NLCP - Unlocking Cannabis: Legalization Timelines Debt Risk + Unique Value Plays With Alan Brochstein And Julian Lin

2023-09-13 11:00:00 ET

Summary

• Alan Brochstein And Julian Lin discuss the importance of navigating timelines and federal legalization headlines in cannabis investing.
• Preferring REITs and Canadian LPs over US operators due to factors such as debt concerns and valuation.
• The negative impact of debt on some major cannabis companies and properly valuing stocks.

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

Alan Brochstein and Julian Lin talk cannabis investing timelines and federal legalization headlines (1:40), preferring REITs and Canadian LPs to US operators (6:30), properly valuing stocks and debt concerns (12:00). This is an abridged version of our recent conversation, Cannabis Investing With Alan Brochstein & Julian Lin - REITs And Canadian LPs Over MSOs.

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Transcript

Rena Sherbill: One of the things that I wanted to ask, and we've definitely talked about this on the Cannabis Investing Podcast before is this notion, and it gets more convoluted probably every year, most definitely. This notion of timelines and in the investing timelines that investors have in the industry and how important it is to navigate where your investment is if you're not trading these stocks.

What would you say to investors at the end of August 2023, knowing what we know now and not knowing what we don't know, how, a, how important is it to pay attention to the federal legalization headlines?

I will say my opinion on that briefly. I feel like at this point, nobody knows what the hell they're talking about. I think everybody's proven that in terms of predicting things. I don't know whether or not the new election coming is going to provide some very positive sentiment for the industry.

I could see it going both ways, but I definitely wouldn't put your money betting on anything. And I would say that it doesn't make good use of our time as investors in the cannabis industry to predict when that is going to happen. I would say we have to navigate what's in front of us.

Having said that, a) do you agree with that sentiment? And, b) how would you advise investors to look at their timelines and what would you advise them based on their timelines to be looking at?

I know that you've mentioned a few stocks to be looking at in general. Based on timeline specifically, is there something to keep in mind unique to that?

Alan Brochstein: I'll go first. So I think you're a 100% on that people don't know what they're talking about. They'll say things like, oh, SAFE Banking is coming, and I'll say, who cares? SAFE Banking doesn't do anything really for the big public companies. It's good, and I'm all for it, but who's it help? The consumer and minority small businesses.

And so I would start off by saying, if you're investing in cannabis, you have to remember it's a big universe. It's not just the big American operators. And so, I think I do a pretty good job of covering both ancillaries and Canadian LPs. There are other sectors. I just don't care about right now. There's certain biotech companies and there’s CBD companies. So I don't mean to say that's the whole thing, but I’m finding a lot of very good values in deeply discounted debt-free cash-rich Canadian LPs.

And then on the ancillary side, I think, they don't pay 280E tax. And some of them don't have that much debt. I know I mentioned Hydrofarm ( HYFM ) has a lot of debt, but you can look at companies that have little or no debt. And so that's the first thing I would say.

So if you were to say, yeah, but I'm talking about American cannabis operators, what do you think there? And I would just say, I wrote for the New Cannabis Ventures Newsletter yesterday, it's very important to start looking at price to tangible book value. And I know that's a term that not that many investors even care about.

And if you're a growth investor, like most cannabis stock investors are, you may not even know that because it's really for growth investing, it's not really a good term. For deep value investing, it is.

But I think that, as Julian pointed to, the debt outstanding is a big problem. And if you're thinking about who's going to make it to the finish line, people with huge negative tangible book values and lots of debt do quickly or in trouble compared to those with lower amounts of debt, high tangible book value in a long time. And so, I think that that's what investors need to start looking at.

Julian Lin: I think, in terms of my views about predicting legalization , I think unless you're making predictions about it taking a long time, it's probably a hard thing to do for your portfolio.

I think that it – it's, I mean, it would have been great to say a couple of years ago, but, I mean, better late than never, it's probably better to position your portfolio, so that it could do well even if or especially if legalization takes a long time. The way these balance sheets are looking at a lot of these MSOs as I've said earlier, time is not your friend.

The more time goes on, the more mortgages get pressured. And I mean, really, these names are having – they're going to have to basically either issue debt or equity just to sustain current operations, pay down interest. Whereas it's I mean, yeah, I get that. It might be a little, quote sexier, to be buying these MSOs. But I am still of the view that the cannabis REITs , especially names like (NYSE: IIPR ) or my top pick, NewLake Capital Partners ( OTCQX:NLCP ) are arguably the best way to invest right now.

Just take, for example, NewLake Capital Partners. It's not going to have the same debt issues as the MSOs. In fact, NewLake Capital Partners has about $40 million of net cash, which if you are familiar with net lease REITs at all, you will know that that's pretty insane.

Typically, when you look at a name like Realty Income ( O ), Realty Income has debt-to-EBITDA in the 5.5x range, or maybe 5x range. In other words, if they're generating $500 million in EBITDA, they have like $2.5 billion in debt just sample numbers, and they have an A minus credit rating.

