The data now confirms that cannabis is more capital-intensive than other similar industries. A new report from Viridian Capital Advisors looked at the capital needs of cannabis companies versus four other industries. Viridian chose to compare cannabis to other companies and sectors that would be likely acquirers of cannabis companies upon federal legalization. They included tobacco, alcoholic beverages, pharmaceuticals, and consumer products.
In the chart, the cannabis section is made up of nine multistate operators with market caps over $100 million. The rest of the group are as follows:
Tobacco includes British American Tobacco (BTI: NYSE), Altria (MO: NYSE), Phillip Morris International (PM: NYSE), and Japan Tobacco (JAPAF: NYSE).
Pharmaceuticals include Johnson & Johnson (JNJ: NYSE), Pfizer (PFE: NYSE), Merck & CO. (MRK: NYSE), and Eli Lilly (LLY: NYSE).
Consumer products include Colgate Palmolive (CL: NYSE), Mondeles (MDLZ: NYSE), Proctor & Gamble (PG: NYSE), and Unilever (UL: NYSE).
To understand its chart, Viridian explained that the capital intensity of each group (depicted by the green bar) is measured by its aggregate next 12-month consensus revenue estimates divided by aggregate capital employed (book equity + total debt –cash). In other words, the lower the bar, the more capital the industry needs to generate $1 in sales.
“The capital intensity issue is a big one for cannabis,” Viridian analyst Frank Colombo said. “I suspect that some of the operators who have just finished big capex/acqs might argue that they are set up for years of growth without much need for additional capital but the uniformity of the numbers across the group argues differently. I have also used forward 12-month sales to account for this. The idea is that your capital comes ahead of your sales.”
Granted, most cannabis companies were likely aware of this fact, but now there’s proof. Much of the problem can be tied to the status of cannabis as a federally illegal product. The MSOs represented in the chart have multiple overlapping operations because their products can’t cross state lines. This duplication of operations leads to inefficient businesses that end up spending more money than their peers on the legal side of the equation.
However, if cannabis gets rescheduled or fully legalized at the federal level, then those costs will likely come down. MSOs could potentially centralize operations to save money and duplicated roles could be eliminated.
“The good news, as I tried to point out, is that when and if interstate commerce happens it will help this issue significantly,” added Colombo. “The ability to reorganize activities on a national/international scale should allow some economies of scale from a capital point of view.”
Unfortunately, many cannabis companies are finding that the need to keep feeding the capital beast is crushing them. Huge debt bills are coming due and getting pushed out. Companies strapped for cash aren’t finding investors willing to take the risk.
“The capital shortage matched with capital intensity makes rapid growth impossible,” Colombo concluded.
The cannabis industry has been mired in a bear market for at least two years now. Challenges range from plunging prices for flower to excessive debt payments, and sales in mature markets have begun to plateau.
Many believed that the catalyst to turn things around would be the passing of banking legislation like the SAFE Act or even TerrAscend’s approved move to the Toronto Stock Exchange. However, it could be something as simple as 280e.
But as with most things in cannabis, even 280e isn’t simple.
Viridian Capital Advisors recently calculated that eliminating 280e would make a bigger difference than either the SAFE Act or a TSX uplisting.
As a refresher, Section 280e in the Internal Revenue Code forbids businesses from deducting otherwise ordinary business expenses from gross income associated with the “trafficking” of Schedule I or II substances, as defined by the Controlled Substances Act.
Most businesses can take tax deductions on various expenses which helps the company’s profitability, but not cannabis.
After analyzing 13 large MSOs, Viridian found that three companies with negative free cash flow (FCF) would have positive FCF without 280e. The adjustment also would more than double FCF for the five companies on the right side of the graph.
The adjustment would add approximately $700 million to the 2023 FCF of the companies reviewed.
The company collected consensus estimates of 2023 cash flow from operations and CAPEX for these companies to calculate FCF after the impact of paying 280e taxes but before any debt maturities. Six of the 13 companies have expected negative 2023 free cash flow.
Next Viridian calculated an adjustment to eliminate 280 taxes by calculating the amount of federal taxes levied on each company based on the 2023 consensus gross profit minus the taxes (if any) that would result from a tax imposed based on pretax profit.
