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Staring Into the Abyss

Greetings,


For today’s letter, we return to a favorite movie Wall Street, where veteran broker Lou Mannheim stoically tells the troubled hero Bud Fox (Charlie Sheen prior to his “Tiger Blood” phase): “Man looks into the abyss, there’s nothing staring back at him. At that moment, man finds character. And that’s what keeps him out of the abyss.” Our penchant for the dramatic quotation aside, we think this is particularly on point for cannabis investors these days, as we stare into an “abyss” of red ink from public stocks. Going back to the highs of Feb’21, for example, the four largest stocks have declined 65% on average, erasing some $20B of market value. This was enough to lead Jim Cramer to confidently crow: “cannabis has turned out to be one of the worst story ideas ever told.” And we thought we were dramatic.


Stepping back, the value of the four largest public stocks has doubled since the end of 2018, creating ~$6B in market value. Over that time, these companies have increased revenue by $3.6B with an average operating profit margin of 20% in 2021. Wall Street analysts expect revenue growth to be ~25% per year over the next two years, with operating profit margins sustaining near 20%. This seems OK, no?


To dig deeper, we took inspiration from our good friend Warren Buffett (actually, we aren’t friends, but we did get a selfie once), who often cites the importance of return on capital, as profit is nothing without the capital required to generate it. We started with return on equity, which immediately threw us off worse than James Harden’s jump shot (too soon, Philly readers?). Net income has been slammed by IRS 280e, resulting in obscene effective tax rates (e.g., GTII 2021 was +60% in 2021 while TRUL was +90%). Additionally, large acquisitions have resulted in one-time P&L charges and inflated balance sheets. To gauge true economics, we therefore looked to normalize profit (prior to one-time items with a standardized tax rate) against tangible capital. This resulted in a more satisfying result, with returns averaging 25% during 2021.


Will these returns hold up producing attractive long-term profit growth? Well, that’s the big question these days. On the one hand, optimists point to the protected nature of limited license markets, the advantages of growing scale, increasingly loyal customer bases, and barriers to entry created by large capital investments. On the other hand, pessimists counter with lower prices from persistent over-supply, weakening demand due to high taxes, profit leakage from IRS 280e, and high capital cost from low debt usage.


Ignoring our views on valuation (the average enterprise value to 2023 operating profit is currently 13x, for reference) and predictions on regulatory changes, there’s another thorny issue weighing on the buy-sell debate: shareholders versus management. As mentioned above, equity is the pre-dominant form of capital, including both fundraising and acquisitions. When cash is raised via equity for investment in operations, we can use return on capital as a yard stick. But what about acquisitions? Looking at balance sheets, for example, shows a potentially worrying trend. About half of total assets and about 90% of book equity come from acquisition-related intangibles (essential the premium paid for tangible assets). Have stock deals led to over-valued acquisitions? If we include these intangible assets in our returns analysis, the average drops to 9%. Additionally, management stock ownership (and selling) has also come under scrutiny recently. Take this exchange between a veteran hedge fund manager and a cannabis CEO during an earnings conference call: “Are you fully invested in the company? You have all the right buzz words, but I don’t see any action. I see insider selling; I don’t see insider buying.”


While this is by no means a conclusive stock appraisal or buy-sell recommendation, we hope it sheds light on the interesting current debate surrounding cannabis stocks. With such a significant decline in valuation paired with favorable long-term demand trends, we think it’s a mistake to disengage from the conversation. In other words, don’t be scared by the abyss; we got your back. Thanks for tuning in, and until our next update, please stay safe and healthy.


Cheers,

Mike, Kip, and Austin

Co-Managers, Presidio View Capital