Cannabis Insight | Emerging Shifts In Regulations, CRON & GTBIF

Emerging Shifts in Cannabis Regulations: Implications for the Industry

The landscape of cannabis regulation in the United States is on the cusp of a pivotal transformation.

Recent insights from Howard Sklamberg, a former Food and Drug Administration (FDA) official who forecasts significant regulatory shifts by the following presidential election, highlight this change. The potential rescheduling of cannabis by the DEA represents a crucial milestone in the ongoing journey toward cannabis reform in the United States. For the cannabis industry, this potential regulatory shift opens the door to a future marked by increased legitimacy, expanded consumer access, and increased R&D and product innovation. As these developments unfold, stakeholders in the cannabis industry should prepare for a landscape that is evolving in favor of broader acceptance and integration into mainstream commerce.

Key Themes and Implications:

Probable DEA Rescheduling of Cannabis

• Insight: Howard Sklamberg, with his background as a former FDA deputy commissioner, anticipates that the Drug Enforcement Administration (DEA) will likely reschedule cannabis by the second quarter of next year.  (This adjustment aligns with strategic regulatory changes often seen in election years.)
• Implication for Industry: A change in scheduling signals a more favorable political and regulatory environment for cannabis, potentially opening up new avenues for business development and innovation.

Alignment with FDA's Stance

• Insight: There's a strong expectation that the DEA will align with the FDA's recommendation to classify cannabis under Schedule III of the Controlled Substances Act (CSA). This classification would acknowledge cannabis's medical utility and lower abuse potential compared to Schedule I.
• Implication for Industry: Moving cannabis to Schedule III could catalyze a wave of research and development in the medical cannabis sector, offering new opportunities for businesses. (A topic to be discussed at a later date.)
  

Tax Implications and Business Viability:

• Insight: Rescheduling to Schedule III would have a transformative effect on cannabis businesses, especially concerning taxation. The current IRS rule, 280E, which hinders cannabis companies from taking standard business deductions, would no longer apply.
• Implications for Industry: This change could significantly reduce tax rates for cannabis businesses, improving profitability and financial sustainability. Are the stocks beginning to reflect this, with the MSOS up 27% over the last three months vs the CNBS up only 1%. What about TCNNF's move last week to not pay 280e?

Regulatory Concerns and Confidence

• Insight: While some legal experts express concerns about potential regulatory challenges following rescheduling, the process will not be linear and could take a year or more. As expected, industry representatives remain optimistic about the positive impact.
• Implications for Industry: Emerging from 50+ years of prohibition will not be easy; the industry needs to temper enthusiasm. 

International Treaties and Domestic Policy

• Insight: Comments from a senior State Department lawyer suggest a flexible interpretation of international drug treaties to support domestic policy changes regarding cannabis.
• Implications for Industry: This approach could provide a more conducive environment for the DEA to adjust cannabis scheduling without conflicting with international obligations. Suggesting Canadian L.P.s will be able to ship medical cannabis into the USA. 

The Cronos reported better-than-expected 3Q23 earnings, and the call provided a comprehensive update on the company's performance and strategic initiatives.

CEST IDEA LONG - CRON 3Q23 GAAP EPS of $0.00 beats by $0.03, and revenue of $24.81M (+21.6% Y/Y) beats by $5.24M.

Cronos reported a 22% year-over-year revenue growth, reaching $24.8 million, with a notable 40% growth in Canada, driven by pre-rolls, flower, and edibles. The gross margin improved significantly, and the company holds a strong cash balance of $840 million. The company highlighted its international expansion efforts, explicitly mentioning the shipment of cannabis to their German partner, Cansativa, and the upcoming first shipment to Australia through Vitura. The German market re-entry is a significant milestone, with Cansativa's network offering a substantial growth opportunity. In Australia, medical cannabis patient approvals have increased significantly, and Cronos is eager to supply Vitura with quality cannabis products. In Canada, Cronos's Spinach brand leads in Edibles and flower categories and shows promising growth in vapes and pre-rolls. New product launches have been well-received, like the SOURZ by Spinach flavor and the Sonic Lemon Fuel pre-rolls. Additionally, Cronos is investing in innovation, particularly in products containing the cannabinoid THCV, and plans to introduce a THCV-infused pre-roll in 4Q24. Cronos is also bringing its Lord Jones brand to Canada with a focus on THC products, starting with Hash Fusions pre-rolls and, soon, a live resin vape. Future launches include the anticipated Lord Jones Chocolate Fusions in 2024, aiming to exceed the success of Spinach SOURZ gummies.

An essential part of the CRON story is Cronos GrowCo, which reported a robust financial performance and contributed positively to Cronos's overall financial health. Despite challenges in Israel, the company grew and maintained product distribution. Lastly, the CEO expressed optimism regarding the potential reclassification of cannabis in the U.S., which could represent a significant market opportunity. Overall, the summary from 3Q23 indicates that Cronos is experiencing growth and navigating the competitive and regulatory landscapes effectively, domestically and internationally.

