The Canadians Aren't Coming
The Bengal Bite
[Note: The comments here deal with a specific group of LPs - those that raised the most capital, tend to have the highest market caps and following among investors and have had historically disappointing financial and operating performance: Canopy Growth Corporation (NYSE: CGC), Aphria (NYSE: APHA), Tilray (NYSE: TLRY), Aurora (NYSE: ACB), and Cronos Group (NASDAQ: CRON).]
In August 1814, during the War of 1812, an army of Canadians, then still British, marched into Washington D.C. with a force of 4,500 men and burned the White House, U.S. Capitol, and many other public buildings. In 2020, many cannabis analysts, who tend to be Canadian because the Canadian investment banks remain the key players in cannabis financings, and investors, who tend to at least sometimes listen to analysts, seem to be expecting another invasion as soon as there is any kind of U.S. federal easing of restrictions on cannabis – that of major LPs flooding over the border taking meaningful share in the U.S. THC markets.
This belief is possibly the biggest disconnect in cannabis between analysts/investors and those actually leading U.S. multi-state operators (MSOs) – a serious possibility, or even certainty, that must be priced into an LP’s stock according to some analysts and investors, and regarded as an utter farce almost unanimously by MSO executives in private.
The belief that major LPs are massing eagerly at the border is, unfortunately, convenient for those that hold it. Canadian investment banks were instrumental in raising billions for the major LPs at lofty valuations, their analysts’ reports often provided the financial justification, and investors hold out hope of future growth emanating from the U.S. And the story has some allure to it: ignore the major LPs’ largely disappointing performance in the Canadian recreational market, or the severe over-promising of major LPs’ quick growth Europe, etc., - they were just being strategic the whole time planning their future entry into the U.S., the big prize.
There’s a term used by small-cap oil and gas, or mining, promoters, also in private, to describe the science you need to use to promote these companies: “closeology” (vs. actual geology). The essence of the entire pitch, backed up by fancy maps and graphs, ultimately boils down to saying “Well, we are kind of close to this other really successful gold mine/oil reserve/lithium mine” and hoping there isn’t a detail-oriented geologist in the room. As here, many major LP holders, new and old, seem to look at them as “close” enough to benefit from the U.S. market’s rapid expansion. With prices buoyed by increased liquidity that comes from being traded on the NYSE/NASDAQ (as we have written about here and here), major LPs have no interest in tempering investor expectations. Many major LPs have instead stoked this anticipation with carefully targeted U.S. acquisitions, such as hemp businesses, softly messaging that these were footholds into the U.S. THC markets while actual MSO operators know they were no such thing. It bears repeating: the very idea that, as soon as legally possible, major LPs will successfully enter the U.S. market is a punchline between MSO executives.
MSO executives will largely avoid saying this in public for political reasons. They often work with the same Canadian banks that issued the sterling initial buy recommendations on major LPs, and are often covered by the same analysts. And, in a way, attention on the space, even if on our northern neighbors, is still seen as a benefit to them because of potential investor spillover from LPs into their own companies.
Why, specifically, do we think the chance of major LPs successfully entering the U.S. market without paying dearly or taking unbelievable dilution is remote?:
- As soon as the LPs can cross, U.S. MSOs will likely be able to list (or soon thereafter). And as soon as they do, they negate the major advantages of increased multiples/liquidity that LPs now enjoy. MSOs are already on pace to beat LPs in revenue and have been beating them in EBITDA for quite a while. The only path to a merger with a major LP for a quality MSO would be to effectively treat the LP as a go-public shell.
- A history of staggering losses, with negative cash flows continuing two years post-Canadian legalization. The major LPs have lost a truly staggering amount of money while generating almost no cash. Canopy Growth has lost over $3B since its inception and has guided that it will not be profitable until the second half of 2022.
