VIRIDIAN INSIGHTS

• Q3 earnings are out for 8 of the over $100M market cap group, which were generally favorable. As shown by the graph below, four of the eight beat on revenues, but more importantly, six of eight beat on EBITDA. The green line shows the net change in the stock from one day before release to one day after, net of the change in the MSOS ETF. Unsurprisingly, there was virtually no correlation between stock prices and revenue or EBITDA beats. For an analysis of a more critical measure, cash flow from operations, see our Chart of the Week. Spoiler alert: all eight beat consensus estimates, but a large amount of the beat was due to increased accrued taxes payable (i.e., deferring tax payments).

• GO OHIO!
• Ohio voters passed Issue 2, making Ohio the 24^th state to legalize adult-use cannabis.
• The issue passed despite opposition from the state’s governor, Mike Devine, and other Republican leaders. Devine is meeting with leaders in the GOP-controlled legislature to seek amendments to the law before it goes into effect. Potential changes would limit advertising, limit THC content, limit public consumption, and mitigate the risk of impaired driving.
• Ohio’s passage is important for several reasons. Now, more than one-half of the U.S. population lives in states where cannabis is legal for adult recreational use. This could be a “tipping point” where the walls begin to fall in other states.
• Pennsylvania is one such state that has been poised to enact adult rec for several years. The specter of lost tax revenues as PA residents cross the border to purchase weed may be the final impetus for legalization in PA.
• Ohio saw a development that we may see repeated in other states: Many Ohio voters came out to vote on Issue 1, a state constitutional amendment to protect abortion and reproductive rights. One of the issues that has been a stumbling block for cannabis legalization has been the fact that, unlike abortion,  it was not an issue that drove people to the polls.
• Ohio’s legalization is significant in its own right. Ohio has an estimated population of about 11.7M. At usage rates similar to Illinois, the state adult market could support around $1.7B of annual legal cannabis sales, a significant increase in total country-wide sales.

• 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 Senator Schumer’s intent 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.
• We created a rough index for likely equity issuance calculated as the multiplication of total liabilities to market cap and EV/2024 EBITDA, reasoning that companies with high valuation ratios and high leverage should issue equity and reduce debt. Likely candidates include Cannabist (CBST: NEO), Cresco (CL: CSE), Jushi (JUSH: NEO), 4Front (FFNT: CSE), and Schwazze (SHWZ: OTCQX).
• Some 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.

• Amend and Extend
• Last week’s Viridian Chart of the Week observed that Trulieve still had significant 2024 debt maturities to resolve. On November 8, 2023, the company announced redemption of the $130M outstanding balance of its 9.75% senior secured notes due June 18, 2024, at a price of par plus accrued interest. Using 2^nd quarter balance sheet figures and 2024 analyst estimates, we had projected that the redemption would require Trulieve to reduce cash too tight. However, the company beat the Q3 cash flow from operations estimate by over $40M, ending the quarter with an ample $192M of cash. Still, we could see Trulieve issuing new debt to provide additional financial flexibility. Given its low trading multiples, we would not expect the company to issue significant amounts of equity.

• 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 11/10/23, 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 potential for multiple expansions. If valuations multiples rose to where they were after the announcement of the Schumer-Booker bill, the incremental gains would equal 113%.
• 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.

• 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 considerable 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.

• • • We estimate annualized tax savings of the top 13 MSOs at $700M.

• • Uplistings to TSX and CBOE have increased the trading liquidity of cannabis stocks, but the gains are starting to level out, and neither the TSX nor the CBOE compares with the liquidity of Nasdaq.
    • The graph below compares the average daily dollar trading volume for the ten highest volume MSOs between 8/31/23 and 11/10/23 and the equivalent period in 2022. The aggregate average daily dollar volume for the group is now only up 18% after measuring 35% higher last month. Gains range from -20% for Trulieve (TRUL: CSE) to 80% 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.

• • Surprisingly, given generally strong Q3 results, analysts’ revenue and EBITDA estimates have not changed since the rescheduling news.
    • 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 6% higher than 2023. The two-year 3.3% 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. Moreover, the growth rate seems illogical when considering the impact of a full year in Maryland and a partial year in Ohio.
    • 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.

• • • The chart below shows our updated 11/10/23 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. Rankings have been updated for Q3 financials where available, and some changes have been striking. The most significant credit moves for the week were Trulieve (TRUL: CSE), which rose four ranking spots to #4 based on stronger-than-expected cash flow and positive equity response to the redemption of its 2024 debt maturities, and MariMed (MRMD: CSE), dropping seven ranking slots to #10 (tied with Ascend (AAOTCQX) based on a significant EBITDA miss, a negative quarterly funds from operation after eight consecutive positive quarters, and the resignation of the company’s CFO.