CA - Reasons To Be Cautiously Optimistic About Cannabis

2023-10-16 10:00:00 ET

Summary

• Cautious optimism is warranted in the cannabis industry due to potential changes, such as the move to federal legalization and improved fundamentals.
• Investors should consider their risk appetite, timeframes, and political catalysts when choosing cannabis companies to invest in.
• Unpacking cannabis ETFs and thoughts on M&A.

Listen below or on the go via Apple Podcasts or Spotify .

Jesse Redmond on why it makes sense to be cautiously optimistic about the cannabis industry (0:55), investors' risk appetites, timeframes and political catalysts (2:40). Will will see M&A in the space? (7:40) Unpacking cannabis ETFs (14:25). This is an abridged conversation from Seeking Alpha's recent Cannabis Investing Podcast.

Transcript

Jesse Redmond: I think it's okay to be bullish right now. And I think it's okay to also just be cautiously optimistic . We've been through a lot of pain.

Rena, I started my investment career right around 1997, and I was at Fisher Investments during the NASDAQ bear market, and that bear market felt like it never was going to end and it was 929 days. Guess what? The ( MSOS ) drawdown lasted 931 days.

And so there's some quote about history doesn't repeat itself, but it often rhymes. And so even having gone through that NASDAQ experience in that painful bear market, I was also managing a hedge fund during the great financial crisis in 2008. So I've been through some pain before, but the duration -- the 931 days and the magnitude of the drawdown, 92%, was a really tough thing to deal with.

But on the other side of that, there's typically a lot of opportunity . Typically when things have gone down a lot, there is a lot of opportunity on the other side.

And I think that could be especially true here because things are actually -- I shouldn't say that, there's evidence that things may be significantly changing. Like before we were getting excited about SAFE Banking , which I still think is important.

But this move to Schedule III is by far and away the single biggest thing that could happen to the cannabis industry because we get rid of 280E. And I think if you combine, we think about cannabis being a state led growth story with a series of hard to time political catalysts , that's always been our thesis on it. And I think we're starting to see those two pieces come together .

I think the fundamentals are improving, there's some opportunity for new states to open. And if you pair that with the potential for one, possibly even two political catalysts, I think there could be a lot of opportunity in the space moving forward.

Rena Sherbill: Okay. So, what companies -- you mentioned kind of the broad strokes of what you're focused on or what investors should be focused on. What exactly does that look like? And I'm also interested in what metrics you're using.

JR : So, I think the kind of companies you want to own probably depends on your risk appetite, number one. Your timeframe , number two. And number three is, how quickly do you think these political catalysts are going to happen?

So if you look off of the bottom Rena, or since August 30th. So, if you look at ( MSOS ) and this is on September 12th, so this could change -- this will change by the time the episode comes out. You have MSOS up about 70%, you have Ayr ( OTCQX:AYRWF ) which was having a really tough year, up 230%. You have Columbia Care ( CCHWF ) up 190%, and then you have Canopy Growth ( CGC ) up 300%.

So if you are a more speculative trader, I would focus on those things that have gone down the most, those things that have a lot of short interests and those things that will benefit most from removing 280E . So businesses that really need that additional cash flow, businesses that might have a higher debt load that are looking to do some refinancing. And again, Columbia Care was really heavily shorted into this rally. And I think that's the reason it's gone up a lot.

I built something, Rena, called the cannabis cash flow portfolio. And what that does is, it takes the eight operators that in 2022 had tax adjusted operational cash flow. And so that means cash flow from operations than accounting for if they were paying their taxes, and I built that as kind of a proxy for quality to see how that was doing this year against MSOS.

We lack proper benchmarks in the cannabis industry. So MSOS is an ETF, but it's also often used as a proxy or a benchmark. And so coming into this event, coming into August 30th, the cannabis cash flow portfolio was outperforming MSOS by 20%.

