MSOS - Finding The Long-Term Winners In The Cannabis Sector December 2023 Update

2023-12-04 20:43:48 ET

Summary

• This article attempts to assess and rank the relative growth potential of the separate competitors in the cannabis industry.
• Long-term trends show projected growth in the U.S., Canadian, and global cannabis industries, and it faces a rescheduling catalyst.
• The article filters through the top revenue-generating cannabis companies in the U.S. and Canada, and ranks them based on weighted analysis.
• This is a quarterly update to this article series.

Thesis

I have been watching the cannabis industry since the rally in early 2021, and believe the industry presents attractive investment opportunities. This is the third article in this series and a follow up to my last article . In this article series, I use weighted analysis to attempt to identify potential long-term compounders. With the industry still in constant flux, and new potential winners coming forth, I am forced to revisit the process every quarter.

Cannabis ETFs

With most of the industry saddled with capital intensive business models, I have chosen to try and build my own basket of companies consisting of only the most attractive potential compounders.

I am trying to select my own companies based on growth potential, and have been shying away from investing into the cannabis ETFs because I believe most of them contain unattractive companies. However, the entire industry faces a significant catalyst from both rescheduling and the passage of some form of the SAFE Banking Act . It was already announced that the DHHS believes it should be moved to schedule 3. We are still waiting on the findings of the DEA before the process can be completed. This means that the 280e tax obligation will be removed from U.S. operators, and the companies in the Canadian sector will finally be able to expand operations into the U.S. without having to delist from major exchanges.

These catalysts appear to be approaching, so I have changed my stance on the ETFs and have begun handing out Buy ratings on them. I recently detailed my new stance in an article I wrote about AdvisorShares Pure US Cannabis ETF ( MSOS ). These same industry-wide catalysts also affect AdvisorShares Pure Cannabis ETF ( YOLO ), ETFMG Alternative Harvest ETF ( MJ ), and all of the rest of the Cannabis ETFs.

Even though the entire industry faces the same catalysts, not all of the players involved are well positioned to outgrow their competition in a post rescheduling environment. I expect that all of the Cannabis ETFs will experience a significant rally when the news of rescheduling is announced. However, they also contain companies which I believe will not do well long-term, this is the primary factor leading to me attempting to select my own basket of potential winners.

The Plan

This means I will be filtering out companies which have been unable to grow revenue, and those which are not cash flow or EBITDA positive. I am also going to use Asset Turnover ratio to produce a rough estimate of their potential cost of expansion. The plan here is to use weighted analysis to rank the companies based on competitiveness as growth companies. I should be clear that these metrics change every quarter, so nature of this process is that it will produce a final list which is different every quarter.

Long-Term Trends

The United States cannabis industry is projected to have a CAGR of 14.2% through 2030. The Canadian cannabis industry is expected to experience a CAGR of 13.26% through 2027. Since Germany is also making progress toward recreational legalization, I am going to include its projected CAGR of 14.01% until 2027. Globally, CBD has a projected CAGR of 31.5% through 2031.

A Look At Margins And Growth In The U.S.

While cannabis is currently considered a Schedule-1 substance by the federal government, the U.S. sector is operating under the oppressive 280e tax obligation. This also means that none of the U.S. Multi-State Operators (MSOs) are permitted to move cannabis across state lines .

A majority of the states have not set up import protections for their local growers . When the federal rescheduling arrives and their restrictions to moving the commodity across state lines goes away, I expect for a price war to break out. As soon as they are allowed, I expect for producers in those states where cannabis is cheaper to attempt to undercut producers in the states where it is currently more expensive. So this is likely going to increase revenue for some companies while forcing both revenue and margins down for others.

Because I am focusing on recreational cannabis, I am intentionally filtering out companies which are merely ancillaries to the industry. This means Scotts Miracle-Gro ( SMG ), Innovative Industrial Properties ( IIPR ), iPower Inc. ( IPW ), and WM Technology ( MAPS ) are not in consideration. This also means I am attempting to filter out companies which focus only on pharmaceutical cannabis applications, so I will not be including Jazz Pharmaceuticals ( JAZZ ). All of these eliminated companies may be good investments, but I am only interested in searching for companies which may be able to establish themselves as major recreational players.

These are the 27 highest revenue recreational cannabis companies in the United States. They are shown ranked by Free Cash Flow Margin. As I am removing companies that have negative revenue growth or negative cash flow, a majority of these companies on this list will not make it to the next step.