NewLake Capital has a net cash position, all right? So they don't – that I can't stress that enough that at the same time, they're not subject to 280E taxes. They're generating around 80% or higher free cash flow margins. That's the actual margin – that's GAAP margins to shareholders, and they're able to pay, use that to fund a 12% dividend yield.

And so, look, if in any situation where these MSOs survive. Forget thrive, they just survive, don't go bankrupt. They're still running a business. Shareholders do a capital. They're getting this huge dividend yield, it should keep growing because these lease escalators grow around 2.7% every year.

And growth could accelerate once the valuations picked up for the stock, they're able to issue stock and acquire more properties. But the idea is that the downside risk here is just in – it just like day and night compared to the MSOs, while still offering exposure to that upside. In fact, in my opinion, greater upside potential than the MSOs over the long-term.

RS: How would you articulate the downside risk? Because it would seem to me, I mean, and we've talked about NLCP and IIPR a bit on the show before on the Cannabis Investing Podcast . Are you worried about the tenants? Are you worried about the tenants' ability to survive, let alone thrive? And what else -- how else would you articulate the downside risk there?

JL: Of course, if it turns out, that selling cannabis legally in the United States turns out to be an unsustainable business model, then at some point, all of the tenants of NewLake Capital stop paying rent, they all go bust, however that looks. And at which point, that's not too great for shareholders of NewLake Capital.

But again, remember, they have no debt. They have $39 million, or $40 million in net cash. Just think about the worst-case scenarios, right? I guess, worst-case scenario, they just kind of have to sell off all their properties, you can go and get some recovery for these properties.

Again, there's – this is a net cash position. This doesn't become a zero, far from it, right? Basically, the only way you get to this apocalyptic scenario where they have to sell off all their properties is if you have the names like, Curaleaf ( CURLF ), Trulieve, Columbia Care ( OTCQX:CCHWF ), Green Thumb ( GTBIF ), these names have to go bust before NewLake Capital reaches that position where they have to sell off their properties and probably – sell out some discount and return the capital to shareholders.

That downside sounds pretty good to me. Obviously, it wouldn't be ideal if everyone goes bust, but whereas the MSOs, there are scenarios where they go to zero just if legalization takes too long or if they never pay down debt. With NewLake Capital, it's just not there.

AB: Yeah. I don't cover NewLake Capital on my focus list of 26 names, but I looked at it while you were talking. And in the past, I've been laughed at because I warn investors, it's OTC. It's not New York Stock Exchange or Nasdaq. And they're like, “Oh, what's that matter?” And I don't know that it matters that much except for the size of the investor base.

But I will say positively, what you pointed out is correct. They have a lot of cash and no debt or limited debt. They have a lot more cash. But I think more importantly for Rena, is it's trading below tangible book value. So it's already factoring in that they won't be able to get if they have to liquidate their assets. They won't be able to get full value, it's already factored in.

JL: Yeah, it's just kind of curious. I think the fact that ( OTCQX:NLCP ) trades at this 12% yield. And again, I need to be clear that not all cannabis REITs, I don't like all cannabis REITs. But that's why I'm specifically talking about NewLake Capital REIT properties, but I – the fact that the landlord is trading at these valuations, basically 7x real estate earnings. It illustrates just how pessimistic things are in the cannabis sector.

The way I view that is, the pessimism is not necessarily defined by how cheap the MSOs get. It's defined by how much the valuations overall are from reality. Just talking about, again, I'm not trying to hate on Curaleaf somewhat. I know we've talked a lot about Curaleaf.

But like the fact that Curaleaf is trading at around 9x EBITDA, whereas Green Thumb is trading at 6x EBITDA. That indicates how weird the sector is, given that Green Thumb has less debt it's profitable on a GAAP basis. Just the fact that valuations almost seem to not make sense. That is an indication of how pessimistic things are.

Yeah, again, with the case of NewLake Capital, I think it's being – it's like a baby thrown out with the bathwater. I think that investors, they don't want to look at the MSOs overall. Like the generalist is not looking at the cannabis sector just because they can't, or they just see the stocks going down. They don't want to.

And I think ironically, investors in the cannabis sector, they seem just so laser focused on the MSOs specifically just kind of wanted to keep hurting themselves. They don't – they're not even expanding their horizons to look at names that are super profitable with no debt.

What I would have been hoping for these management teams to be doing, which they haven't, although TerrAscend ( TSNDF ) ironically has been in terms of debt, is that, I was hoping they would be -- being more aggressive in terms of resolving their debt, even resorting to issuing equity to pay down debt.

And I realize how painful it sounds to be issuing equity after it's fallen this much to pay down debt. But at the same time, when you have something like a Trulieve ( OTCQX:TCNNF ), let’s talk about Trulieve , right?

Trulieve is trading around 4x adjusted EBITDA. That valuation is pretty low, but at the same time, because of how much debt and interest expenses they have, they're not really generating any cash flow, especially if you don't include the stock-based compensation. They're not generating real earnings for shareholders.

But again, 4x adjusted EBITDA. At the same time, if they were simply to issue the stock and pay down debt, that valuation 4x adjusted EBITDA does not get diluted, obviously the equity valuations in terms of price-to-sales or price-to-earnings will get diluted.

