VIRIDIAN INSIGHTS

• • A CANCELED MERGER LEADS TO A DEBT-TO-EQUITY CONVERSION
    • Only four days after Agrify’s May 16, 2024, announcement that it had signed a definitive merger agreement to become a wholly-owned subsidiary of Natures’s Miracle, the company announced a joint termination of the agreement, citing “unfavorable market conditions.”
    • Agrify’s stock fell approximately 18% between the collapse of the deal and Friday’s close as investors pondered the reason for the swift deal collapse.
    • Agrify’s year-end 2023 financial statements contained “going concern” qualifications, and the company had received a warning letter from the Nasdaq citing a violation of minimum listing requirements.
    • To regain Nasdaq compliance, Agrify completed a $13.8M debt-to-equity swap in which CEO Raymond Chang and board member I-Tseng Jenny Chan converted $11.5M senior convertible notes into a pre-funded warrant for 8.6M shares at a calculated price that equates to $1.34 per share. In addition, GIC Acquisitions, an entity controlled by Chang, converted $2.29M of its junior secured notes into pre-funded warrants for 3.2M shares.
    • The actions increased the shareholder’s equity to above the required $2.5M, allowing the company to comply with Nasdaq requirements.
    • The company continues to represent substantial risk. Proforma for the transaction, applying current market prices to the issued shares, the company has total liabilities to market cap of approximately 4.6x and an annualized free cash flow adjusted current ratio of .33x.
• LESS RECOGNIZED BENEFITS OF RESCHEDULING: HIGHER SUSTAINABLE DEBT LOADS AND INTERNALLY FUNDABLE GROWTH
  • Key takeaways from the chart below
    • The analysis assumes a hypothetical company with $1 of sales, 50% gross margins, and 30% EBITDA margins.
    • The analysis shows that the hypothetical company experiences greater than 100% effective tax rates despite the allocation of 80% of depreciation expense and 25% of SG&A expense to COGS. The same company would have a combined state and federal effective tax rate of 27.32% without 280e
    • Debt levels of 3x EBITDA are not sustainable in a 280e world, but not because interest coverage is inadequate. Using 15% average debt, we get 2.14x EBITDA/Interest coverage. The issue is the debt payback period. We calculate a debt payback of over 14 years with the given assumptions, which no regular cannabis lenders (except sales leaseback providers) will accept. S3 reduces the payback period to a more acceptable 6.11 years.
    • If we assume ten-year payback periods, the removal of 280e would increase sustainable debt loads from 2.65x Debt/EBITDA to 3.91x.
    • The bottom set of numbers shows the impact 280e has on internally fundable growth. In this analysis, we utilize the capital / sales ratio of 1.54x, which we discussed in the Virdian Chart of the Week. With 280e and 3x debt, companies can only internally fund 4.2% sales growth. The elimination of 280e more than doubles internally fundable growth to 9.6%.

• • The DOJ has signed off on S3, and the 60-day public comment period has commenced. Why does the equity market not care?
    • 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.” It now seems to us that it is overwhelmingly likely to happen, and the critical question is whether it will really happen as quickly as advertised.
    • 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. Widely differing opinions exist on when S3 will actually become effective.
    • 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.
    • We generally give little credence to claims that the DEA and FDA will become more rigorous in enforcing federal laws requiring S3 products to be approved by the FDA. Our position is based on two words: politics and money. Rescheduling is only coming to fruition because Biden is desperate for youth votes, and his DOJ is unlikely to support a new crackdown on state-licensed cannabis programs that it didn’t do while cannabis was S1. It is likely to undertake actions detrimental to tax-paying state-based businesses.
    • 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. We still view a doubling in price levels as reasonably achievable.

