CVSI - Green Thumb: Best House In A Bad Neighborhood

2023-08-23 17:57:01 ET

Summary

• The state-driven trend of legalizing cannabis is encouraging, suggesting potential federal alignment. However, relying solely on this regulatory progress is risky due to bureaucratic delays.
• Investing in profitable cannabis companies like Green Thumb offers value in the interim, capitalizing on growth while awaiting broader legislative changes.
• Green Thumb boasts a robust balance sheet, with cash reserves that exceed yearly obligations and a manageable long-term debt ratio, setting it apart in the industry.

Investment Thesis

The cannabis industry is in its early stages, and selecting a clear winner amid the many contenders is a challenging feat. For those new to the sector's nuances, this terrain might seem overwhelming. However, understanding a few key challenges and markers can significantly enhance your chances of placing a bet on a potential leader:

Taxation Issues

Firstly, the '280E tax provision' poses a unique hurdle, restricting cannabis businesses from making common tax deductions, leading to steeper tax burdens. Regardless of profitability, cannabis companies have to pay taxes.

For example, despite reporting an operating loss of $163 million in 2022, Verano Holdings ( VRNOF ) paid $105 million in tax, bringing its net loss deeper into the red to $268 million. Similarly, Curaleaf ( CURLF ) incurred a loss before tax of $226 million, only for tax provisions to decrease the net loss by another $150 million, bringing the 2022 net loss to $377 million.

The origin of the 280E tax code involves a drug trafficker in the early 1980s who tried to deduct his drug-related expenses from his tax returns. The Tax Court allowed some of these deductions, leading to a public outcry. In response, Congress introduced Section 280E in 1982, preventing businesses from deducting expenses linked to trafficking Schedule I and II controlled substances. This rule significantly impacts the legal cannabis industry, given its federal classification as a Schedule I drug.

Although Congress quickly created the 280E rule, its repeal today is moving slowly. This can be frustrating, as mirrored in the share prices of cannabis companies. However, this might be good news for long-term investors who can wait it out.

Banking Issues

The Federal prohibition of cannabis also brings many hurdles related to interstate shipping, packaging, and advertising, among others, limiting economies of scale. More importantly, the status of cannabis as an illegal substance alienates banks, limiting access to necessary funding. Those who find a lender are often faced with high interest rates.

To navigate this labyrinth and increase your odds of picking a promising contender in the cannabis industry, consider the following guideposts:

1. Solid Financial Position: Look for companies with a good balance between reserves and debt.
2. Consistent profitability: Spot businesses that have a track record of earning more than they spend
3. Strategic Vision: Choose businesses with a strategy that matches your risk/reward profile.

Among the long list of cannabis players, Green Thumb Industries ( GTBIF ) stands out with sound financial health, a fair history of profitability, and a relatively clear strategy to make them a compelling prospect. While no investment is without risk, especially in a fledgling industry, venturing into the cannabis sector with a discerning eye can offer promising returns.

Consistent Profitability

Navigating the cannabis market can sometimes feel overwhelming. There are the big teams, the undecided mid-caps, the underdogs, some akin to a seller offloading extras, and then there are the stars that shine in any group they're put in. Green Thumb is one such star, and here's how I've analyzed its performance.

First, I've compared Green Thumb side by side with its fellow big-league players - these are cannabis companies of comparable market size (at least $150 million in market cap). Out of this group, Green Thumb stands out as the only profitable company. This isn't a minor detail; it's a sign that Green Thumb is doing things right while others struggle.

Many companies highlight their 'adjusted EBITDA', which takes out some costs to make their financials look better. In reality, I believe only Green Thumb is genuinely creating value for those who've invested in them. Interest and tax are critical performance metrics at this stage, given that no one knows when the Senate will act on the 280E tax code or when access to equity markets will come back. So GAAP EBITDA isn't really the best measure to go by in my view and let's not get started on 'Adjusted' EBITDA.

If you're willing to take the risk and go beyond the big league and look at smaller cannabis companies, you'll find few that are profitable despite their size. For example, CV Sciences ( CVSI ), Leafly Holdings (LFLY), and Vext Science ( VEXTF ) are microcaps, with a market cap of $6 million, $14 million and $24 million, respectively, but are profitable on a GAAP basis. MariMed ( MRMD ) has a market cap of $100 million, which is fair but pales against Green Thumb, which enjoys a market cap of $1.6 billion on $1 billion TTM Sales.

Thus, out of the few cannabis companies making money, only Green Thumb has a big enough operation to catch my eye. For me, it's the top pick in this industry.

Solid Financial Position

For any company, a robust balance sheet is a safety net to help weather tough times, whether in the form of a new competitor, technological change, or economic downturns. In the cannabis sector, the stakes are higher. This industry is in its early stages, rapidly changing and, faces unique challenges. Traditional banks often avoid the cannabis space, making borrowing costly. Given this, one would expect cannabis companies to prioritize financial security. But surprisingly, many don't.

Of the fifty publicly traded cannabis companies, 33 don't have cash to cover their obligations for the next year. It's alarming, especially when prominent players are among those at risk. Curaleaf Holding, for instance, has a quick ratio of just 0.26 and a current ratio of 0.9. Verano's has a quick ratio of 0.38 and a current ratio of 0.9. Interestingly, out of the elite list of profitable cannabis companies, only Leafly and Green Thumb have a quick ratio of more than 1x.

In terms of long-term leverage, Green Thumb seems to have its house in order. Their long-term debt isn't too high compared to their size. Specifically, only 14.5% of their capital comes from long-term debt. This is fair when compared to Canopy Growth ( CGC ) 55%, ((MRMD)) 39%, ((CURLF)) 33%, and Trulieve ( TCNNF ) (31%). On the other side of the spectrum, you see Cresco Labs ( CRLBF ) and Planet 13 ( PLNHF ) taking a conservative approach to balance sheet management, holding no debt on their balance sheets.

Summary

The cannabis industry is still young and full of potential. For new investors, figuring out the best company to back can be overwhelming. But here's a simple pitch: while nearly all the industry is struggling, Green Thumb Industries is showing promise. They're one of the few actually making money. They shine even brighter when stacked against other big players, being the only ones profitable in this league. This, combined with their decent growth and solid financial position, make GTI an appealing prospect to gain exposure to the fast-growing state-regulated cannabis sector in my view.

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