And so these were generally a little bit smaller companies, but you had GTI ( GTBIF ) there, you had MariMed ( OTCQX:MRMD ), you also had smaller companies like Grown Rogue ( OTCPK:GRUSF ), C21 ( OTCQX:CXXIF ). There were eight different names there, but this higher quality cash flow portfolio was out-performing during the downturn. And that's fairly common. Stocks perceived as higher quality tend to do better and hold up better in a bear market.

However, this has completely shifted since the bounce, and over this last two weeks now it has underperformed by 32%. And so this is common, not just within cannabis, but across different sectors and even looking at that NASDAQ bear market that ended in the early 2000s. It was a smaller, more beat up names that bounced most off of the bottom.

So here we are in the year where what worked for most of the year reversed and the factors that mattered are completely different. And so I think what I would be inclined to do, Rena, is still focus on the higher quality names.

Examples of those are someone like Green Thumb Industries ( OTCQX:GTBIF ), I think continues to be the class of the cannabis sector. MariMed, which is a name we cover, I think is excellent as well, strong balance sheet, excellent revenue growth, seasoned management team.

And so I think long-term, I would focus on those higher quality names that aren't as reliant on debt markets that have leverage into new states that are opening. However, if you are a more speculative trader, there still could be opportunities in the names like your Ayrs and your Columbia Cares which were down so much coming into this.

One thing I would caution investors about is, owning Canadian stocks, and that's not to say there aren't quality Canadian names, there absolutely are. But if you think about what 280E removal means that applies to U.S. plant touching operators.

So while you may see these other businesses benefit, and ancillary companies fall a bit into that category as well, I think it's the ones on the OTC, the ones that are plant touching, the ones that could potentially uplist down the road as well, that have the most leverage to this type of move.

And so we've -- ancillaries haven't participated as much in this rally. And I think that makes sense. They're not subject to this 280E, they could benefit because the people that generally use their services are these plant touching operators and as their businesses get healthier, they will have more money to spend on these ancillary services.

So I'm not bearish on ancillaries. I'm not even bearish on Canada, and I'm not against diversifying a portion of your portfolio into those types of things. But I would put the emphasis on high quality U.S. plant touching operators.

RS : Do you feel like M&A is going to keep -- not keep, is going to pick up, a) with this news maybe if some catalysts develop, what are your thoughts on M&A kind of going into this new year?

JR : Yeah, I think we will see more M&A, I think maybe some smaller operators getting acquired by larger operators. When you look at the larger operators, the challenge is the overlapping assets. And so most states have a cap on the number of stores that one operator can own. So New Jersey, that's just three. In Maryland, it's four. In Illinois, it's 10, which gives you a little more flexibility.

But let's say you have two operators that both have three stores in New Jersey and they want to merge or do an acquisition, they need to figure out who they're going to sell those other three stores to. Now in New Jersey, that may not be as hard of a market to sell assets just because it's been so profitable. But there are real challenges in divesting those overlapping assets.

And so I've always thought that Trulieve ( OTCQX:TCNNF ) and Ascend are pretty complementary businesses. There's not a ton of overlapping assets there. Ascend ( AAWH ) is not in Florida or Arizona. And Trulieve doesn't have New Jersey, which is big for Ascend. And so I think that those types of businesses, I think there are some opportunities to fit those puzzle pieces together. But I think in order to do so, you kind of need to look at the map of the States and figure out which ones could fit together. And then also say what happens with the management teams.

For example, if you were to have Ascend and Trulieve merge, I don't think Kim is looking to retire. I think she's probably looking to lead the business. So you would need a structure where those two management teams could fit together. So I think that with the bigger operators, there's more challenges on a couple of levels to getting those sorts of things done.

But I wouldn't be surprised to see smaller businesses get acquired by larger ones. It’s not a great example, but last week we did see the acquisition of VidaCann by Planet 13 ( OTCQX:PLNH ) to build out their Florida footprint. And so it won’t be a surprise to see more of those things.