But would they? Because of 280E taxes, when you're paying down these debt, you're actually creating -- these are, like, double 20% yields, free cash flow yields on the debt after accounting for 280E taxes. I'm of the view that if these names had substantially less debt for generating real cash flow, even no matter how pessimistic you're on cannabis, they would not be trading at 4x EBITDA. Right now, the valuations here is not a custody issue, it's a debt issue.

AB: I agree. Julian, people are scared of the debt. And I happen to think that they're right to be scared, unfortunately. I hate to be the guy who rains on everyone’s parade because there are some cannabis stocks that are here right now, right here, I like. But the biggest are not the best. And let's just pick on Curaleaf ( OTCPK:CURLF ), for instance , that is the biggest and not the best, in my opinion.

And I wrote a piece on Seeking Alpha when I got lucky. It was at $4 when I wrote it, and that was the peak. And I said, sell the rally. That's very unlike me to tell the public to sell. And although a lot of my pieces are – they're usually more like don't buy it yet, but I said sell.

And my target on that is based on a pretty high multiple that Julian just said 4 for Trulieve, which is correct. I was using 7 for Trulieve for my year-end target. And I've lowered it to 6. And my target is now 2.20 for year-end, and the stock is pushing $3 right now, south of 3. And so what is wrong with Curaleaf? I think a lot. They have negative tangible book value in excess of $700 million negative. That's number one. Number two, they have a ton of debt. Number three, they're not generating positive cash flow.

And I think there really is too much debt. And I think what Julian says could work if they've just, even at the low price got rid of the debt, turn it into equity, it's so cheap that maybe people would buy it. But I'm going to step back and say wait, though, until 280E goes away, or you can trade on the Nasdaq because the stock would be more valuable. And I don't think either of those things are going to happen right away. I'm on the lookout, but I don't think that they're going to happen immediately.

JL: Yeah. And I think that, related to that, I think that management teams have – that's the reason why they haven't been issuing equity is that they seem to be hoping for some SAFE banking induced rally or some miracle, some Hail Mary to happen, like legalization, so that their equity will go up, and then obviously issuing equity at that point will be less expensive.

But I think at this point, we need to come to face the reality that our politicians, they don't really seem to want to remove 280E taxes , or decriminalize cannabis, or whatever, at least not that quickly. So, I think that the issue is that the longer they wait, every single year is another year where they're having to basically issue more debt to pay for their capital expenditures and interest expenses.

So time is not their friend when they have this much debt, whereas and again, they don't really have to remove all of their debt. But if they were to even remove just enough debt so that, they're generating some more cash flow and that cash flow could be used to, at least, cover their capital expenditures and pay down more debt.

Then you start getting to a positive loop where time does become your friend. And that, I think, in my view, kind of differentiates some of the names like Green Thumb Industries ( OTCQX:GTBIF ), which are profitable on a GAAP basis and have cash flow to pay for capital expenditures, pay down debt versus unfortunately, a name like Trulieve, which, again, I highly respect their management team, their stock is extremely cheap.

But the reality is, every year that passes by, the valuation position gets a bit worse just because they're probably going to have more and more debt as the years go on.

AB: Yeah. So I wanted to add. On Curaleaf, I was saying what's wrong with it, and I've left off one thing, their current ratio. And the current ratio, I think most of your listeners probably know this, but just to repeat what it is. It's the current assets divided by the current liabilities. So a high number is good, a low number is bad. And for Curaleaf, that number is I'm just looking up 0.9x.

So in other words, they have more liabilities than assets that are due within a year. And this captures, by the way, a big thing that my tangible book value barely captures, and that is the income tax payable. And I don't even throw that income tax payable into net debt, but I think maybe I should because it's real, and it's a big burden. And, Curaleaf owes a lot in taxes. $210 million, to be precise.

And GTI, which I don't think it's time yet to buy GTI, by the way, but GTI shines compared to that. And I wrote a piece this weekend for my subscribers, and I said, GTI is a good replacement for Curaleaf. I don't own it in my model portfolios, but I know some people like the big MSOs (multi-state operators), like ( MSOS ).

And the reason is, it trades at 3x tangible book, not -- it has a tangible book value of $551 million, which is way more than the minus $700 million and change at Curaleaf. And it has less net debt, and its current ratio is 1.9x because they only have $10 million of income tax owed. GTI only owes $10 million in income taxes that haven't been paid. And for Curaleaf, it's more than $200 million.

And this is a big problem. If you look across the entire industry, not the Planet 13 ( OTCQX:PLNHF ) that I like , they don't have that problem, but all of them owe a lot in taxes. And it's worse at some places than others. But I would just say back to Julian’s point about, pushing the debt out. That's what some companies are doing.

Ayr ( OTCQX:AYRWF ), for example, that has way too much debt , and it's been killing perceptions about them. And they've been kind of extending it, but I don't think it does the trick, unfortunately. I think as long as they have debt, people are going to worry. I like Hydrofarm ( HYFM ). They have a lot of debt. It's not due until 2028, but people don't care. It's got too much debt. 2028 is a long time, especially in cannabis land.

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