The orange bars in the graph above show the adjustment. The green bars depict the FCF of each company after eliminating the impact of 280e.
Challenge of Ending 280e
Killing a tax code should be pretty simple, right? Congress could just make a change to the IRS.
Unfortunately, there doesn’t seem to be much political desire to go this route. The issue doesn’t drive voters to the polls and taking a stand on 280e won’t affect reelection.
Of course rescheduling to Schedule III of the CSA would immediately remove the tax issue, but as Viridian pointed out in its report, “Rescheduling to level 3 or below has its own issues, including introducing FDA oversight on a limited set of products and continuing state control over others. It will likely take years to draft and approve the necessary regulations and achieve coordination among the federal agencies involved.”
Since the country just celebrated Independence Day, Viridian felt it fitting to state, “Unlike in 1776, there is currently no rallying cry to eliminate ‘taxation without representation.’”
In consumer-related industries, companies often have debt instruments that get graded by companies like Moody’s or Standard & Poors. That hasn’t been the case for cannabis, but Viridian Capital Advisors recently set about the task of measuring various cannabis company credit scores.
The Viridian Credit Tracker said it utilizes 11 different bespoke credit ratios to evaluate four aspects of credit quality:
The company said it looks at the extreme quartiles of its ratios to identify credit stresses.
Despite the extreme capital stress in the overall industry right now, Viridian wrote, “Remarkably, the median free cash flow adjusted current ratio for the group is 1.07x, indicating that more than half of the group should be able to get through the next year without significant financing needs.”
According to Viridian’s Credit Tracker, the top five rated company, in order, are:
Green Thumb Industries
Planet 13 Holdings
Viridian stated that MariMed (OTC: MRMD) and Vext Science (OTC: VEXTF) pushed previous stalwarts Verano (OTC: VRNOF) and Curaleaf (OTC: CURLF) out of the top 5 to No. 6 and No. 7, respectively.
Company executives were keen to highlight their balance sheet strength in recent earning calls.
For example, GTI CFO Matt Faulkner said, “We ended the first quarter of the strong balance sheet, including cash of $185.4 million and working capital of $170.7 million, compared to $149.2 million a year ago. At quarter end, we had $277.8 million in debt with the majority being the $250 million of senior notes at 7% due in April of 2025.”
Planet 13’s profitability score wasn’t as strong as the others in the top five, yet it was number one for liquidity ranking. The company had a cash balance of $42.7 million and no debt at the end of March 2023.
MariMed continues to impress its peers in the industry as the company keeps getting stronger. “We continue to execute on our plan to improve efficiencies, and we were pleased to report a sequential improvement in our non-GAAP gross margins of 100 basis points and a 58% increase in our adjusted EBITDA. Our balance sheet remains conservatively leveraged and our ability to generate positive cash flows from operations remains a core strength of the company,” CFO Susan Villare said in MariMed’s recent earnings announcement.
Vext Science is quite small when compared to other players on the list, include Trulieve, which hit the list below Vext. During the company’s latest earnings call, Vext CFO Stephan Bankosz noted that the company expects “improvement in cash flow moving forward as the Ohio operations continue to come online and are consolidated and we see the working capital normalize.”
In addition to the Ohio changes, Vext has no significant capital expenditures planned for 2023. Vext ended its latest quarter on March 31 with $3.4 million, which it says is “adequate to execute our business plans.”
Those positive thoughts, however, were tempered by the reality of liquidity challenges, with the lower quartile suggesting that more than a quarter of the companies tracked by Viridian are experiencing significant liquidity issues.
The firm believes that the options for these companies are painful:
Sell at low valuations
Issue dilutive equity
Take on more debt, often with strong equity kickers
“On the leverage front, the median total liabilities to market cap is now 3.28x, and the median debt/market cap (not shown) is about 2.6x,” the credit tracker report noted. “Our analysis has shown that 3.0x is difficult to sustain in a 280E environment, so we are not yet there as a group. However, the upper quartile is over this level at a debt/market cap of 3.43x.”
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