RS : Do you still feel like it's a possibility, Trulieve acquiring Ascend? I mean, I guess maybe you do. It sounds like. Because I was asking Ascend's Interim-CEO a few months ago about it.

It's been -- you've been talking about it for a while. It's been talked about for a while and I wonder with the acquisition of Harvest, which, you know, who knows how to judge that exactly at this point, but certainly not an easy process. Do you think that that's still a possibility?

JR : I think it's a possibility. I wouldn't really assign a high probability to it. And I don't have any unique information around that. I just think in terms of when you think about those couple of factors about little overlapping assets and the potential for one management team to lead and the other one to be integrated. I think those fit together. Potentially a bit more to Ascend, although they just did -- they just -- especially when they didn't have a CEO, right?

When Abner moved to Executive Chairman, they were in a CEO search for around nine months maybe? And they do have a great new CEO. So maybe the probability of that has gone down even further. So I'm not pounding the table bullish on that. I just think if you look at the top 10, those are a couple of pieces that do fit together, but I wouldn't give that a real high probability.

Ascend is -- that stock is one of the ones that’s more than doubled over this past couple of weeks. It was way oversold for a while there. So that's a name that I've been forever too bullish on. I've liked that name for a long time.

It doesn't get a lot of love. It doesn't get a lot of attention. But I think with the footprint they have and some of the changes they're making, I do like that name.

RS : And what about Trulieve ? People are talking about its reliance on Florida and it's going to come to bite them, and what's happening with Harvest, and what are your thoughts on Trulieve?

JR : So I think they're in a tougher period where if you just look at their footprint, competition is fierce in Florida. Florida is, I'm sure most of our listeners know, is a medical-only market. It requires being vertically integrated.

There are a limited number of operators there, but there are a lot of stores and so your Ayrs, your Trulieves, your Veranos ( OTCQX:VRNOF ), et cetera, have 50, 60,70, 80 stores in Florida. So there are a lot of stores and what that leads to is a lot of price competition.

And we've seen that, we've seen that in terms of basket sizes going down, constant promotions in Florida, lower - margins coming down in a lot of cases. And so, I think Florida is still a good market and as long as it's medical, but I think the real massive opportunity is one that potentially flips rec.

Arizona is a different state. Similar challenges in terms of price compression, but for different reasons. I don't know if you know this Rena, but Arizona doesn't have seed to sale tracking. And so that means you can grow a bunch of weed in Oklahoma and bring it to Arizona and find creative ways to fit that into the system. And so that's led to a massive oversupply in Arizona and prices dropped about 50% over 12 months. And so, I think that acquisition of Harvest, you know in a hindsight's 2020. But I think in hindsight, that probably wasn't great timing and they overpaid for that.

So I think Trulieve is in the core markets today and those will change a little bit as new states turn on. But I think that the core markets today with Florida and Arizona are in a bit of transition periods. But no one is more levered to the potential shift to adult-use in Florida than Trulieve. I mentioned that Florida has about 22 million people and that's one of the states that's been growing in terms of the population, but it also gets 120 million tourists every year, with the medical system those tourists can't buy cannabis.

But if they flip to adult-use anyone over 21, that's a snowbird coming down from where we're from Rena in the Midwest. I know lots of people from Minnesota that go down there, but also the spring breakers. If you're over 21, they could buy cannabis. And the cruise ships is another interesting one. Sunburn has a great location. I think they acquired it from MedMen ( OTCQB:MMNFF ) in Key West. And when you walk off with the cruise ships docked there, one of the first things you see is that store.

And so I think Arizona -- I think rather Florida is a super exciting market. The question is, when does that potentially turn to adult-use? And is that - possibly we see that on the ballot in 2024 and if that were to get on the ballot and ultimately pass, that would be a massive catalyst for Trulieve. And Trulieve has been one of the more beat up names coming into this that had gotten fairly cheap.

