Viridian Key Insights

        VIRIDIAN INSIGHTS

• DEBT CAPITAL IS FLOWING IN, BUT IT SURE ISN’T CHEAP!
  • Last week, we discussed the new Canopy Growth convert, which included $50M of new money and the extension of existing converts that were to mature in 2025. We calculated an all-in cost of 23.48%, primarily due to the high value of the conversion option embedded in the structure and, to a lesser degree, the value of the attached warrants.
  • Similarly, this week, we have a C21 convert where the conversion price is actually in the money! The coupon is 12%, but we calculate an effective cost of over 37%. C21 ranks 12/30 on the Viridian Credit Tracker credit ranking model.
  • Tilt Holdings, not to be outdone, announced a deal whereby it obtained availability of up to $10.5M to stand up to three Pennsylvania retail locations. The final maturity is 2027, and the interest rate starts at 20%, graduating to 30% upon the first sale from a dispensary and then to 40% in six months after that sale. This has the look and feel of a bridge loan. The company may or may not need the money but wanted to have standby liquidity in case it does. P.A. is a state likely to go adult rec in the next several years, and the value of being vertical (Tilt already has cultivation and manufacturing is high. Tilt has a challenged credit profile with a current ranking of 28/30.
• IS IT REALLY POSSIBLE THAT RESCHEDULING WAS ANNOUNCED AND NOBODY CARED?
  • On April 30, the DEA confirmed to the Associated Press that it will move to reschedule cannabis to Schedule 3 as recommended by the federal Health and Human Services Department.
  • The ruling is the most critical since the first state legalization, significantly improving cash flows to the industry by eliminating IRS rule 280e.
  • The impacts are diverse and strongly positive:
    • The industry is looking at a potential savings of $2B with more than $700M from just the top ten companies. Moreover, many of these companies are likely to start the savings program early by just not paying.
    • Reinvigoration of the Cannabis Capital Markets. For the last few months, we have been talking about the cannabis capital markets being frozen due to the uncertainty surrounding rescheduling. We are now about to see the reversal of that process. Several companies have existing shelf registrations, and we expect companies to “average up” by doing minor equity issues as prices continue to recover. The debt capital markets seem to be believers, based on this week’s deal activity.
    • New investors at the margin. We don’t think rescheduling by itself will bring the Blackrocks of the world to cannabis as we do not believe that it will allow uplisting to senior exchanges. Still, the greater optimism surrounding the industry’s financial footing will attract more investors who will initially be drawn to larger companies.
    • A kick-save to overleveraged companies. Increased free cash flow from lower taxes has a direct impact on the sustainability of debt. We have noted that more than half of the large MSOs have more than 3x debt/2024 EBITDA, a level we believed unsustainable in a 280e world. We have noted our belief that a likely catalyst would both increase debt sustainability and provide an opportunity for re-equitization.
    • A re-acceleration of industry consolidation. M&A has been in the doldrums as companies conserve cash and focus on operating for profitability rather than growth. However, the valuation gap rebounded to 3.55 on the DEA news, the second highest it has been since May 2021 (the highest was 3.71 on 2/24). This gap will grow as the markets rally further, and it indicates a growing ability for the most prominent companies to complete accretive acquisitions. We predicted a resurgence of M&A at the beginning of the year, and finally, the catalyst has occurred. The catch is that we do not see a return to deals with high cash percentages, and our chart for the week shows an uptick in stock-based consideration.
    • The graph below shows the impact of past legislative/regulatory announcements on the trading multiples of cannabis companies. EV/NTM EBITDA multiples are now 8.76x, having drifted downward by 14.6% since the DEA announcement. We believe that a much higher gain is in store. Specifically, we have been saying that we expect the market to rally beyond the 15.73x multiples from the Schumer/Booker proposal, possibly reaching the 18.35x achieved in May 2021 after the 5^th House passage of the Safe Act.
    • Progress leads to progress. We remain skeptical about the SAFER ACT in a highly charged election year. However, rescheduling is part of a process of normalizing cannabis that we believe increases the chance of the bill. The industry potentially now has multiple shots on goal: S3, the Boies Lawsuit, SAFER, and a Garland memo. Some combinations of S3, SAFER, Boies, and Garland are becoming increasingly likely.
  • So what could go wrong, and why has the stock market response been so muted?
    • Investors are tired and have been spoofed too many times. When someone says, “It could take up to a year…” Cannabis investors immediately immediately think, “It’s never going to happen.”
    • The investor base is heavily retail and may not fully understand the potential implications of rescheduling or the impact of the removal of 280e.
    • Investors, especially institutional investors who have avoided the space, would rather miss part of the rally than jump in for another ride like the last two years. Talking to investors, rating agencies, and other constituents, we find deep distrust for administrative actions like rescheduling. It is ironic that the very lack of congressional involvement that makes S3 likely to happen also imbues it with an aura of impermanence. Like the Cole memo, the fear is that a new administration may delay implementation or even reverse course.
    • Many details still need to be worked out, and investors still question how the State programs, the FDA, and Big Pharma will interact in an S3 world.
    • S3 could potentially have some perverse results. The extra funds might be competed away in misplaced attempts to gain market share. Also, the additional cash could foster capacity additions that hasten oversupply and commodity price declines.
    • Still, despite the uncertain timing, regulatory implementation, etc., our view is that the various regulatory, judicial, and legislative tracks for cannabis industry reforms are mutually reinforcing. We have never seen so many potential upside catalysts in any other industry.

