VIRIDIAN INSIGHTS

• Reschedule, Reschedule, Reschedule!
• The HHS recommendation to reschedule cannabis to Schedule 3 has dramatically impacted cannabis equity prices.
  • As of 9/29/23, the MSOS ETF was up 62% 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.

• • Although multiples have rebounded to close to the levels seen for the 5^th or 7^th SAFE Act passage in the House, 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 84%.
  • The potential additional gains also pose an increased risk. If the DEA does not follow the Schedule 3 recommendation, cannabis prices could drop to new lows. Although sheepish, we believe “things are different this time.” Simultaneous progress on 280e and the SAFE Act has never happened before, and we believe the benefits of these two acts together would exceed the benefits of the Schumer/Booker proposal from July 2021. On a down note, interest rates are significantly higher than they were in 2021, and industry economics is more challenging.
• 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:
  • Our best guess is rescheduling is unlikely to occur before Q2:2024.
  • In developing scheduling evaluations, DEA must consider and evaluate eight statutory factors:

1. 1. 1. Actual or relative potential for abuse.
      2. Scientific evidence of the pharmacological effects and general pharmacology of the drug or other substance.
      3. The state of current scientific knowledge regarding the drug or other substance.
      4. Its history and current pattern of abuse.
      5. The scope, duration, and significance of abuse.
      6. What, if any, risk there is to the public health?
      7. Its psychic or physiological dependence liability.
      8. Whether the substance is an immediate precursor of a substance already controlled.

• • Once it has done 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– Two definite rescheduling results are the removal of 280e and the fostering of cannabis research.
  • 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.

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

• • • Rescheduling will also spur cannabis research by reducing licensing requirements. Over time, this should accelerate medical product creation, providing significant patient benefits.
  • What would NOT change:
    • Rescheduling should not be confused with legalization. Cannabis as a Schedule 3 substance will continue to be federally illegal, which has several important implications:
      • Uplisting to Nasdaq is not assured. Nasdaq is reportedly studying its policies concerning Schedule 3. It may require the SAFE Act to push them over the line.
      • The SAFER Act would also probably be necessary to remove restrictions on credit card usage in dispensaries since state-legal adult-use dispensaries will still be violating federal law.
      • Significant increases in institutional capital may occur with Schedule 3 status; however, institutions that are concerned with federal illegality may not gain sufficient comfort from Schedule 3.
      • Rescheduling will not give cannabis companies access to Chapter 11 bankruptcy proceedings as the business will remain federally illegal.
    • Potential pitfalls
      • Increased role of FDA. While cannabis is Schedule 1, regulating the industry falls primarily to the DEA. Rescheduling to 3 will potentially increase the role of the FDA. While we have no reason to believe the FDA will feel empowered to begin more aggressively regulating the industry (especially since it will receive no new funding), it is a risk.
      • The importance of a new “Cole memo” or Garland memo, which would explicitly draw limits on federal enforcement against state legal business, would be heightened. We expect such a memo will be forthcoming.

• How much SAFER will it be?
  • 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.
  • The prevention or at least postponement of a government shutdown was more good news this week.
  • The remaining drama may be on the House side. It will be instructive to see whether a stand-alone bill will be voted on. We believe any attempt at a “shell game” of trying to insert the bill inside other legislation will be treated harshly by the market. Too much déjà vu!
  • Opinion is mixed as to how much the SAFER Act will accomplish. Seven tries ago, it would have been more critical, but since then, most cannabis companies, even relatively small ones, have obtained bank accounts, albeit expensive ones. We also do not see banks rushing to lend money to cannabis companies. The creditworthiness of most cannabis companies is below bank standards, and the industry still requires considerable specialized knowledge that the banks do not yet have. Moreover, for the Tier One banks like Chase, the sector is too small to move the needle. We have no doubt that Chase may want to participate in a junk bond offering for GTI, but lending to a medium sized cannabis company? Probably not, at least not immediately.
  • SAFER would be a huge deal if it directly allowed for dispensary credit card usage. However, our read, after hearing the thoughts of more sophisticated legal minds like Marc Hauser and Shane Pennington, is that while it will give the payment processors cover, it remains to be seen if the card companies will play ball. We think SAFER, along with rescheduling, will eventually tip the balance and produce both up-listing and credit cards, but neither directly achieve those goals.
  • Still, the passage of the SAFER Act after all these years would be a major psychological boost that cannot be underestimated.
• Re-equitization is in the air.
  • Three new companies have jumped on the equity bandwagon alongside Cannabist and Canopy Growth:
    • Curaleaf (CURA: CSE) completed a marketed offering of 2.7M shares at approximately US$4.39 for total gross proceeds of US$11.85M. TSX listing requirements primarily drove the transaction, but the proceeds will support international operations and general working capital purposes. We viewed the company as a likely issuer even without the TSX requirements because of its high EV/2024 multiple.
    • Vext Science (VEXT: CSE) announced a non-brokered private placement of up to $10M. The company believes an existing investor and the management group will purchase most of the issue. Frankly, Vext doesn’t fit our model of who would be next. It neither trades at an exceptionally high multiple nor has excessive market leverage. VEXT has solid uses for the capital in its Ohio expansion. Proforma for all announced acquisitions, Vext will have an operating Tier I cultivation facility, an operating manufacturing facility, and four retail dispensaries in Ohio. No wonder the stock traded up this week.
    • Aurora Cannabis (ACB: TSX) sold 53.2M common shares at approximately US$0.534 for gross proceeds of about US$27.9M. Aurora intends to use most of the proceeds to retire its outstanding US$25M in convertible notes. Aurora doesn’t fit the model espoused below, either. Its liabilities to market cap is only 1.02x, and it trades at a modest multiple of 2024 EBITDA of 7.25x.
  • 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 and SAFER stay on course. We could see Cannabist and Curaleaf hit the market again on this basis.
  • Based on this reasoning, likely candidates include AYR (AYR.A: CSE), more from Cannabist (CBST: NEO), Cresco (CL: CSE), more from Curaleaf (CURA: CSE), Jushi (JUSH: NEO), and Trulieve (TRUL: CSE).
  • 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. This could change rapidly with the further evolution of stock prices or improvements in operations at the companies.

