VIRIDIAN INSIGHTS

• • HOW WILL THE END OF “CHEVRON DEFERENCE” IMPACT CANNABIS?
    • On Friday, June 28, the Supreme Court overturned a 40-year-old doctrine called “Chevron deference,” dating back to a 1984 case Chevron v. Natural Resources Defense Council. The ruling in the 1984 case required Federal Courts to defer to federal agency interpretation of statutes so long as those interpretations were reasonable. Friday’s ruling overturned the earlier ruling and cited the principal as “fundamentally misguided.”
    • The decision fundamentally weakens the ability of federal agencies, including HHS and DEA, to promulgate rules without Federal Judiciary oversight.
    • This could theoretically result in increased court challenges to rescheduling and other cannabis regulatory rule interpretations. Stocks did not react overly negatively to the rule, probably because the potential for delays in S3 implementation was already baked into prices.
    • The primary near-term impact is ramping up uncertainty- as though we didn’t have enough: Biden/Trump, S3, Boies, IRS, Chevron,….;
• THE IRS FIRES A SHOT OVER THE CANNABIS BOW
  • On Friday, June 28, the IRS issued a statement that roiled cannabis stocks:
    • Until a final federal rule is published, the Internal Revenue Service today reminded taxpayers that marijuana remains a Schedule I controlled substance and is subject to the limitations of the Internal Revenue Code.
    • The law with respect to the schedule or classification of marijuana has not changed. Taxpayers seeking a refund of taxes paid related to Internal Revenue Code Section 280E by filing amended returns are not entitled to a refund or payment.
    • Although the law has not changed, some taxpayers are filing amended returns. The grounds for filing such claims vary, but these claims are not valid. The IRS is taking steps to address these claims.
  • Viridian’s Chart of the Week details the impact on companies depending on their accrued tax liabilities. Suffice it to say the IRS still wants their money!
• THE BOIES LAWSUIT WAS DISMISSED
  • The landmark lawsuit, brought by Canna Provisions and joined by Verano against the federal government, alleging that the CSA infringes on intrastate commerce, was dismissed.
  • The result was not particularly unexpected, and there was even some good news: The court recognized that the Plaintiffs had standing in the case. This sets up the appeal process, which was always intended to go all the way to the Supreme Court.
  • Bad news? Time. The process of appealing this to the Supreme Court, even if successful, is likely to take years. And cannabis years are like dog years.

• THE RIGHT TIME TO SELL IS WHEN EVERYONE ELSE IS BUYING
  • On June 17, 2024, Cannabis Company (CBST: Cboe)(CBSTF: OTCQX) announced it was swimming against the tide and selling out of Florida, just as other MSOs struggle to build their Florida positions in anticipation of the State going rec.
  • Assets for sale include 14 dispensaries, three cultivation and manufacturing facilities, and its medical cannabis license.
  • Cannabist has not done well in the Sunshine State, losing approximately $4.8M on around $6M in revenues in the most recent quarter. The company blames the losses on the fact that its “asset base is not commercially optimized with more cultivation capacity than our retail locations require.”
  • One thing is for sure: the company needs the cash. With total liabilities to market cap of 9.1x and net adjusted debt/ 2024 EBITDA of 7.58x, Cannabist stands out as an outlier on our leverage graphs. Its 20/30 credit ranking in the Viridian Credit Tracker model has improved by three slots since it announced the sale, but the company still appears as an outlier on our credit charts.
  • Against this backdrop, we applaud the company’s decision to take some chips off the table, and we sincerely hope that some of the proceeds will be earmarked for de-leveraging.
  • Cannabist said that it has $2.75M in escrow from “multiple transactions,” but further details of the divestiture transactions were not released.

• THE CANSORTIUM/RIV MERGER WILL CREATE A TOP-TEN CANNABIS CREDIT
  • The announced merger with RIV Capital enhances Cansortium’s credit profile, and the Viridian Credit Tracker model ranking improves from #18 to #8,
  • Cansortium’s net cash position goes from -$60.7M to $5.1M, dramatically improving its Viridian Capital Liquidity ranking from #23/30 to #9/30.
  • Leverage is also significantly reduced, predominantly from the conversion of $175M of Hawthorne debt into Cansortium equity. The conversion also demonstrates support from Hawthorne’s parent, Scotts Miracle Grow.
  • The combined company will jump to a #10 size ranking compared to the t#21 ranking Cansortium had prior to the announcement.
  • Cansortium is “all in” in Florida and the transaction significantly improves the combined company’s ability to attack the potential conversion to rec of the state.
  • The deal risk arb spread now stands at over 59%, which is quite wide but probably appropriate for this stage of the process with a difficult-to-estimate closing date and a number of hurdles to complete. We will be ranking the proforma combined company going forward with the proviso that Cansortium’s credit ranking will fall precipitously if the deal is canceled.
• 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 unlikely 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.

• 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 eighteen 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. This week, we included Cansortium, proforma for the merger with RIV. We analyze the credit quality of the combination further below in our credit modeling results but suffice it to say the graphs presented here make a case for significant uprating.
  • 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. Cannabist has seen the writing on the wall: to levered to issue equity or debt, its only option was asset sales, and its exit from Florida was a recognition of this.
    • 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 REBOUNDS OFF LOWS
      • The average daily dollar volume of $26M was up 85% from last week, spurred by a flurry of news: Biden’s debate performance, the IRS announcement, the Chevron deference reversal, and the Boies lawsuit dismissal. None of these were clearly bad news except the IRS notice, and markets behaved accordingly.
      • 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. Despite the positive progress since last week, the weekly reading of 561 on 6/28/24 days was the sixth worst reading of the year. A 561 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 112 days to trade out of his position. The age-old chicken and egg question: are there no institutional investors because market liquidity is so low, or is market liquidity so low because there are no institutional investors?
      • We are firmly in the grip of the summer doldrums. This week’s news portends exciting days ahead. Will this foster greater trading volume or drive investors back into their holes?

• GIVING CREDIT WHERE CREDIT IS DUE
  • The chart below shows our updated 6/28/24 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.
  • There were no big movers this week. MariMed pushed AYR out of 12^th place, and Schwazze beat out Cannabist for 20^th.