• • AS WE PREDICTED, ANALYSTS SIGNIFICANTLY UNDERSHOT ON Q1, PARTICULARLY UNDERESTIMATING MARGINS.
    • Our claim since the beginning of 2024 has been that, after being burned by having to continually mark down their estimates for 2023, analysts are now too conservative on the upswing in 2024.
    • The first chart below shows that analysts were 1.4% under on revenues but 9.5% under on EBITDA, primarily because they underestimated margins by almost two full points.
    • The second chart shows that they have been slow to adjust their 2024 estimates upward. Q1 EBITDA beat expectations by $37M, but full-year EBITDA estimates have only been increased by $14M.
    • 2024 Revenues for the group are now projected to rise 4.3% compared to 2023. The estimated group’s 2024 EBITDA margins of 25.98% are only 2.0 points higher than the 2023 margins and barely above the 2022 margins. Moreover, full-year margins are now projected to be lower than actual q1 margins. Q1 is a seasonally weak quarter, and margins for the group have been lower in q1 than in the whole year for each of the last two years.
    • Analysts are still updating their models based on q1 results and company guidance. We expect further upward revisions in the weeks to come.

• VALUATION, LEVERAGE, AND LIQUIDITY
  • The two graphs below show the Enterprise value to 2024 EBITDA multiples against two leverage measures. In the first graph, we have calculated an Adjusted Net Debt/ 2024 EBITDA figure by adding any accrued taxes over 90 days of tax expense to debt before subtracting cash to arrive at Adjusted Net Debt. We would expect any regular company to have accrued taxes equal to their last quarterly tax expense and consider that a standard working capital item. Several companies on the chart have far greater than 90 days of accrued taxes, and we consider the excess to be debt. Verano’s excess tax liabilities equal nearly 40% of its debt. Other companies with relatively high imputed tax debt include Curaleaf (CURA: CSE), 4Front (FFNT: CSE), and Terrascend (TSND: TSX). We have adjusted our accrued tax liabilities for comparability by adding back the tax liabilities that Trulieve and TerrAscend moved into long-term liability accounts.
  • The first graph shows that ten of the seventeen companies have net debt/ 2024 EBITDA over 3x, which we view as the cutoff of sustainability in a 280e world. We view 4x as sustainable in a post-280e environment, and five companies are now over that threshold.
  • The second graph looks at leverage through the lens of total liabilities to market cap. This measure separates the companies into three groups:
    • On the bottom left are companies with low valuation multiples but also low market leverage.   The group includes Verano, Trulieve, Cresco, MariMed, and Vext. With regard to Vext and MariMed, the consensus seems to be that both lack sufficient scale for the long run. Vext is small enough and geographically constrained enough to be a takeout candidate, while MariMed is priced attractively based on its fundamentals. However, it is geographically diversified enough to pose issues of overlap with potential acquirers. The other three show that the market is not yet willing to fully sign on to the Florida rec story.
    • Meanwhile, in the bottom right are companies where the market has doubts about whether the company can discharge its liabilities without highly dilutive actions, like discounted stock sales or refinancing debt with a heavy warrant or share consideration.
    • And in the top left, the darlings of the market. These companies have high valuation multiples and low market leverage. They have excellent currency for acquisitions but could also stand more leverage if a great debt deal were to be possible. These companies may be candidates to buy cash flow through accretive acquisitions.
