ACRDF - AFC Gamma: Top Borrower Acreage Fades Distributable Earnings Dip

2023-10-03 08:59:12 ET

Summary

• AFC Gamma's distributable earnings were only 1 cent above its recently rightsized quarterly dividend.
• The cannabis lender's portfolio is highly concentrated in just thirteen companies, with Acreage being its largest borrower.
• A continued decline in distributable earnings could see the current dividend rightsized again.

It's not hard to be bearish on cannabis tickers. The industry has been hamstrung and goose-stepped to intense capital loss from a burdensome tax and regulatory regime across the US states where it is legalized for recreational and/or medical use. AFC Gamma (AFCG) fills a critical niche as a provider of capital to a sector that's still broadly barred from accessing standard banking services due to the status of cannabis as a Schedule I substance. The mortgage REIT's credit portfolio as of 4 August 2023 had a $400.5 million principal balance but was only spread across 13 companies. The largest individual position was a $84 million loan to the subsidiary of an unnamed public company, most likely Acreage Holdings (ACRHF), which accounts for roughly 21% of AFC's principal balance.

To be clear, AFC does not actively disclose its borrowers with a search for Acreage on its recent fiscal 2023 third quarter Form 10-Q pulling up nothing and with the Acreage obfuscated in its second-quarter earnings presentation. However, AFC and another lender did extend a $100 million senior secured credit facility to Acreage on 16 December 2021 which matches up with the original date of funding on their second quarter presentation. AFC committed around 60% of this initial credit facility and would have committed more funds since Acreage's principal balance stands at $84 million. The mREIT last declared a quarterly cash dividend of $0.48 per share , in line with its prior payment and for a 16.4% annualized forward dividend yield. Whilst the earlier 14.3% dividend reduction broke with what had been five consecutive hikes since the IPO, the yield has moved back up on the back of commons that have dipped by around 9.8% since then.

Show Me The Dividend

The fat yield is enticing, but it's this high precisely because of how precarious it is as the headwinds facing the US cannabis sector are not in any way transient but a seemingly perpetual feature of a market that has so far failed to live up to the cannabis dream. This is now set against a dwindling legion of retail investors who embraced the hype of euphoria that followed the wave of cannabis legalization in 2018. Three things stick out from AFC's second quarter. The first is that gross interest income dipped 18.4% year-over-year to $17.68 million from $21.65 million. Further, the mREIT's interest expenses actually fell by $171,229 despite the period covered seeing the Fed funds rate rise markedly to sit just 25 basis points under its current 22-year high of 5.25% to 5.50%.

This was due to a balance sheet heavy on fixed-rate debt. The mREIT held a total debt balance of $87.7 million as of the end of its second quarter, this comprised a 5.75% senior unsecured note due in May 2027 that was issued in November 2021. Finally, the mREIT recorded a $1.6 million reversal of current expected credit losses due to the sale of two-thirds of a loan to private company I that was previously placed in foreclosure. The sale was to an unnamed multistate operator at par plus accrued interest, with AFC expecting a full recovery on the remaining one-third of the debt outstanding.

GAAP net income was $12.1 million, around $0.59 per share, which was a growth of roughly 2 cents over the year-ago period. Critically, distributable earnings at $9.9 million, around $0.49 per share, was a significant dip from distributable earnings of $0.69 per share in the year-ago period and barely covered the dividend. The downtrend of distributable earnings has come as a result of a fall in current commitments, with the mREIT simply not underwriting the volume of loans required to keep interest income coming in and only funded a $25 million loan to private company M after the end of the second quarter.

Acreage Poses Material Risk

AFC's outsized exposure to Acreage poses a significant level of risk. The MSO agreed to be bought by Canopy Growth (CGC) in 2019, but the closure of the deal has stalled since then, with Canopy simply not allowed to consummate its purchase as long as cannabis remains a Schedule I substance in the US. The initial merger saw Acreage come with a $3.4 billion price tag, but the MSO has seen its equity value, cash position, and merger prospects collapse since then. The situation is severe with Acreage having a cash and equivalents position of $16.4 million as of the end of its recent second quarter set against long-term debt of $224 million .

AFC's current 33% discount to book value per share of $16.64 as of the end of the second quarter needs to be contextualized against this. Acreage has less than two quarters of a cash runway left, as Canopy Growth faces a liquidity crisis of its own. Canopy's cash position is collapsing, and its BioSteel unit recently filed for Chapter 15 bankruptcy in the US. In light of the Acreage issue, AFC is to be avoided with continued pressure looming for distributable earnings.

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