HHS - Impact Of 280E On MSO Income And Cash Flow

2023-09-04 12:52:11 ET

Summary

• MSO investors have been eviscerated by catastrophic percentage declines in their stock prices since 2021.
• On Wednesday, August 30, Bloomberg reported the U.S. Department of Health and Human Services "HHS" sent a letter to the DEA recommending that cannabis be moved to Schedule III.
• MSO prices soared once HHS confirmed it had indeed recommended rescheduling of cannabis.
• Moving cannabis to Schedule III is expected to remove IRC Section 280E which disallows most MSO expense deductions.
• Removal of 280E is expected to make MSOs profitable and cash flow positive.

Introduction

Suffering MSO investors who were lured by a belief that cannabis was a once in a lifetime opportunity to achieve great wealth finally got some good news this past week. The U.S. Department of Health and Human Services ((HHS)) on Wednesday, August 30, formally recommended that the Drug Enforcement Administration ((DEA)) ease restrictions on marijuana by moving it to Schedule III from Schedule I of the Controlled Substances Act ((CSA)). The HHS recommendation came 11 months after President Joseph Biden directed it to conduct a review of marijuana.

Under Schedule I, the IRS prohibited cannabis touching companies from deducting numerous expenses and caused MSOs to have effective tax rates well above 50%. In fact, most MSOs experienced large federal income tax bills even though they were reporting significant losses. Observers believe moving marijuana from Schedule I to III will remove the yoke of 280E by allowing MSO companies to deduct expenses in calculating taxes just like other companies.

It is important to realize that the DEA is not bound by any HHS recommendation. Furthermore, the DEA follows a time-consuming rule-making process when it schedules, deschedules, or reschedules a drug. DEA's process includes posting any proposed rule in the Federal Register then allowing time for public comment. During the public comment period, interested persons can request hearings.

This article measures the impact that 280E had on the net income after taxes ((NIAT)) and free cash flow ((FCF)) of 12 of the largest public MSO companies in 2022. These 12 were selected because of their size and the fact that each disclosed the dollar impact of 280E in their audited financial reports for the year ended December 31, 2022.

MSO Investor Pain

MSO investors would love to see their stocks return to the halcyon days that prevailed in early 2021 when all-time intraday highs were set. Lofty MSO prices were reached when Democrats gained control of the U.S. Senate, because investors believed that would usher in favorable cannabis legislation. Investor optimism turned into a trail of tears as cannabis investors were played by politicians.

Exhibit 1 shows the all-time intraday prices, which were mostly set in February 2021, and the percentage declines experienced from those highs through August 25, 2023. MSO investor pain is evident in the huge percentage declines shown from all-time highs to the closing prices on the Friday before the HHS announcement. Ayr Wellness ( AYRWF ) shareholders suffered the greatest loss as that stock fell 97.9% from its all-time high, while Goodness Growth ( GDNSF ) fell 97.4%, Ascend Wellness ( AAWH ) 96.9%, Jushi ( JUSHF ) 96.0%, 4Front ( FFNTF ) 94.9%, Columbia Care ( CCHWF ) 94.8%, Cresco Labs ( CRLBF ) 94.0%, Trulieve ( TCNNF) 93.4%, Verano ( VRNOF ) 90.6%, TerrAscend ( TSNDF ) 90.1%, Curaleaf ( CURLF ) 84.2%, and Green Thumb ( GTBIF ) 82.6%.

It is worth noting that in the seven-day period preceding the HHS announcement, seven of the 12 MSOs (Ascend Wellness, 4Front, Goodness Growth, Jushi, Trulieve, and Verano) all traded at all-time intraday lows as shown in Exhibit 1. The percentage declines and all-time lows recorded by MSO stocks have eviscerated a legion of investors.

MSO Prices React To HHS Announcement

MSO investors have been starving for a catalyst that would reverse the persistent decline in their share prices. The HHS announcement is considered to be that catalyst; and, it was met by an enthusiastic investor response.