• • Trading Volumes are Increasing
  • The graph below compares the average daily dollar trading volume for the ten highest volume MSOs between 8/31/23 and 9/29/23 and the equivalent period in 2022. The aggregate average daily dollar volume for the group is up 156%. Gains range from 2% for Cannabist (CBST: NEO) to 301% for Curaleaf (CURA: CSE).

• Analysts have not revised their slow growth estimates for the remainder of 2023 and 2024, waiting for more clarity about the fate of SAFE and rescheduling.

• • The impact of the combination would be considerable, enabling higher revenues through credit card purchases, promoting higher internally financed growth rates, and fostering the revitalization of the cannabis capital markets.
  • 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%. 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 2022. The 3.9% CAGR is decidedly anemic and reflects ongoing wholesale price compression, somewhat offset by positive impacts of new adult rec states.
  • 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
  • We expect that most of the over-levered cannabis companies will be able to work their way out of their debt maturities through some combination of equity-financed debt reduction, maturity extensions enticed with warrants and fees, asset sales, and perhaps a sprinkling of equity for debt swaps. Our primary reasoning is that lenders will bend over backward to avoid having to repossess their collateral.
  • However, there are exceptions to this rule, and so far, they have usually led back to SNDL and its lending affiliates and JVs. Examples include Skymint and Parallel, parts of which are being folded into a ring-fenced SNDL entity called Sunstream USA after the lender moved to repossess the assets. The ability of SNDL to own these U.S. cannabis assets in a non-voting, non-participating structure is still untested. But it doesn’t seem far different than the structure Canopy is hoping to use to control its U.S. assets.
  • Meanwhile, some companies’ trading prices appear to imply a decision tree valuation approach. Take the AYR 12.25s of December 2024, for example. Echelon Partners sees bonds offered at prices as low as 68. It doesn’t seem likely that investors are buying bonds at this price, expecting a 51.4% yield. And yet, if one assumes that the maturity is pushed back to 2026, we would get a 28% yield. This strikes us as much too high. We will stipulate that AYR has too much debt. However, if the $243 million 2024 maturity pressure was pushed off a couple of years, we do not think the bonds would trade nearly as badly as 28%.
  • So, how does one make sense of the prices? Perhaps it’s just technical, and there are forced sellers into a horrifically illiquid market? That seems possible. Another possibility, however, is that investors are ascribing some probability that no deal is reached and the bonds trade to a recovery value. What if we ascribe a 20% probability to default/receivership and consider what the bonds would be worth under that assumption? Perhaps 30, just for the sake of argument? We don’t know. The more likely case is “amend and extend,” and the company will successfully extend maturities to 2026, give or take. Marking the bonds to a 20% yield to a 2026 maturity would give us around 83. The expected value given these numbers works out to approximately 73. This approach is commonplace in pricing stressed/distressed debt, but have cannabis investors adopted this approach? It seems a bit too rational for cannabis.
• The chart below shows our updated 9/29/23 credit rankings for the 27 U.S. cannabis companies with over $20M 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. We have also added offered side debt yields, which show a strong correlation to the Viridian Capital Credit rankings. Note we have priced AYR to a 2026 maturity.