VIRIDIAN INSIGHTS

• The Big Guys are Still Looking at Cannabis
• Canadian cannabis company Organigram was up 33% on Monday on news that tobacco giant BAT agreed to invest C$124.6M through a private placement. The first tranche is expected to close in mid-January 2024.
• The significance of the transaction is that it shows that the usual suspects, Tobacco, Alcohol, and CPG, are still out there looking to get involved. We don’t think the valuation afforded this transaction is as important as this demonstration of long-term interest.
• When will it be SAFER?
• On Wednesday, September 27, The Senate Banking Committee passed the SAFER Act with a 14-9 vote, marking the first time members of the Senate have voted on the bill despite its passage in the House 7 times! We can quibble about the margin of victory and the timing, but it must be counted as a significant achievement to get this far.
• This year, there appear to be sufficient votes in the Senate from both sides of the aisle to pass the bill. One bit of drama stems from the intent of Senator Schumer to roll the HOPE and GRAM bills into SAFER before the Senate vote. HOPE provides the states with funding for expunging cannabis offenses while GRAM ends the prohibition on firearm sales to medical cannabis patients. Will he get greedy and try for even more? We would count it implausible, except that we have seen this movie before.
• Despite better-than-ever popular support (especially in the Senate), SAFER now seems unlikely to see a vote in 2023. A cannabis-unfriendly Speaker, squabbles about Israel and Ukraine support and the upcoming budget battle have sucked most of the air out of the room

• Is Re-equitization still in the air?
  • The pace of new equity issuance has slowed since stocks have given back most of their rescheduling gains. Curaleaf (CURA: CSE), Vext Science (VEXT: CSE), Aurora (ACB: TSX), and Cannabist (CBST: Cboe) all did small issues, but we expected to see more.
  • The table and chart below help frame the likely candidates for additional issuance. Companies with high leverage but reasonable valuation parameters will likely follow with moderate-sized equity issuance. We expect companies will look to “average up” with the expectation of further price gains if rescheduling stays on course.
  • Based on this reasoning, likely candidates include Cannabist (CBST: NEO), Cresco (CL: CSE), Jushi (JUSH: NEO), 4Front (FFNT: CSE), and Schwazze (SHWZ: OTCQX).
  • Some companies that could benefit from re-equitization, like Goodness Growth (GDNS: CSE) and Tilt (TILT: CSE), may struggle to get an equity issuance done, given their extreme leverage.

• Reschedule, Reschedule, Reschedule!
• The HHS recommendation to reschedule cannabis to Schedule 3 dramatically impacted cannabis equity prices, propelling the MSOS ETF upwards by nearly 85%.
  • But after almost two months of generally downwardly drifting prices, on 11/3/23, the ETF was only up 20.0% from before the rescheduling news. The chart below shows enterprise to next-twelve-month valuation multiples now compared to previous times when positive regulatory/legislative news hit.

• • Multiples are now approximately 29% below levels after the 5^th SAFE Act passage in the House in February 2022, but the rescheduling news is more significant as it dramatically impacts cash flows. We conclude that there is significantly more multiple expansion potential to come. If valuations multiples rose to where they were after the announcement of the Schumer-Booker bill, the incremental gains could exceed 125%.
• There is still substantial uncertainty about the likelihood, timing, and potential impacts of rescheduling, and we will continue to update the summary below as we learn more:

• Likelihood:
• There is a high likelihood that the DEA agrees to reschedule cannabis to level III.
  • The DEA has historically never overridden scheduling recommendations from the HHS.
  • The most plausible reason for the DEA refusing the HHS recommendation is that cannabis is subject to control under the Single Convention on Narcotic Drugs of 1961, and rescheduling to lower than level two would not assure compliance with this treaty. Notably, the failure to prevent states from licensing adult-use cannabis put the U.S. in violation of the treaty. No matter the DEA’s position, it cannot bring the country back into compliance with the treaty. Still, this remains the most significant potential sticking point.
• Timing:
  • Timing is difficult to predict. We would not be shocked to see the DEA announce its findings before Q1: 24, but final implementation could take the majority of 2024
  • Once it has completed its analysis, the DEA will post its recommendations and analysis to the Federal Register for public review. It will also open a 60-day public comment period. Interested parties may request a hearing before a federal administrative law judge to present other evidence or to object to the proposed rule.

