Kass: Picking the Cannabis Winners in an Industry Full of the Walking Dead
Against a difficult operating and financial backdrop and uncertain legislative outlook, there are only a handful or two of cannabis companies that reside in the land of the living.
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The gut-wrenching multi-year decline in cannabis equities finally came to a halt last week as the promise of legislative advances once again came to the fore.
That said, the rally quickly petered out — from very low historical levels — as a tattered retail community of cannabis traders and retail investors did not have the firepower to sustain the sector's advance. (Custodial and banking issues continue to plague the cannabis sector, leading to very little institutional sponsorship.)
By now most acknowledge that the pie-in-the-sky intermediate-term promise and projections for the total addressable cannabis market were dramatically overstated and the subsequent optimism surrounding rapidly forecast individual company sales, cash flow and profits has been largely unfulfilled.
Cannabis investors also faced near-term pressures as state markets opened in the last few years delivered somewhat less initial growth relative to expectations. Perhaps more important was that those markets began to experience evidence of maturity far sooner than even the most pessimistic observers expected.
With the November 2024 failure of the key state of Florida to pass adult recreational use and a slower-than-expected rollout in other states, the industry's demand/supply equilibrium, which was already under pressure, succumbed to the pressure of an over abundance of supply of cannabis and continued market-share inroads from hemp and unchecked illicit cannabis sales.
Speaking of state regulations in the embryonic stage of my investing in cannabis, I was hopeful that there would be the clear emergence of a select group of dominant industry brands. But it became clear to me very early on that state silos — with several states restricting the number of dispensaries — made the promise of brand dominance and economies of scale (e.g. Burger King and McDonald's MCD) unlikely.
While these fundamental problems weighed heavily on cannabis companies and the stocks — to make matters worse — the industry's access to capital was evaporating and its cost of capital was skyrocketing.
How bad was the financing environment that cannabis companies have faced in the last several years? Limitations to and costs of accessing capital led a number of companies to finance their operations and growth by not paying federal taxes and accumulating large government IOUs on top of large existing (traditional corporate) liabilities. This all led to a worrisome increase in liabilities at a time that current cash flows disappointed relative to expectations and now challenge many companies' ability to service their total debt.
Even if rescheduling and/or Safer Banking is made law, leveraged balance sheets remain.
The cannabis industry now consists of only a handful or two of private and public companies that are healthy and who reside in the land of the living.
Unfortunately, most of the other public equities are among the walking dead, with their very existence dependent upon their ability to refinance large debtloads.
However, even if they are able to refinance, the equity dilution will be considerable — leaving shareholders with little.
And, remember, a company's enterprise value is the equity capitalization plus net debt. So, arguably, the cannabis companies that are the most indebted may still be the most overvalued.
Which Cannabis Business Model Will Survive and Prosper in the Future?
Let's briefly gaze at the future of cannabis — specifically, what industry business model will be the winner and which will be the loser? Clearly, the future is less than clear given the multiple possible legislative outcomes that lie ahead.
What we do know is that, as a result of market conditions (demand/supply has weakened leading to product price compression) over the last five years, the dispensary unit economics have been very weak relative to previous optimistic expectations and it is (legislatively) unclear whether the "box" unit economics will improve in the future.
A very key existential issue, going forward, is the delivery of the raw material product of cannabis into regional and state dispensaries.
1. Will legislated distribution remain on an intrastate basis only (and, therefore, being "protected" from national cultivators) or will cannabis be sold interstate (nationally) by companies like Glass House GLASF? If the former, one would want to own the surviving MSOSs.
2. If it is the latter and low-cost producers go nationwide, are MSOSes simply Med Men stores in disguise (i. e., high cost purveyors disrupted and competitively vulnerable to much more product price and profit margin compression)? If so, one would not want to own an MSOS and would choose to own a low cost national cultivator, like Glass House.
Investing in Cannabis
1. Construct your own portfolio of financially and operationally strong cannabis companies
2. Avoid the MSOS ETF MSOS
When I began to invest in cannabis my chosen vehicle was AdvisorShares Pure US Cannabis ETF MSOS — the industry's largest ETF (by far!).
MSOS traded actively and the shares were readily and easily tradeable. It took me years to conclude that I would rather invest in individual cannabis stocks rather than MSOS.
- To begin with, I would rather structure my own ETF by creating my package vis a vis the MSOS manager's selected holdings. I don't need to pay a fee if I can more efficiently construct my own cannabis portfolio.
- I have too often seen the MSOS portfolio manager dispose of positions in the best companies (e.g. Green Thumb GTBIF) and using those positions as an ATM to fund third- and fourth-tier cannabis holdings (and perhaps inadvertently providing an "out" for insiders in the process!).
- On that score, for years the MSOS ETF has had positions in certain cannabis holdings that are likely to fail or be so diluted out in financings that equity holders feel like the company has gone bankrupt!
- A relatively liquid MSOS whose constituent holdings are illiquid could lead to manipulation. I can't be certain but my guess is that there has been some unsavory actors contributing along the way to MSOS shares falling from above $50/share to about $3/share.
Frankly, given that the components of MSOS are illiquid, I do think (though it is hard to prove) that the industry would have been better off if MSOS never existed. MSOS has clearly become the tail that wags the cannabis dog.
Last week, as posted (and for the reasons mentioned above), I sold out my MSOS position for the above reasons and others.
Picking the Winners
- In the next 12-18 months there will likely be numerous receiverships of leveraged cannabis companies facing a 2025-2027 "debt maturity cliff."
- Industry consolidation lies ahead — providing some opportunity for accretive acquisitions by the financially-stronger cannabis companies that remain relatively healthy.
- Depending on the context of (possible) future legislative advances, industry consolidation and heightened merger and acquisition activity might improve the current dismal product demand/supply condition and serve to ameliorate the intermediate-term industry sales and profit outlook.
- While MSOS unit economics and economies of scale remain uncertain, values exist in a core list of operationally and financially strong companies.
- Green Thumb, Trulieve, Glass House and TerrAscend are attractive for patient long-term investors (but for different reasons).
From my perch, Trulieve TCNNF, TerrAscend (TSNDF), Green Thumb GTBIF and Glass House GLASF are among the cannabis companies that currently merit my attention in the difficult operating and financial backdrop and uncertain legislative outlook.
While there are other stocks that are investable, their market capitalizations are too small and their liquidity limited. Even the best of the cannabis lot will require patience — in such an uncertain operating and legislative backdrop — but there remains consequential upside (and relatively limited downside) over the next several years.
This commentary was orginally posted in Doug's Daily Diary on TheStreet Pro.
At the time of publication, Kass was long GTBIF (VS), TCNNF (VS), GLASF (VS) and TSNDF (VS).