- Major LPs have not demonstrated any evidence of superior ability to grow or process cannabis. The major LPs' history of crop failures and low gross margins (before biological asset adjustments, which we think is a useful rough proxy for growing operational ability) is fairly good evidence that they have no operating advantage over MSOs. The trend the chart below shows is the key in our minds: as MSOs operations start to mature in limited license states, gross margins rapidly begin to accelerate. Even in mature markets such as Colorado, Oregon, and Washington, the top-tier operators tend to be able to have higher gross margins than major LPs. Having shown no meaningful acceleration in some time, much less superiority to MSOs, we see no reason why LPs would develop this in the future.
- Many major LPs have significant looming debt maturities and limited available cash. The only way almost all major LPs can pay to enter the U.S. is with their own stock which, per our first point, will likely rapidly reprice downwards as U.S. companies are themselves able to list. The notable exception among LPs is Cronos Group - its annualized revenue from operations based on its last quarter was $54M (putting it smack dab in the middle of Vireo Health and 4Front Industries in terms of revenue), while it had $1.1B cash as of last quarter on its balance sheet, so it is effectively a Special Purpose Acquisition Vehicle (SPAC) attached to a relatively small existing cannabis business.
Again, not to paint all LPs with one brush. Some of them are quality companies, and the global opportunity is a real advantage to those that can meaningfully exploit it. The U.S. companies will likely meaningfully lag in developing opportunities in the EU and elsewhere which, although they are not growing as quickly as major LPs promised, are certainly real and lucrative. Additionally, the federal legality of Canada allows them to accelerate research and development and build intellectual property that will be foundational to the industry going forward.
But, right now the market is generally valuing a dollar of revenue, EBITDA, etc. more if it comes from Canada than from the U.S., which strikes us as fundamentally wrong. Liquidity is certainly a driving factor in higher LP multiples - as we wrote about before, LPs’ NYSE/NASDAQ listings drive increased liquidity, which in turn drives increased multiples. While levels of liquidity are much higher in LPs, for many larger MSOs, there is now sufficient liquidity for smaller investors, maybe even medium investors managing multiple millions, to easily be able to buy relatively large stakes in them.
Smaller investors’ ability to slip into MSO positions without the problems larger institutions face is a significant advantage to them – a rarity in financial markets. And it is to exactly these investors, those who can just as easily invest in MSOs but instead choose major LPs, that the Canadian invasion wishful thinking is so detrimental. Some of these investors may miss the very cannabis wave they thought they were betting on, and that would be a shame.
Unless, of course, you think the Canadian army is going to come down soon and finish what they started in 1814, in which case we would potentially consider LPs’ premium over MSOs justified.
This week's Bite:
- #MSOSGang fights back: Following a rollercoaster week for cannabis stocks, American cannabis company executives are pushing back on social media discussing why U.S. MSOs should not be lumped in with Canadian LPs as if they are in one industry. (Bloomberg)
- Pot-powered job creation engine: The cannabis industry created 70,000 jobs in 2020 making it the 5th largest job sector by employment in the United States. (Marijuana Business Daily | Leafly)
- Green rush, land grab: Generally to find a suitable property for a licensed cannabis operation you need to: (1) identify parcels that meet state buffering requirements (e.g. 1000 feet from a school); (2) Out of those, identify those parcels in local jurisdictions that don’t impose more onerous rules than state requirements; (3) then, you need to either buy a parcel or find a landlord who will rent to a cannabis company; (4) out of the landlords that would potentially rent to a cannabis business, you need to identify one that does not have an existing mortgage that would bar a cannabis business (provisions that are quite common, and sometimes ban even federally-legal activities like gun stores). So, those landlords left are able to charge a significant premium to cannabis businesses, as this article explores. (Wall Street Journal)
- Green Thumb initial public offering in the U.S.: Raising $100m from one institutional source, GTI closed its first public offering in the United States. (CNBC | Press release)
- This Valentine's Day more people than ever in Oregon broke up with their dealer: The 38% YoY growth that this mature market saw in 2020 shows that the legal cannabis sector has a lot more room to grow as the over $60bn in nationwide illicit cannabis sales transition to the legal market. (Marijuana Business Daily)
- A rising tide of legalization: New Mexico, Connecticut, Washington D.C., and Kentucky are all looking at expanding access to cannabis.