• Impacts– Undoubtedly, the most significant result of rescheduling would be eliminating 280e.
  • The removal of 280e would have a dramatic financial impact on plant-touching companies.
    • The table below demonstrates that for a hypothetical cannabis company with 50% gross margins, 20% SG&A, and 3x Debt/ EBITDA, 280e can result in effective tax rates (on pretax income) of over 100%. The table demonstrates our previous claim that debt/EBITDA over three times is unsustainable in a 280e world, as the calculated payback period for the debt would be an unacceptable 12.26 years. Cannabis companies under 280e need less than 2x debt/EBITDA to have acceptable 5-year payback periods.
  • The table shows that combined effective rates (depending on state tax rates) would be reduced to around 27% without 280e, making a huge difference in debt capacity. Without 280e, companies could comfortably carry 3x leverage with acceptable payback periods. Importantly, by making interest expense tax deductible, the elimination of 280e also reduces the cannabis cost of capital and increases the intrinsic value of the firms.

• • • A previous Viridian Chart of the Week demonstrated that the extra cash flow from tax savings could propel meaningful increases in internally funded growth.
    • We estimate annualized tax savings of the top 13 MSOs at $700M.

• • Trading Volumes are up from 2022, but the increases are slowing.
  • The graph below compares the average daily dollar trading volume for the ten highest volume MSOs between 8/31/23 and 11/3/23 and the equivalent period in 2022. The aggregate average daily dollar volume for the group is now only up 25% after measuring 35% higher last month. Gains range from -13% for Trulieve (TRUL: CSE) to 89% for TerrAscend (TSND: TSX). TerrAscend’s move to the TSX has paid off with better liquidity, but Curaleaf should be a better test case of the impact due to its much larger public float.

• Despite daily volume gains, the days required to trade the market cap indicator, shown by the green line below (measured on the right axis), continue to show tremendous illiquidity compared to the Canadian LPs, many of which trade on Nasdaq. For example, Verano’s 428 days would mean that if an investor had a 5% position in Verano and wanted to trade out of their position, assuming that they wish to represent less than 25% of average daily volume, it would take them 85 days to sell out of the position. The same percentage position in SNDL could be traded in under eight days.

• Analyst revenue and EBITDA estimates have not changed since the rescheduling news, and we do not expect Q3 earnings releases to be very impactful.

• • The graph below shows consensus revenue and EBITDA estimates for the 10 top MSOs for 2023 and 2024. The light blue line at the bottom shows that 2023 consensus EBITDA margins are now 24.0%, down from the beginning of the year expectations of 27.2% and 2022 actual margins of 25.0%. 2023 consensus EBITDA estimates are now 3.3% lower than actual 2022 EBITDA for the group. 2024 margins, shown in the dark blue line, are now expected to be 26.1%.
  • The green lines at the top show that 2023 revenues are expected to be 1% higher than 2022, while 2024 revenues are expected to be 8% higher than 2023. The two-year 3.9% CAGR is decidedly anemic and reflects ongoing wholesale price compression, somewhat offset by positive impacts of new adult rec states. This is not the kind of growth rate cannabis investors signed up for.
  • The green lines at the top show that 2023 revenues are expected to be 1% higher than 2022, while 2024 revenues are expected to be 8% higher than 2023. The two-year 3.9% CAGR is decidedly anemic and reflects ongoing wholesale price compression, somewhat offset by positive impacts of new adult rec states. This is not the kind of growth rate cannabis investors signed up for.
  • Lower revenue and margin expectations are among the reasons we do not believe cannabis multiples are likely to fully retrace the path back to peaks of over 20x EV/EBITDA.

• Amend and Extend
  • Amend and Extend activity hit a crescendo with last week’s AYR (AYR.A: CSE) restructuring/extension of nearly all of its 2024 debt maturities. The company paid a heavy price for the debt relief, parting with 30% of its equity and a 50bps increase in the coupon on its $243M 12.5% (now 13%). We would have preferred to see the company make some progress in reducing debt, but instead, it got an additional $50M in credit commitments. AYR is still overleveraged but has no significant pressure points until 2026 when the magnitude of industry-wide debt maturities could make for drama. Hopefully, a schedule 3 fostered stock market reawakening will allow equity refinancing before that day arrives.
  • The graph below is a reprint from our Chart of the Week. It shows that several players still need to do some balance sheet work. Trulieve (TRUL: CSE) looks to have enough cash on hand along with expected 2024 EBITDA to cover all of its cash uses and debt maturities; however, it seems tight, and we would be surprised if the company doesn’t take some steps to increase financial flexibility. TerrAscend (TSND: TSX) and Jushi (JUSHF: OTCQX) still have to refinance bank lines and credit facilities maturing in 2024. Essentially, though, Amend and Extend 2024 has concluded.

• The chart below shows our updated 11/3/23 credit rankings for the 30 U.S. cannabis companies with over $5M market cap. We have dropped the minimum market cap criterion to add three new companies to the rankings: Body & Mind (BAMM: CSE), Slang Worldwide (SLNG: CSE), and StateHouse (STHZ: CSE). 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.