VIRIDIAN INSIGHTS

• WAIT, YOU WANT TO RAISE EQUITY NOW?
  • 4Front Ventures (FFNT: CSE)(FFNTF: OTCQX)  stock rose 36% on July 8, 2024, following its announcement that it canceled a planned underwritten offering of equity units. It seems like an odd reaction, given that FFNT is overleveraged and needs cash. 
  • The brokered offering, announced on June 26, proposed the issuance of up to 47.6M units at a price of Cdn $0.105 per unit. The units included a whole warrant with a $.13 exercise price (23.8% premium) and a five-year maturity.
  • The deal reminded us of the deal that Planet 13 completed back in March 2024. It had the same structure, similar warrant premium, and, more importantly, the same impact on the stock.
  • FFNT stock fell about 13% following the deal announcement, and part of the impact was purely technical. We conservatively value the five-year warrant at $.0279 per unit, producing an implied net share price of $.077. The shares actually traded as low as $.64.
  • The one big difference between Planet 13 and FFNT is credit standing. PLTH and FFNT are on opposite sides of the Viridian Credit model rankings: FFNT has a #23/30 ranking, while PLTH has a much stronger #6/30 ranking.
  • In a way, the credit quality differential makes FFNT’s desire to issue equity seem more reasonable. The company is an outlier on Viridian’s net adjusted debt/EBITDA chart and has one of the lowest free cash flow adjusted current ratios of the 17 companies Viridian graphs weekly. (See below in the VALUATION, LEVERAGE AND LIQUIDITY section). The company needs to re-equitize, and the liquidity measure shows that FFNT needs to raise new capital to discharge its current liabilities.
  • So why did the market react so negatively to the deal announcement and so positively to its cancellation? We suspect that the key is in the signaling impact of the transaction.
  • The current capital raise environment continues to be highly challenging, and equity prices (as measured by the MSOS ETF price) have dropped 25% from their mid-May levels. Announcing an equity raise in this climate begs the question, “Why raise now?” and invites the suspicion that the company must really need cash badly—hardly a negotiating position of strength.
  • As much as FFNT needs to de-leverage and needs additional cash, the optics of pushing equity into an inhospitable market were just too great. We are big believers that an opportunity to de-leverage stressed balance sheets by issuing equity is coming; it’s just not here yet.

• THE ONLY LOAN-TO-OWN GUN IN TOWN
  • On May 24, 2024, Delta 9 Cannabis announced that it had received a demand letter from SNDL for the repayment of its 10% Senior Secured second lien convertible debentures for a total of about $10M. Delta 9 replied that it was not in payment default on the notes, leaving open the question of whether it was in violation of the covenants. Delta 9 promptly formed a committee of its Board to review “strategic alternatives.”
  • On July 5, 2024, SNDL stepped up the pressure with an announcement that it had acquired $20.7M of Delta 9’s First Priority secured debt from Connect First and Servus Credit, gaining a first priority secured interest in substantially all of Delta 9’s assets. SNDL’s playbook is pretty straightforward. Look for them to play tough enough as creditors that Delta 9 falls into bankruptcy, and then SNDL will credit bid its debt for ownership of the assets. Delta 9 is in pretty tough financial shape. It ranks #27/31 in the Viridian Capital Credit model for Canadian Cultivation and Retail companies with less than $50M market cap. Its total liabilities to market cap ratio of 40x basically says it all.
  • SNDL carried out a similar strategy with Skymint and Parallel and is now the stalking horse bidder for Indiva Ltd.
  • The most interesting unanswered question is why SNDL appears to be alone in pursuing the loan-to-own strategy in cannabis.
  • SNDL is uniquely situated to pursue the strategy. It has a lending arm that can both make direct loans and facilitate the purchase of debt from other creditors. It has an operating arm staffed with people who have the expertise to run the companies it acquires. Finally, SNDL has formed a U.S. Holding company similar to Canopy U.S. to hold and eventually operate or sell U.S. assets.
  • Still, loan to own is a risky strategy in cannabis because the “good company/bad balance sheet” example is too hard to find. There are always operating/ strategic issues that need to be worked out, and doing so and making a profitable exit is far from assured.

• THE END OF A 40-YEAR-OLD LEGAL DOCTRINE DOES LITTLE TO MOVE CANNABIS STOCKS
  • 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, although more authoritative legal voices have minimized the impact. We believe that stocks did not react negatively to the rule, mainly because the potential for delays in S3 implementation had already been baked into prices.
  • We are reminded of the ancient Chinese curse, “May you live in interesting times.” Times have never been more interesting in cannabis.

• 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.
  • Last week’s Viridian Chart of the Week correlated the percentage stock decline against the “excess tax liabilities” to show that the IRS ruling arguably had a more significant impact on stocks than the demise of Chevron.

• 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
• The DOJ has signed off on S3, and the 60-day public comment period has commenced. Why does the equity market not care?
  • It now seems 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 $16M was the second lowest of the year in a holiday-shortened trading week. Liquidity, both in terms of dollar volume traded and Days to Trade Market Cap (see below), was worse than the corresponding period in 2023 despite several uplistings in the interim.
      • 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 913 days on 7/5/24 was the second worst reading of the year. A 913 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 183 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, but exciting macro events seem likely for the month ahead. Will trading volumes accelerate accordingly?

• GIVING CREDIT WHERE CREDIT IS DUE
  • The chart below shows our updated 7/5/24 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 most significant move this week was the five-notch deterioration in 1933 Industries (TGIF: CSE) from #14/30 to #19/30. The decline was primarily caused by a sharp deterioration in leverage ranking, driven by higher relative total liabilities to market cap.
  • Jushi (JUSHF: OTCQX) gained three notches due to a two-notch improvement in total liabilities to market cap and an overall 2 notch gain in profitability ranking.
  • Schwazze (SHWZ: CSE) deteriorated by two notches from #20/30 to #22/30, primarily driven by the sharp decline in the company stock from its announcement that it will down list to OTC Experts Market because of its continuing late filing of financial statements for March after a change in accountants. We have been noting the slide in Schwazze’s rankings for several months.
  • We will be focusing more attention on Ascend Wellness and its progress toward refinancing the $275M 9.5% Senior Secured Term Loan that matures in August 2025. The company is reportedly already out in the market exploring options. Our biggest concern is the size of the required refinancing which represents about 140% of the company’s market cap.
  • Our contacts tell us that the cannabis debt capital markets are looking significantly better and this will be an excellent test case.