Happy New Year, dear readers!! Time definitely flew by this year, amidst the battle royal of vaccines versus virus strains, unending video calls, and socially distanced family. Honestly, did you all really want to be that close to your in-laws anyways? And think of how much we’ve learned – we can roll out of bed, attend a video meeting with no pants, still get that promotion, and be back in bed by noon. Back slaps all around, we say.
Before we peace out on 2021 and lovingly embrace 2022, we wanted to do a quick wrap-up on U.S. cannabis. Finding the right inspiration can be difficult, but we stumbled across this Calvin & Hobbes quote in our archives, and we think it fits: “that’s one of the remarkable things about life. It’s never so bad that it can’t get worse.”
What’s got us down? On the surface, all is hunky-dory in U.S. cannabis, with 2021 sales growth of ~40% to $25 billion (BofA), 68% of the population supporting legalization (Gallup Nov’21), and states pocketing ~$3 billion of tax revenue (Marijuana Policy Project). But looking deeper reveals a much rougher story.
Let’s start with the stock market – the great gauge of future business prosperity. Since the beginning of 2021, U.S. multi-state operator equity valuations have declined by 40% on average, with enterprise value-to-EBITDA multiples compressing from 12x to 7x. As valuations have declined, incremental stock issuance has become increasingly dilutive to existing shareholders. Sadly, stock issuance is one of the few capital channels available, as banking reform has gone nowhere.
Well, how about fundamentals? In certain states with limited license structures, companies can earn solid profits. However, we’ve seen choppy earnings reports recently, as management teams struggle with an aggressive pace of market expansion, ballooning overhead, wholesale price volatility, and the complexity of merger integration. In other states with more open license structures, we see most companies struggling, as intense competition, capital shortages, and high operating costs combine to leach away profits. And none of this addresses the booming illicit market, as high taxes attract producers and consumers while limited enforcement does little to scare anyone away. Illicit companies can even hide in plain sight, with a “legal front” providing the perfect cover.
Wait! This is a new year – where’s the optimism? We’re glad you asked! In 1971, computer scientist Alan Kay told a group of worried Xerox executives “the best way to predict the future is invent it.” Kay believed that, with the growing power of technology, anything that could be envisioned and articulated could be built. With this spirit in mind, we’d like to envision a path for U.S. cannabis success. First, the industry needs a cohesive and powerful voice on taxation. As noted in other missives, taxation is a disaster across the board, crippling profits, stoking the illicit market, and distorting company decision making. Second, the industry needs consolidation. Given the high regulatory and compliance costs, companies need more volume over which to amortize these costs. Merge, baby, merge. This could also help control wholesale pricing volatility. Third, companies need bank capital. We’ve touched on this idea previously but funding capital-intensive companies with equity is unsustainable. Companies give away shares like they are chiclets (remember that gum?), whether it’s for fundraising, acquisitions, compensation, warrants for private loans, etc. Fourth, companies need more product standardization. Wholesalers and retailers have had mass SKU proliferation, as they’ve tried to guess what consumers want. Plus, cultivators seem to roll-out new strains every few weeks. Taken together, this is leading to bloated inventories (which is managed by hand in many cases), tying up precious cash flow and creating risk of loss. Lastly, companies need more sophisticated marketing. While this is also tied to regulatory reform, companies must move beyond pay-to-play arrangements with retailers as the de facto strategy. They must connect more with consumers, building repeated sales from each marketing dollar versus the purely transactional model of today.
The U.S. cannabis cannot continue to have its future dictated to it by distracted politicians, misguided regulators, and short-sighted executives. It must take its future into its own hands and invent a better tomorrow. Thanks for tuning in, and until our next update, please stay safe and healthy.
Mike, Kip, and Austin
Co-Managers, Presidio View Capital