the company produced second-quarter revenue growth of 240% year-over-year, and 39% quarter-over-quarter, for a total of $35.2 million. KushCo raised its revenue guidance for the full year by $30 million, a whopping 26% at the midpoint. It's like another quarter of sales appeared out of nowhere.

This kind of head-over-heels top-line growth is nothing new for KushCo, having more than doubled sales in both 2017 and 2018. Clearly the company is serving its customers well and adding new ones every quarter. But there's no real playbook for that kind of growth, especially for a business that outsources its production overseas, and losses have mounted as the company has had problems with execution. As CEO Nick Kovacevich admitted last year, the young company didn't have the proper processes and systems in place to support its growth. As a result, KushCo has had massive challenges in managing its supply chain.

A supply chain nightmare in 3 acts

KushCo's problems with managing growth started showing up late last year. The company uses contract manufacturers in China, and ordinarily ships goods by surface to keep costs low. With transit times from China to the West Coast of about five weeks and supplier lead times on top of that, KushCo needs to be very good at forecasting demand well in advance of orders. Unfortunately, the marijuana industry is experiencing chaotic growth, and KushCo has a complicated offering, with its biggest customers ordering 70 different SKUs (stock keeping units) on average. Forecasting all those orders accurately and filling them in a timely way is a herculean effort.

KushCo had to take some extraordinary measures to serve customers well. For products that were in short supply, the company resorted to costly air freight to eliminate the transit time across the ocean. In fiscal Q1, the three months ended November 30, the company spent $1.25 million on air freight, almost 5% of revenue. KushCo also ran up additional costs by shipping directly to customers on the East Coast from California rather than stocking inventory in its Massachusetts distribution center, and by taking some extra measures to address quality control issues. Altogether, KushCo's gross margin plummeted from 24% in fiscal 2018 to 13% in the first half of 2019.

The high cost of meeting high demand

Getting back to historical margins while maintaining high product availability meant that KushCo needed to bring on new factories in China and make huge investments in inventory to stock its distribution centers with enough supply to get ahead of demand. Also, in order to move SKUs from air shipment back to surface freight, the five-week pipeline of parts in transit had to be refilled.

The cost of doing this showed up in the latest quarter, which ended February 28. Inventory doubled from the quarter before to $36 million, and the company reported negative operating cash flow of  $34.8 million. With only $13.5 million in cash at the beginning of the quarter, KushCo had to use external means to fund working capital, raising $34 million through an equity offering that diluted existing shareholders. In the current quarter, the company raised an additional $21.3 million in debt through the placement of a senior note.

Going forward, KushCo says that maintaining supply chain lead times of two to three months coupled with its crazy growth rate will force it to spend more money than it is taking in for the foreseeable future. It plans to prioritize funding its ballooning need for working capital through debt, but the banking environment around cannabis makes that a challenge. Further dilutive equity financing is a virtual certainty.

How trade wars hit KushCo

As if it didn't have enough problems managing exploding expenses, the company has been hit with a new supply chain cost: tariffs. KushCo's air freight bill came down significantly in Q2, but it paid even more in tariffs in the quarter: $1.4 million from the second round of tariffs on Chinese goods, which went into effect on January 1.

KushCo is looking at passing on some of the cost of tariffs to its customers through a tariff supplement fee it implemented this quarter. But the current quarter will have three full months of tariffs on ever-increasing purchases to support sales and inventory growth. And if President Trump makes good on his threat to raise China tariffs from 10% to 25%, the company will have even tougher demands on its cash.

Profits? Not this year

KushCo reported a quarterly profit as recently as Q1 of fiscal 2018, but with its current problems it's nowhere close to that now. Net loss in the second quarter was $8.9 million, or $0.10 per share, but that includes a paper gain of $5.6 million on the fair value of contingent consideration. Excluding that, but also subtracting out those air freight, product quality, and tariff costs -- which definitely won't be one-time events -- the company still lost $7.1 million, compared with a loss of $7.6 million in the period a year ago.

KushCo will need to restate its results of the last two years because of an accounting error, but that's merely a distraction. The real issue for investors is the fact that the company's current business doesn't come close to generating enough cash to fund its growth.

Kovacevich is optimistic that the company will grow out of its problems. KushCo is optimizing its warehouses with a new management system, discontinuing free shipping to its customers, and solving quality problems, and will be enjoying some cost benefits from its increased scale. He believes the company could achieve 30% gross margin and be profitable in fiscal 2020. And if the STATES Act passes, the company should be able to finance further growth with debt rather than another run to the equity market.

2 important reasons to be wary of the stock

KushCo is obviously doing a lot of things right to be able to grow its business at the breakneck speed of its first few years in business. The company has 10 customers that have generated over $1 million in sales, whereas in fiscal 2018 there were only four and in 2017 there were none. Vaporizer sales are expected to become legal in Canada later this year, which could be a big boost to sales. States such as Michigan and Illinois that have recently relaxed marijuana laws are a tailwind, and sales into the company's biggest market, California, nearly tripled from a year earlier.

But along with that growth comes the biggest reason to be wary of KushCo stock: a rapacious need for cash that isn't going to get better any time soon. KushCo has 40% more shares outstanding now than it did a year ago, which is a big reason why the stock price hasn't gone anywhere in that time. It's the nature of KushCo's business that will continue to drive its need for working capital. The company is a middleman for a large variety of inexpensive products for an industry in a state of relative chaos. That means large and growing inventory needs in an environment where long term debt is difficult to obtain, and that, in turn, means further dilution of shareholders.

The other risk for KushCo's shareholders is its dependence on the vape category. While it's a hot area of growth right now, it's also vulnerable to competition, and the company needs more diversification. KushCo doesn't own the proprietary rights to the vaporizer products it sells, but is one of four licensed distributors of CCELL technology, owned by Chinese company Shenzhen SMOORE Technology Limited. KushCo is attempting to build a moat by being a "one stop shop" for the customers it serves, but other well-funded players are also pursuing vaporizer development, and market disruption is a strong possibility.

Most investors should wait and see

On the surface, KushCo Holdings, with a market capitalization under $400 million, looks like a small company with fantastic growth that's just waiting to be discovered. In reality, the company faces tough challenges managing that growth in a chaotic environment. The company has done a fantastic job of serving its customers and navigating uncharted waters so far, but shareholders haven't profited.

KushCo may emerge from its present challenges as a profitable company in 2020, as it expects. Adventurous investors may want to make a bet on the market rewarding that. But they should keep a sharp eye on the cash flow statement rather than on the income statement. And most investors should avoid KushCo entirely until it can demonstrate that its business is sustainable.