  • The third graph introduces the free cash flow adjusted current ratio liquidity measure into the mix. Companies with less than 1x on this measure will likely have to raise capital next year. Surprisingly, seven of the companies fall into this bucket. Note the lower liquidity position of Trulieve and TerrAscend relative to last week’s graph. This graph also breaks the sector into three distinct groupings. The bottom left group has low leverage but also modest liquidity. Some of the companies, including Verano, MariMed, and Cresco, have sufficient but not comfortable levels of liquidity, while others, including Curaleaf, TerrAscend, and Glass House, are below the critical 1x liquidity line. Companies on the lower right generally have constrained liquidity and high leverage, a potentially dangerous combination in a capital-constrained environment. Several of these have high optionality, however. Jushi, for example, is highly influenced by developments in Virginia and Pennsylvania. 4Front’s finances are dependent on the success of its massive Illinois cultivation project. AYR’s success rides heavily on Florida. Each of these companies bears careful monitoring. We know what to look for, but guessing the outcomes is nearly impossible. Ascend is a particular case and shows up on the graph in a region of its own. It looks to have excellent liquidity; however, this disguises the material debt maturities facing the company in 2025, which is just beyond the purview of our liquidity ratio.
  • Looking at leverage in two ways and having a comprehensive measure of liquidity can give investors a good idea of possible scenarios for today’s overleveraged companies.

• • • CANNABIS STOCK LIQUIDITY RETURN TO ITS TRENDLINE PATH OF VERY SLOW IMPROVEMENT
      • Average daily dollar volume dropped to an unremarkable $26M from $95M in the previous week.
      • The Days to Trade Market Cap (DTTMC) series depicts the number of days it would take to trade the market cap of a stock or group of stocks. Its weekly reading on 5/10/24 of 549 days is the third worst weekly reading in 2024. A 549 DTTMC implies that an investor who acquired a 5% position in the stock, assuming he wanted to be less than 25% of the average daily dollar volume, would require 110 days to trade out of his position (down from 169 days last week.)
      • The five bars on the far right show that the daily activity and liquidity readings returned to the levels before the DEA announcement.

• • • GIVING CREDIT WHERE CREDIT IS DUE
      • The chart below shows our updated 5/10/24 credit rankings for the 30 U.S. cannabis companies with over $5M market cap. The number below the ticker symbol indicates the change in credit ranking since last week, where a negative number suggests credit deterioration, while a positive indicates improvement.
      • The blue squares show the offered-side trading yields for each company. Trading yields have declined significantly since the HHS rescheduling announcement.
      • Curaleaf, Cresco, and Verano now trade at similar yields, and the premium to Trulieve is now starting to look too wide. Similarly, the two hundred basis points between Trulieve and GTI look too extreme, and GTI’s absolute yield level of 7% seems too tight relative to treasuries. We have no question that GTI is the best credit for the group, but investors can now pick up nearly 400 basis points by trading into Verano paper.
      • Cansortium has been volatile, moving sharply higher in the rankings after dropping several ranks last week. We remind investors that the company has the most Florida adult rec torque of any of the companies we rank.
      • C21 was the biggest gainer of the week, moving up four ranking notches based on gains in liquidity and leverage rankings.