And so I think to have a perspective - if you're thinking about taking a hard look at Trulieve, I would look at what the valuation is there, and then I would look at what's your perspective on those core markets and particularly what do you think are the probabilities that adult-use gets on the ballot in 2024 in Florida, and ultimately passes.

RS : I'm curious, you mentioned MSOS as an ETF and as a proxy index. What are your thoughts about the ETF space ? There's a lot of negativity around MSOS and how they're set up, and how they're set up to continue.

And in general, the surrounding ETFs, a lot of complaints around their very existence, some not in existence anymore. What are your thoughts about the ETF space in cannabis ?

JR : Yeah, I feel like that's a lot of that angst and complaining is really misguided. MSOS is a great proxy for U.S. cannabis . And if you can't buy the individual names and you need something that's NYSE listed, which is true for a lot of investors, if you can't access things that are on the OTC, you may not be able to get them in your brokerage firm.

You may have custody issues with those types of names and you want exposure to U.S. cannabis, I think MSOS is a perfectly fine way to do that. It's going to be more expensive because they do use swaps and swaps have financing costs. And so it's a more expensive way to get access. It does have a management fee. I think it's right around 75 basis points all in.

So if there is an additional cost there in terms of doing that versus owning the underlying, but in my opinion, it gives you fairly good exposure to U.S. cannabis. I don't think it's super clever. You don't see real active management moving around - it is actively managed, but you don't see short term trading there, you don't see market timing.

Here they definitely have made a few mistakes. Along the way, there's names that they've owned too much of, there's names maybe in hindsight they shouldn't have owned period. The Parent Company ( OTC:GRAM ) is one that stands out there. But we've all made mistakes along the way.

RS : Not me.

JR : Yeah, I know Rena.

RS : Just kidding.

JR : You would never own The Parent Company.

RS : I would never own The Parent Company. No.

JR : No. Yeah. And so, yeah. Yeah. Exactly. And there's names that they don't own. Like, it's super interestingly they don't own Ascend. That’s the only, I think, top-20-ish name that they don't own and certainly the only top 10 they don't own. So I think we could have different opinions on how we might go about running an ETF like MSOS. But if you want exposure to U.S. cannabis, I don't think that's a terrible way to go and I don't fully understand all the complaining around that.

There are other options. Our friends at Poseidon did close down PSDN and that was my favorite cannabis ETF. So that's not available anymore. You do have Tim Seymour who I think is a bright player in the space with ( CNBS ). If you want global exposure through AdvisorShares, you have ( YOLO ). There’s the – ( WEED ) has good exposure to the top five names. So that's another credible option. So there's a bunch of different ones out there.

I would probably start by deciding, do you want exposure to global, or do you want exposure to U.S.-only. If you want exposure to U.S.-only, then MSOS, or the ticker WEED are probably good ways to do that. If you want to get some Canadian exposure, some more global names in that kind of portfolio, then maybe a CNBS or YOLO would be a better fit.

But I think part of the complaining, Rena, is that when a space is down 90% who's going to get super excited about the ETFs in the space? And so I feel like there may be a little bit of collateral damage for what's going on more broadly.

And I guess my closing thoughts, Rena, would be just going back to where we started, where cannabis is a state-led growth story with a series of hard to time political catalysts. And we went through a really hard period and I think for valid reasons, we went through a hard period.

Prices were coming down. We didn't have a lot of new states opening and we were seeing zero political progress. And that led to 931 days of pain and a 92% drawdown.

And I think there's reasons to be cautiously optimistic. It feels like things are starting to improve. Going back to the beginning with Morgan Paxhia saying, it's okay to be bullish. I agree with his sentiments and I'm excited to see what takes place in the second half of the year.

RS : Absolutely. Amen. Here's to better news. And anybody wanting to know more about cannabis investing, definitely search Jesse out either on Water Tower Research, or on Twitter . You won't regret it. He's got some great analysis. Really appreciate you, Jesse. Thanks for coming on and talk to you soon.

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