Chart of the Week
The Viridian Capital Chart of the Week highlights key investment, valuation and M&A trends taken from that week’s Deal Tracker that we believe are impactful for investors, companies and acquirers.
Viridian Capital Chart of the Week: Better Capital Efficiency is the Missing Piece to Achieve Solid Returns on Invested Capital
- In an earlier Chart of the Week, Viridian discovered that very few cannabis companies have returns on invested capital high enough to cover their weighted average cost of capital (WACC). This week’s graph delves into the underlying factors for the weak ROICs.
- We calculated projected 2025 ROIC (Return on Invested Capital) for each of the fourteen companies on the chart by first calculating NOPAT (Net Operating Profit After Tax) by taking consensus estimates of 2025 Operating Income and tax effecting them using a 25% tax rate, making the aggressive assumption that 280e will be resolved in time for 2025 taxes. We then divided NOPAT by Invested Capital (Book Equity plus Debt minus Cash. The resulting ROIC is depicted by the green line on the graph. We then broke ROIC down into two components: Net Operating Profit after Tax / Sales (represented by the red line) and Sales/Invested Capital, a measure of capital efficiency, depicted by the black line.
- The ROICs range from -.7% for AYR (AYR.A CSE) to 18.5% for Jushi (JUSH: CSE). Financial theory tells us that if a company’s ROIC is greater than its weighted average cost of capital (WACC), then it creates value for its owners. But, if ROIC < WACC, then value is being destroyed.
- The table below the chart does some indicative WACC calculations based on the following assumptions in the Capital Asset Pricing Model (CAPM):
- Risk-free rate 4.25%
- Market risk premium 5.75%
- Debt rates that vary from 9% to 18% as leverage increases
- Only three of the fourteen companies, Cresco (CL: CSE)), MariMed (MRMD: CSE), and Jushi, have ROICs over 10%, and given their respective market leverages, it is unlikely that any exceed their WACCs.
- The principal issue seems to be capital efficiency. We have noted previously that the industry is highly capital-intensive, but it is worth looking at this from a funding point of view. The group average Sales / Invested Capital is only .78x, which implies that for every dollar of sales added, $1.28 of extra capital is required, which cannot be internally funded given the group’s after-tax profitability (even assuming no 280e)
- Cannabis needs to become more capital efficient to be able to both earn solid returns on invested capital and internally fund growth. Progress towards this goal is likely to come from the intrastate consolidations we are beginning to see in markets like Missouri and Michigan. On a longer-term basis, intrastate commerce will allow significant capacity consolidation and materially improve the group’s capital efficiency and ROIC.
