The author of a year-end letter to cannabis investors expects smaller cannabis companies to have an easier path than multistate operators going forward.
The letter came from the Bengal Catalyst Fund run by Bengal Capital, which outperformed the cannabis ETF MSOS by more than 2,100 basis points in 2022 and 2,500 basis points since inception – confirming its bona fide to comment on the industry.
Bengal questions the long-term performance of the large MSOs, noting, “Large MSOs often did not become large by being great cannabis growers, processors, and/or sellers, but instead good raisers of money and license applicants – which made sense for early cannabis.”
The authors said that the cost for these MSOs to package and distribute cannabis is more than $1,000 per pound, while smaller, more efficient operators can do the same for $500 a pound. The letter also points out that when faced with strategic decisions, MSOs tended to opt for the immediacy of more production and more sales versus trying to cut costs.
That strategy worked while prices stayed high in emerging market states, especially since MSOs tended to have that early market advantage. However, these markets have matured and many have expanded their licenses adding to more competition. Add falling prices to that equation, and the advantage evaporates.
“Many MSOs were not built to turn a profit when pricing becomes even mildly competitive, and the problem has only been exacerbated with their balance sheet choices,” Bengal Capital wrote.
The report highlighted the decision to use REIT financing, where companies sell real estate assets and then agree to lease the property back with rapidly rising rents. One example in the report explains that if a company borrowed $50 million from Innovative Industrial Properties (NYSE: IIPR) at 15% interest, it would need a profit of $7.5 million to pay back IIPR – and that’s before rent payments. This was easy in the salad days, but as the prices fall and the rent rises, watch out.
The report goes on to suggest that these large cultivation facilities built by MSOs don’t necessarily result in lower costs and that quality is harder to control in a large facility.
Bengal Capital also questioned how the large MSOs have spent money on acquisitions. It pointed to Curaleaf (OTC: CURLF) likely having spent $100 million on its West Coast businesses only to shut them all down. The company was essentially spending $2 for every $1 dollar that was coming in and suggesting that was just how the market dynamics were working.
At the same time, Bengal Capital points out that Grown Rogue in Oregon doesn’t seem to be facing the same problems Curaleaf cites.
“We see investors running for the door and large MSOs running into significant business issues. We see unloved, high-quality cannabis companies that are grinding away almost completely ignored,” Bengal wrote.
Small Cap Focus
The company points to the beer industry as a comparison. Craft beer accounts for only 13% of industry volume, but it makes up 26% of the revenue. The letter made it clear that these aren’t stock recommendations and calls the group its “Scrappy Operator Club.” They include:
- Grown Rogue (OTC: GRUSF), craft cannabis in Oregon
- Urban-Gro Inc. (Nasdaq: UGRO), cannabis facility operator
- XS Financial (OTC: XSLF), cannabis specialty finance focused on equipment leasing
- Body & Mind (OTC: BMMJ) cannabis operations in Arkansas, California, Nevada, and Ohio.
Bengal disclosed that it put together a special purpose vehicle investment of $3 million convertible debt in Body & Mind, with just over $1 million from a side pocket of the fund.
Bengal said that it once believed in the large MSO story. The company now believes it will see better returns by focusing on high-quality, smaller, and overlooked companies. While some MSOs will do well, Bengal thinks it will be harder to reliably predict their performance.