OUTLOOK

Significant Trends for 2023

• Commodification-based wholesale pricing declines will continue. We have seen some firming in California in the last month, but prices are still at levels where most producers cannot make money. We expect this to continue until significant capacity is wrung out of the system, which could take most of 2023. The dynamic has become clear: when new markets turn rec, there is a period of strong wholesale pricing as cultivation lags the rollout of dispensaries. This premium pricing entices new cultivation capacity to enter the market until capacity exceeds demand and pricing begins to fall. Sadly, the period of solid pricing appears to be getting shorter in each new market. We attribute this to the fact that most established MSOs have now built new capacity in many markets; they are getting better and faster at standing up new facilities.

• The wholesale pricing collapse lays bare the fallacy that branding will support pricing, which is unlikely to be the case until brands can be marketed seamlessly across state lines and advertised. And this is unlikely to happen in 2023 or even 2024.

• Inflation will prove challenging to eliminate, and cost increases that cannot be passed on via higher prices will continue to pressure cannabis margins.

• We expect little progress in 2023 on federal legalization, descheduling/rescheduling, 280e, or banking reform. The key takeaway from the 2022 midterms is that cannabis is not a powerful enough issue to sway votes. No legislator fears losing his seat because of inaction on cannabis; accordingly, attention will turn to other matters. Another lesson learned, however, is how poor our ability to anticipate action or inaction in Washington is; we stand ready to be surprised – this time on the upside.

• The lack of legislative action probably means that the pace of new investors entering the cannabis market will slow. The carnage of 2022 is painfully fresh. Investors are (and should be) willing to miss a bit of the upside to avoid more pain. This reduction in inflows will keep a tight lid on cannabis capital raises. One exception seems to be the continued influx of banks willing to make well-collateralized loans like the recent Trulieve deals.

• The pain in 2023 will revolve around business failures, which we expect to set new records. Zombie Canadian LPs will finally collapse as they exhaust the liquidity from their initial sugar-daddy investors. U.S. companies that have not been able to achieve positive EBITDA will find financing more difficult and liquidity hard to maintain. Companies within spitting distance of cash positive will push every button to get there, including tight cost controls, stringent working capital management, and reduced CAPEX. One of the little-appreciated issues of federal illegality is the lack of cannabis company access to the bankruptcy courts, which will make the upcoming period of restructuring messy and more unpredictable than it should be.

• We expect the capital market slowdown and capital budgeting rigor to result in an upswing in M&A activity. MSOs will find buying distressed companies to be a more cost-efficient method of expanding capacity or entering new markets than internal builds. The negotiating power is shifting to larger, better-capitalized companies relative to their hamstrung smaller competitors.

• The good news is that this period of belt-tightening and consolidation will result in a healthier industry better positioned to face the challenges of legalization when and if it arrives. Fundamentally, cannabis stocks are incredibly cheap, but investors need to sharpen their credit analysis as many companies will not survive the upcoming period.