Financial Overview:

Of all the Canadian L.P.'s CRON financial trajectory stands out. The company entered new markets and categories (highlighting the company's market share gains in Canada). Leading to strong top-line growth, steady gross margin improvement, operating expense reduction, cash balance optimization, and improving cash flow from operations positions the company for a bright future:

Revenue Growth: Consolidated net Revenue was $24.8 million, marking a 22% increase from the previous year, with growth of 30% QoQ. Adjusting for constant currency, the net revenue increased to $26 million, a 27% increase. This growth was attributed mainly to increased sales of cannabis flower and extracts in Canada and the start of shipments to Germany. However, in Israel, sales were negatively affected by competitive activity, stagnant patient growth, and political unrest.

Gross Profit: Reported gross profit was $4 million, translating to a 16% gross margin. After adjusting for a $0.7 million inventory write-down at Cronos Fermentation, the gross margin was approximately 19%. This improvement was driven by higher sales in Canada, lower biomass costs, and supply chain optimizations. The gross margin has shown a solid sequential increase from 15% in 1Q23 to 19% in 2Q23 on an adjusted basis. Gross margin by product: Edibles remain the highest margin product, with Lord Jones Choco Bites expected to enhance company margins further. Vapes, pre-rolls, and flower follow in descending order of gross margins. Despite price competition, Cronos's flower products are still performing well due to their quality.

Adjusted EBITDA: The adjusted EBITDA for the quarter was negative $15.2 million; this represented a $3.3 million improvement YoY. This was primarily due to reductions in G&A, research and development expenses, and increased gross profit.

Operating Expense Reduction: Cronos increased its target to reduce operating expenses by $20 million to $25 million in 2023 and expects an additional $10 million to $15 million in savings in 2024, following significant cost-cutting measures implemented in 2q23.

Balance Sheet and Cash Flow: The company ended the quarter with $840 million in cash and short-term investments, a slight decrease of about $1 million from 2Q23. Cronos received $2.3 million from GrowCo in interest and principal repayments. CRON has the best balance sheet in the industry, allowing them to make strategic bets within the industry while focusing on reducing cash burn.

Cash Flow Improvements: The cash flow from operations was nearly break-even at negative $180,000, showing substantial progress towards creating a self-sustaining operation. Free cash flow was only negative $510,000.

Revenue Impact from New Products: Cronos saw minimal revenue impact from the Lord Jones brand in Q3 but expects it to be a significant growth driver in 2024.

Canadian Competitive Landscape: There has been a noted exit of some producers due to many bankruptcies in the Canadian cannabis industry. However, new entrants are still coming in. The competition mainly affects lower-quality, value-tier products. Cronos sees opportunities in mainstream and premium segments to grow market share and improve margins through innovation rather than price hikes.

International Pricing Strategy: While there is more competition from Canadian licensed producers in the European market, the absence of excise tax and provincial distribution margins makes it accretive to Cronos. Focusing on product quality gives them an edge as consumers become more discerning. Medical markets like Israel, Germany, and Australia continue to offer favorable margin profiles compared to more mature adult-use markets, with no trend reversal observed.

GTI Industries: Navigating Growth and Challenges in the Evolving Cannabis Landscape

Green Thumb Industries (BEST IDEA LONG GTBIF) 3Q23 GAAP EPS of $ 0.05 beats by $0.01- Revenue of $275.4M (+5.4% Y/Y) beats by $18.19M. The increase in revenue was primarily driven by increased retail and consumer packaged goods sales in Maryland, reflecting the legalization of adult-use cannabis on July 1.

Green Thumb Industries (GTBIF) reported a robust financial performance for 3Q23, with significant growth and strategic expansion signaling a strong outlook when the operating environment improves. GTBIF revenue increased by 9% QoQ to $275 million, supported by adult-use sales in Maryland and market share gains across its brand portfolio. Adjusted EBITDA stood at $83 million, which is substantial in profitability. The company also demonstrated strong cash flow management, as evidenced by $61 million in operating cash flow and a disciplined capital allocation strategy, investing in growth while returning value to shareholders through a $25 million stock repurchase. GTI's strategic positioning for future growth was evident in its capital expenditures totaling $184 million year-to-date, aiming to reach approximately $230 million for 2023, and its continued retail expansion, notably in Florida and Nevada. The CFO's comments underscored the company's readiness to capitalize on new markets, like the recent legalization in Ohio, and a solidified presence in established ones. From an investment standpoint, GTI's third-quarter performance, strategic positioning, and management's focus on cash flow generation and balance sheet stability paint a picture of a company poised for sustainable growth. The conservative approach to operating without expectations of federal regulatory relief suggests resilience and adaptability in a volatile regulatory environment.