• • ANALYSTS ARE CATCHING UP TO Q1 REALITY, BUT THEY AREN’T THERE YET!
    • 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 chart below shows analysts’ 2024 estimates from 5/1/24 compared to their estimates on 5/28/24. Revenue estimates have been adjusted upward by .2%, while EBITDA estimates are up 1.44%.
    • The companies on the chart beat EBITDA estimates by $45M, but overall EBITDA estimates have only been revised upwards by $35M. Has something become less favorable for the remainder of 2024 than it was at the beginning of the month?
    • Full-year EBITDA margin estimates are now at 25.98%, remarkably still lower than the actual results of 26.06% for Q1, a seasonally weak quarter whose margins have been lower than the full-year margins for the last two years.
  • We continue to expect more upward revisions.

• 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, TerrAscend, and AYR moved into long-term liability accounts.
  • The first graph shows that twelve 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 nine companies are now over that threshold. These totals are up from last week due to upward revisions from tax liabilities to adjusted debt. The other significant change from last week is that valuation multiples are sharply lower. For example, GTI, which was at around 9.25x EV/2024 EBITDA last week, is only around 8x this week.
  • The second graph looks at leverage through the lens of total liabilities to market cap. This measure separates the companies into four groups:
    • On the bottom left are companies with low valuation multiples but also low market leverage.   The group includes Verano, Trulieve, Cresco, and MariMed. The other three show that the market is not yet willing to fully sign on to the Florida rec story.
    • In the middle, between 2x and 4x total liabilities/market cap, we see 4Front, Ascend, AYR, Goodness Growth, and Jushi. Each of these has more than 4x debt/ EBITDA, which is borderline in terms of sustainability, even in a non-280e world. However, each also has significant upside catalysts that could mitigate or exacerbate the excess leverage. FFNT is ramping up production at its mammoth Illinois cultivation facility. Ascend has a $275M term loan maturing in August 2025 that will need to be extended or refinanced. This loan is 110% of the company’s market cap, which is higher than the percentage of debt maturities that AYR restructured at the end of 2023. Jushi is levered to potential adult rec developments in Pennsylvania and Virginia.
    • On the right lie Cannabist and Shwazze. The high level of market leverage tells us that the market questions whether they can discharge their liabilities without significantly dilutive actions, doubts also shown by their 21/30 and 20/30 positioning in our weekly credit ranking.
    • At the top left are companies with high valuation metrics and low leverage. These companies should look to do an equity issuance depending on their positioning in the liquidity graph below.
  • 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, eight of the companies fall into this bucket. 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. Shwazze bears particular attention. The company has just changed auditors and has announced that it will be late in filing its q1 reports. Moreover, the company has $29M of debt maturing in February 2025, and progress toward refinancing this debt should be watched closely.
  • 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 REMAINED RELATIVELY ROBUST, BUT A QUIET PERIOD LOOMS
      • The average daily dollar volume of $46M remained well above YTD weekly averages.
      • 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. The weekly reading on 5/24/24 of 313 days was the seventh-best in 2024. A 313 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 63 days to trade out of his position.
      • But summer doldrums are approaching, and no significant catalysts are expected in the next month or so to drive volume.

• • • GIVING CREDIT WHERE CREDIT IS DUE
      • The chart below shows our updated 5/24/24 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.
      • The yield spread between Trulieve and GTI has widened to around 230 bp, which we view as being too wide. We also continue to believe 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 440 basis points by trading into Verano paper.
      • Ascend paper, which we had been recommending due to its undeserved 230 bp spread to Verano, has tightened and now trades virtually on top of Veraono. We now recommend trading out of Curaleaf into Verano for a 140bps yield increase and a three-notch better credit ranking.
      • Schwazze (SHWZ: OTCQX) gained back the four spots it lost last week, but the overall trend remains down. At the end of the second quarter, the company was ranked 11/30 relative to its current 20/30 spot. We are curious to see if the financial statement review triggered by the SEC decertification of the company’s former auditor will produce any significant adjustments. Meanwhile, we await news of a refinancing of the company’s approximately $30M debt maturing in February 2025. The company has plenty of time to get this done, but the market doesn’t like uncertainty.
      • 4Front (FFNT: CSE) was the most significant credit loser, dropping six ranking spots. The company’s 1^st quarter results showed lower liquidity and significantly higher market-based leverage as its stock led the loser’s list, down 28.91% for the week.