MSO prices spiked higher around noon on Wednesday, August 30, when Bloomberg reported HHS had sent a letter to the DEA. That letter was confirmed by HHS officials after the market closed. News of the HHS action spread rapidly on social media and set the stage for MSO prices to march dramatically higher on Thursday, August 31. Most MSO prices peaked around noon on Thursday and tended to hold at higher levels through the close on Friday, September 1.

Exhibit 2 compares MSO prices for the week ending September 1 versus the prior week ending August 25 and shows the dramatic price increases. Ayr Wellness stockholders enjoyed the greatest weekly gain of 84.9% followed by Columbia Care 83.6%, Jushi 75.2%, Goodness Growth 71.9%, Trulieve 62.4%, Cresco 58.1%, Ascend 57.5, 4Front 57.1%, Verano 42.6%, Green Thumb 39.9%, Curaleaf 32.4%, and TerrAscend 25.5%. The largest percentage gains for the week were recorded by the smaller MSOs.

The huge returns enjoyed by MSO investors for the week ending September 1 dwarfed the returns observed in the overall market. The S&P 500 was up 2.5%, NASDAQ 3.2%, and the Russell 3.6% during the same period.

Financial Impact Of Schedule III Classification

Aside from full legalization, the removal of 280E has been viewed as the catalyst most needed by MSOs. It is generally believed that once MSOs are treated the same as other companies by the IRS, and allowed to deduct all expenses, they will become very profitable, generate free cash flow, and be able to satisfy maturing debts.

Exhibit 3 shows the net income after taxes and free cash flow for 2022 reported by each of the 12 MSOs. Free cash flow was calculated by adding net purchases of property, plant, and equipment to net cash generated from operating activities after taking into consideration payment/nonpayment of income taxes. All data were obtained from 2022 audited financial reports filed with the SEC and/or SEDAR.

Actual Net Income With 280E

Exhibit 3 shows that Green Thumb ( GTBIF ) is the only MSO that reported a profit in 2022. Its NIAT of $11.978 million equated to earnings per share "EPS" of $0.05.

Losses at the other 11 MSOs totaled $2.537 billion. Columbia Care's loss of $416.005 million was the largest, while Schwazze's $26.270 million loss was the smallest.

Actual Free Cash Flow With 280E

Exhibit 3 shows all 12 MSOs had negative free cash flow in 2022. Trulieve's negative FCF of $183.131 million was the largest, while 4Front's negative free cash flow of $6.275 million was the smallest.

Negative free cash flow for all 12 MSOs totaled $1.186 billion.

Actual Cost Of 280E

Exhibit 3 shows the reported cost of 280E for each MSO. These amounts were reported in the notes that accompanied audited financial statements. In absolute terms in 2022, Trulieve bore the largest cost at $137.413 million, while Goodness Growth shouldered the smallest cost at $10.231 million.

The cost of 280E to all 12 MSOs totaled $672.344 million. If 280E did not exist in 2022, the aforementioned amounts would have flowed into net income after taxes.

Impact Of 280E On Net Income

Exhibit 3 shows what the NIAT and FCF would have been in 2022 for each of the 12 MSOs if they had not been subject to 280E. Interestingly, Green Thumb would have remained the only one to show a profit. The other 11 MSOs would have still reported net losses after taxes.

Green Thumb's profit without 280E in 2022 would have been $52.848 million. It had 238 million fully diluted, weighted shares outstanding in 2022; therefore, its earnings per share "EPS" would have been $0.22. Its stock ended 2022 trading at $8.64, so it theoretically had a price earnings ratio "PE" of 39.

Impact Of 280E On Free Cash Flow

If 280E did not exist in 2022, four of the 12 MSOs that reported negative free cash would have been able to report positive free cash flow. Those four MSOs were Green Thumb, 4Front, Planet 13, and Schwazze.

Conclusion

This article shows that most MSOs lost money and bled cash in 2022 with 280E. Importantly, it shows the non-existence of 280E would not have made these MSOs immensely profitable nor would it have enabled them to generate huge free cash flows. This article calls attention to the fact that action by the DEA on the HHS recommendation will take time.

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