Three Most Important Themes from the Earnings Call:

1. Robust Financial Health: GTI reported strong financial results, with significant revenue growth and adjusted EBITDA margins. The company's focus on maintaining a healthy balance sheet and generating substantial cash flow positions it well for ongoing investments and shareholder returns.
2. Strategic Expansion: The company is leveraging strategic investments to expand its market presence, particularly in states like Maryland and Ohio, where recent legalization has opened up new opportunities. The emphasis on brand building and award-winning product offerings will likely continue driving market share gains.
3. Conservative and Disciplined Approach: GTI plans for the future without relying on federal regulatory changes or tax relief, indicating a prudent and disciplined approach to growth. This strategy ensures stability and profitability regardless of external changes in the cannabis industry landscape.

We believe GTI's approach and performance indicate a substantial buy opportunity, considering the company's solid financial results, strategic market expansion, and the management's prudent approach to navigating the evolving cannabis industry.

Financial Performance

In 3Q23, Green Thumb Industries (GTI) reported a revenue of over $275 million, marking a 5% increase year-over-year and a 9% increase in QoQ. The growth was partly fueled by the legalization of adult-use sales in Maryland and contributions from eight new stores opened within the year. Retail revenue grew by 3% YoY, with a slight uptick in comparable sales based on 77 stores. The CPG segment saw an 18% increase in gross revenue compared to the prior year's quarter. Underneath all this, GTI faced challenges, including effective price compression, which impacted the top-line growth and led to a gross profit of $133.8 million, or 48.6%, down from 50.2% last year. GTI faces some underutilization of production capacity. In Ohio, for example, they are planting less than before due to lower demand, but this could change with the introduction of adult-use cannabis. New Minnesota, Virginia, New Jersey, and New York facilities are ramping up, contributing to increased costs. Thus, certain facilities are not operating optimally, leading to a higher cost per unit. Selling, general, and administrative (SG&A) expenses accounted for 30.8% of revenue at $84.8 million, compared to 31.6% in the previous year, with a noted sequential increase in expenses due to the costs associated with opening new stores and supporting the adult-use launch in Maryland. Net income for the quarter was reported at $10.5 million, or $0.05 per share, a slight increase from $9.8 million, or $0.04 last year. Adjusted EBITDA was $83 million or 30% of revenue, slightly down from 32% of revenue year-over-year. GTI concluded the quarter with a strong balance sheet, including $137 million in cash and $170 million in working capital, and remained up-to-date with significant tax payments. The company's cash flow from operations was robust at $154 million for the nine months, a substantial increase from $88 million the previous year, with $61 million generated in the third quarter alone.

Investment Conclusion:

Green Thumb's financials showcase a company growing its revenue and expanding its market presence while navigating industry-wide challenges such as price compression. The company's disciplined cost management in an inflationary environment and strategic capital allocation, evidenced by share repurchases and new store openings, underpin its operational strength. With a solid balance sheet and impressive cash flow generation, GTI appears poised to maintain its growth trajectory and navigate the competitive landscape effectively. The slight decline in gross margin and adjusted EBITDA as a percentage of revenue are areas to monitor, but the company's overall financial health suggests a potentially substantial investment case.

Long-term considerations:

1. Revenue Growth Amidst Industry Challenges: GTI is achieving revenue growth despite price compression in the market, showcasing the strength of its business model and the success of its strategic initiatives, including entering new markets like Maryland.
2. Expansion and Brand Development: The company continues expanding its retail footprint and developing its consumer packaged goods brands, leading to increased market share and industry recognition.
3. Financial Resilience and Execution: GTI's strong balance sheet, disciplined expense management, and impressive cash flow from operations reflect a financially resilient company executing effectively against its strategic goals.

Specific markets mentioned during the call that are indicative of GTI's strategic responses to these challenges include:

1. Maryland: Legalizing adult-use sales in Maryland is highlighted as a significant positive development for GTI. The company has capitalized on this opportunity through preparedness and timely execution, contributing to the revenue increase in the quarter.
2. Illinois: GTI's brands were recognized with multiple awards at the High Times Cannabis Cup in Illinois. This suggests that the company can maintain a high product quality that resonates with consumers and command a premium in a competitive market despite the challenges.
3. Ohio: The recent passing of an adult-use bill in Ohio represents a new market opportunity for GTI. With a solid retail footprint and a state-of-the-art cultivation and processing facility in Toledo, the company can effectively address this new market's demands.
4. Florida: The mention of store openings in Florida indicates GTI's expansion efforts in this market, which is rapidly growing and presents its own challenges and opportunities regarding the regulatory environment and competitive dynamics. The recent store openings in Florida are standalone RISE stores. GTI is still working with the Department of Health on operationalizing stores adjacent to Circle Ks. The CapEx spend in Florida was front-loaded, with investments made in wholesale capacity before retail to ensure adequate supply for new stores. This strategy is expected to show positive results in 2024.

The strategic locations for expansion, such as in Maryland and Ohio, indicate GTI's focus on states with new or evolving legal cannabis markets. The emphasis on Florida also suggests an investment in markets with a large population and a growing acceptance of cannabis use and the potential for adult use in 2024/25. These expansions align with the company's strategy for organic growth, increased cash flow, and leveraging legislative changes that create new market opportunities.