A Look At Margins And Growth In Canada

Canada legalized recreational cannabis roughly 5 years ago and overproduction lead to a price war . Growers are forced to destroy product once it reaches expiration, so they end up dumping it onto the market in hopes of avoiding a complete loss. This has crushed margins across the sector, and forced many into bankruptcy .

These are the 12 companies in Canada with the most revenue. They are sorted by Free Cash Flow Margin. I am eliminating those which haven't experienced revenue growth or aren't free cash flow positive.

Estimating Growth Advantage

All of these companies are essentially competing for the same base of consumers. Thoroughly examining their cost of expansion by pouring through their earnings calls and 10-K's is beyond what I am willing to do, so I am instead using Asset Turnover Ratio to assess, in a very rough way, their cost of expansion. I need to clarify with all of you that Asset Turnover Ratio is absolutely not New Market Revenue/Cost of expansion. It is trailing revenue divided by current assets. Yet it does give us a clear indication that some of these companies have business models which allow for them to generate larger values for revenue using fewer assets. The companies with the highest Asset Turnover Ratio are likely to have lower cost of expansion.

Unfortunately, some of these companies are EBITDA negative. Because EBITDA is an important measure of profitability, I am removing them.

Here is the final list. These are the only companies in the industry which have been growing revenue over the last year, while experiencing both positive EBITDA and positive Cash Flow this most recent quarter. They are sorted by Asset Turnover Ratio.

I went into this in further detail in my last article in this series, but I am applying a 2x modifier to both the revenue growth values and the Asset Turnover Ratio. My goal is to combine all these metrics to achieve a rough measure of which companies are more likely to become long-term compounders, so I am applying additional weighting.

Just like what happened during the last one, I believe that a majority of these companies are going to use market offerings to raise cash during the next major industry wide rally. This means I am paying no attention to cash on hand, and am deemphasizing Free Cash Flow Margin. My justification is that those companies with the most competitive business models should be able to grow revenue and capture market share more easily than those which are less competitive. Those with more efficient business models should have higher Asset Turnover Ratios. This is meant to be a measure of long-term expansion potential. The column on the far right shows the final results.

I need to clarify that the metrics being used here are:

2(Revenue Growth)*(Free Cash Flow Margin)*2(Revenue/Assets).

Which roughly equates to:

2(Growth)*(Profitability)*2(Efficiency).

These are results of x2 YoY Revenue column, sorted from most to least:

So this quarter's final list is:

Nova Cannabis ( NVACF )

High Tide ( HITI )

Decibel Cannabis ( DBCCF )

Cansortium ( CNTMF )

Medicine Man Technologies ( SHWZ )

Glass House Brands ( GLASF )

Curaleaf ( CURLF )

Green Thumb ( GTBIF )

TerrAscend ( TSNDF )

Verano Holdings ( VRNOF )

Ayr Wellness ( AYRWF )

Conclusions

Clearly, some of these companies appear to have more potential than others. Notably, Glass House, High Tide, and Decibel Cannabis are standouts. These numbers will change every quarter, but these three companies all ranked well on my last analysis in August. Glass House is still in the top slot, and High Tide is still in second. Decibel moved from the 5th to 3rd.

This type on analysis is not thorough enough for picking actual investments, but it is an excellent place to start when deciding which companies are worth further research. I have already been writing about some of them, and have yet to get to others. Presently, my top pick for the entire industry is High Tide because of their how amazingly competitive their business model is, while my top pick for the United States is Green Thumb. Both companies have competent management which have already proven they understand the industry.

Also, after showing up near the top of the rankings two quarters in a row, I clearly need to do a deep dive on both Glass House Brands and Decibel Cannabis. This means you can expect articles from me about them in the not too distant future.

If any of you are finding that your favorite investments didn't make the cut this time around, don't worry. If they truly are attractive investments then they should make it onto the final list in future articles. I plan on publishing a new article in this series every quarter. With the next wave of earnings landing in early April, it will be about 5 months until the next installment.

What Am I Missing?

Because this process has me only reviewing the highest revenue companies in the industry, I believe it is likely there are diamonds in the rough that are simply too small to show up. If any of you have additional companies that show promise as long-term growth monsters, yet are presently too small to show up here, I invite you to make the rest of us aware of them down in the comments.

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