CLEANING UP A MESS - CANNABIS 3.0
We are making several changes to the Cannabis Position Monitor - we are removing AYRWF, TLLTF, TRSSF, and CNTMF from the List. Until legalization occurs, the cannabis industry is a maturing industry that is fighting margin pressure from many sources and is also capital constrained. Those that don't behave like it will not be around to see the golden years.
INDUSTRY CONDITIONS decelerate further
We have written about the more challenging operating environment for the past year but held on to several of the longs in the hope that there are bigger things to come for this industry. That was a colossal mistake, and we may be making mistake by coming off these names now, but the balance sheets will limit the upside. Following a challenging LTM for several companies, we are refocusing the list on a core group of companies. Unfortunately, we did this in January 2022 but did not go far enough. Cannabis is not immune to the current economic setup, which puts further pressure on short and intermediate-term industry forecasts. Another factor, the desire to be in limited license states on the verge of going recreational, has led to significant oversupply in some markets resulting in significant pricing pressure. The current economic setup on top of further pressure is coming from low-margin wholesale businesses, causing many to pull back on that business, putting further pressure on revenue estimates. In the wholesale business, where appropriate, companies need to reallocate products from the wholesale channel to their retail footprint and further refine the production mix to maximize margins. The decline in profitability for these companies and the revised outlook make the balance sheets too leveraged to ignore. Some of these companies need to jettison non-core assets and activities that will allow management teams to concentrate on more impactful business segments. We would like to see companies focusing on performance within high conviction markets, adding dispensaries in core states, increasing the sale of branded products through branded retail, and utilizing data to meet evolving customer preferences.
While the prospect for legislation is low, there is a glimmer of hope that some form of the incremental move might pass in the lame duck session. Without this change, highly leveraged cannabis companies will struggle. With the MSOS at $11.75, down 67% over the past year, the stocks are not discounting any positive move in Washington, and management teams should behave accordingly. Given the current regulatory structure, the cannabis industry, combined with the illicit market in many states, is an oversupplied and mature industry. Currently, 44% of the US population lives in states that have legalized cannabis, which rises to 73% when we include medical states. With much of the population having access to legal weed and a robust illicit market until we see full legalization, estimates of legal industry sales doubling will likely prove aggressive. Cannabis industry executives need to stop pushing the TAM story because it's not believable anymore.
If there is good news from all this from an overall industry perspective, expectations are now approaching reality, and valuation is now only 1.2x 2022 sales, with many companies trading below 1.0x. The current uncertainty is shifting to the 2023 revenue estimates, which show an acceleration from 2022. Why? New states are coming on? Maybe, but pricing pressure will continue in many limited license states, and we are headed toward a recession. TBD on how that unfolds. With many investors have thrown in the towel and given up on the space, the upside/downside risk-reward is more favorable for the strongest players. Across the board, we need to see now is for management teams of the leading companies to fly closer to reality and manage their business by focusing on operating existing assets more profitably. The cannabis industry is one big roll-up, and like most roll-ups, they have blown up. With this as the reality in cannabis, managing the current assets better will improve financial performance, lead to better valuations, and ultimately higher stock prices.
COMPANY COMMENTARY
AYRWF – The extensive 2Q guide has severe implications for the company balance sheet and has made many questionable capital allocation decisions over the past 12 months. AYRWF's Net Debt/EBITDA has grown from 1.2x in 4Q20 to 5.6X in 2Q22, and the company deferred tax liability stands at $69.4 million. AYRWF's margin structure and fortress balance sheet had been a source of differentiation, but its rapid growth in 2021 has put the company in a precarious position. The company has expanded its footprint from two states (Nevada/ Massachusetts) to eight states (FL, NJ, AZ, PA, IL, and OH). Additionally, the company has made significant investments in cultivation/manufacturing. The lack of scale in IL and other states suggests that the company is seeing a more extended ramp-up period for the company's asset base. While the investments are nearing completion, the transition focusing on improving the profitability of those assets will take time in a recession complicated by price compression in multiple markets.
TRSSF – The timing of the Gage acquisition was unfortunate. The MI market has operational challenges, which became more apparent this quarter. TRSSF reported 2Q22 Revenue and (A)EBITDA of $65M & $6M, respectively, well below the consensus of $77M & $12M. The top-line miss primarily to Michigan, with 2Q22 revenue coming in at $17.5M, down 27% from 1Q22 (Pro-forma). The revenue shortfall is mainly attributable to the company's decision to stop sales of lower-margin bulk products—the wholesale demand pressure in Pennsylvania was also a problem. Management noted that the transition to new genetics is complete, as is the overhaul/expansion of the facility. This is the second consecutive year of operational challenges for TRSSF. The company ended the quarter with $48M in cash/equivalents and total debt of $278M. The debt includes loans assumed in the acquisition of Gage, including a senior secured term loan for $53M that matures in November 2022 - management noted it is working to refinance that term loan. Without any further erosion in profitability, the company balance sheet at the end of 2022 will be 5.2x Net debt to EBITDA. However, a healthier macro environment and adult-use legalization is needed to drive incremental demand growth in PA. NJ is a tailwind for the company, but that only gets you so far. We will come back to TRSSF at some point.
CNTMF – Management time to sell the company has come and gone. FL is now saturated with over 400 dispensaries run by the most prominent players in the business that are well capitalized. Yes, adult use will be a catalyst in FL, but that is a 2024 event if we are lucky.
TLLTF - TILT non-cannabis inhalation margins will remain under pressure for the foreseeable future, which like the others, makes the balance sheet look highly leveraged. The cannabis operations are performing well, but MA is a challenging market.
Staying on the LONG list:
GTBIF - This quarter, we saw some positive moves with GTI management's focus on preserving cash and taking a step back from NY. GTII exited 2Q22 with cash/equivalents of $145M. During the quarter, GTII spent $69M in gross CAPEX but only $14M net of reimbursements from sale/leaseback agreements, focusing on projects in NJ, VA, NY, and FL. Late in the quarter, the company amended its sale/leaseback agreement with Innovative Industrial Properties, providing GTII with an additional $55M for facility enhancements. After quarter end, the company exercised its option to extend its $250M maturity in 7.0% senior secured notes from April 2024 to April 2025. The extension did not require amendments to the notes' terms or additional consideration. Based on the current assumptions, cash is available as dry powder to fund M&A and/or accelerate CAPEX.
TCNNF - Took the difficult step of incorporating strategic changes across its different businesses while accounting for the impact of inflation on consumer spending, softness in wholesale markets, and the lack of visibility in the economy. Rationalizing assets and activities weighing margins and resources is a net positive as they focus efforts on driving its core business lines. For example, the company announced that it decided to discontinue wholesale operations in Nevada in July. Every company needs to look closely at every market and decide whether they have the capacity and resources required to drive meaningful market share in that market.
Cannabis Update & Q&A
CALL DETAILS:
|
Tomorrow we will dive deeper into what it would take to see meaningful cannabis industry growth, which many companies gave long-term estimates during this earnings period. We will also dive deeper into how tough the market conditions really are for this decimated industry and which companies are over and underperforming following the industry's 2nd quarter results.
