TheCannalysts’ multi-part series on legalization in the US has put forward a regulatory ‘straw-man’. This model is but one of many possible outcomes. But.
Given existing sectors (eg: tobacco & alcohol) and their attendant regulations, we believe that through any formal legalization/decriminalization, existing elements of various trade and taxation measures will be applied. We are not claiming this will be the end state – but we believe covering the economic and commercial implications are vital to the investor.
After all, equity prices are simply a reflection of the underlying assets and cashflows. And as GoBlue has pointed out in Part 1 (the general framework), KISS satiates many of the facets around discussion of federal regulation. Part 2 examines the Retail landscape, and is a great illustration of how wide the gap may become when Retail assets aren’t serving a single master anymore. Part 3 addresses the implications for cultivation and processing assets. I hope the primary takeaway to the reader is that existing MSO equities are – in reality – not much more than a basket of single-state operators (SSO’s).
Whether equity prices contain expected legalization uplift – well – one can hold a variety of opinion. TheCannalysts strongly believe that the absence of discourse around the separation of production and distribution within the sector does not serve investors. The lack of discourse around the Dormant Commerce Clause (DCC) and the potential for alcohol-like ‘Tiering’ struck us similarly. We identified both in April and March of 2021 respectively. Subsequent moves by government saw NY impose restrictions on size/scale of business, and Schumer/Booker/Widen’s CAOA introduced that very tiering – which in part led to a whole year of folks sitting on dead money.
Interest has been rekindled in the sector due to renewed regulatory efforts. While glacial, each passing month brings more hope that cannabis legalization/decriminalization is an inevitability. Good. Particularly for jobs, tax creation, and bringing a large and durable market into the world of formal commerce.
Before we begin, I’d like to reiterate a point I’ve made on our podcast. That much of the sector – the financial sorts, stock promoters, sell-side brokers – did not surface the potential for DCC and Tiering. To me – that means one of two things. They didn’t know, or, they knew and didn’t mention it.
I reflect on that often, as I see the impact of these issues to future share price as material, and unarguable. That these weren’t addressed in any forum I’m aware of by the financial ‘industry’ – to myself – is unforgivable. Particularly from firms that command massive amounts of resources and capabilities. ‘Caveat Emptor’ seems an understatement in this light.
At any rate – Adam Smith is getting a real workout this week. Today, we’re going to take a look outside of the cannabis value chain, and muse about other players and their potential entry into US cannabis following federal regulation.
The list is not a short one: there’s many more out there. They all hinge on federal action though, and presumably LP’s haven’t made these deals simply to create a press release.
When the KISS strawman is applied to these deals – what do LP’s actually have? Without a federal distribution permit, they hold a piece of a basket of SSO’s. With all the islanded cultivation, processing, and packaging operations that existing MSO’s hold. Retail will discover its’ need (desire) for independence – or even if not – pricing pressures will flow back upstream internally.
Does this change the calculus of these deals? In a word: yep.
Similarly for brands. I think of Wana here, where $CGC heavily touts the ‘scaleability‘ around their option to purchase ahead of legalization. But, absent national distribution, the product remains siloed at the state level, and ostensibly ‘fixed’ at the licensing level. Would input cost and processing capability in-state be able to counter a flood of cheaper product from ex-state? Will regional markets emerge – requiring additional cost and research and SKU count – defeating the notion of a brand executing the synergies assumed under the capstone of ‘federally legal’?
As an entry point, an SPV might be able to provide an LP the ability to split out retail from say – cultivation or branded assets. ‘
This is to encourage the reader to consider how separating distribution from production/sale can impact existing LP investment in the US. And I hope it lays out the stark risk around the assumption that a federal flip to legal will immediately benefit LP’s that have built doors into the market. There is no guarantee there’s going to be a handle to grab on those doors. Nor, that what’s on the other side is what was envisioned.
Consumer Packaged Goods:
There is a strong notion that formal commerce will be incoming to cannabis vis a vis ‘Consumer Packaged Goods‘ (CPG). This assumption has been around for several years – be it Shoppers Drug Mart (as aggregator), or more upstream (think Altria/Imperial Brands).
If anything prompts one to think of ‘supply chain’ – these would be companies that do it.
And what they do is create and path product across wide distribution. Distribution itself – a relatively unsexy, but profitable and eminently durable part of the economy – is a powerful and specialized piece of commerce.
The creators of CPG know how to create products, brands, price them, market, and get them onto shelves. I don’t believe there’s much competency in MSOs at this level. Over the past two years, LP’s and MSO’s have been bringing this talent into their shops and (presumably) prepare. I don’t think it’s much a coincidence that CPG actors in the space have had limited overall impact (yet).
With respect to Canada, the State Monopolies act as distributor – adding a layer of price and product discrimination that’s challenging to navigate. I’ll add that the sector itself in in relative infancy – I suspect product refinement and target operating states are far from settled at this point.
In the US – brand homogeneity is extremely difficult to achieve. State by state cultivation and processing conditions are not centralized. This resists the ability to operate at scale – which is the underlying premise of federal legalization/decriminalization – which will boost earnings, and thus, asset value.
Should KISS – or federal distribution be enacted, I have little doubt we will see entry by large existing CPG companies that know how to create economies of scale and facilitate/create distribution. The first that comes to mind here is Amazon. While tut-tutted in the home delivery sphere by more than one pundit – distribution is their thing. It’s virtually their entire business model. I see no reason why a subsidiary exploiting B2B interstate commerce wouldn’t seek to become a federal distributor. They’ve got money, expertise, and they’re hungry as hell.
Institutions
This is probably the most challenging of these topics to analyze.
They’ve been used as a pump device by the carnies – who intimate they’re the metaphorical ‘Barbarians at the Gate’ – patiently waiting with their billions of dollars, ready to pounce on all those underpriced MSO assets out there. Their relative absence in the market is touted as being the reason for low trading volumes, and the very second that switch is flipped – the inrush of capital will create generational wealth for anyone even thinking about an MSO ticker.
I’ve worked in institutions for more than half of my professional career. And from that experience, I’ll tell you straight up that is not how they think.
Institutions think about risk. Alot. All-day-every-day to be precise. They think about economic risk, transactional risk, liquidity risk, macro-economic risk. Etcetera, etcetera. You get the idea.
Risk/reward is the primary consideration when opening exposures, and I can’t see any sizeable position being held with a regulatory meteor shower in the forecast. They might take some longer term derivative positions, but these outfits live eat and breathe risk management for a living. They are here already – make no bones about it. But typically in smaller, more specialized shops. Which, brings up…..
A secondary factor is reputational risk. The brokers/bookrunners available to weed shops in Canada aren’t terribly deep, and thus, capital flows are confined to who will do business with you. Weed’s had a bad name for generations, and generations it will likely take to normalize the product more broadly. Whether that crimps new participant potential in institutional capital is an unknown.
Another ‘must have’ for institutions is in the ability to hedge exposure. I saw this first hand around the Malaysian ringgit. That’s the primary currency of Malaysia. It’s largely what the world rubber supply is traded in as the settlement currency with Malaysian producers. The management of the currency by the government can also be described as <ahem> arbitrary at times. Many institutions don’t like risk that’s not only unforeseen and nation-state guided, but also largely unhedge-able.
Cannabis could fall into the business that is unable to access the primary financial currents. I honestly don’t know, aside from thinking that the cost of capital will fall with federal action. I also believe there will be a massive inrush from those who have waited for clarity on federal regulation. If this is the case, there will be many assets in formation, adding a layer of competition that was absent.
Another facet is that of which institutions will come forward. Long time readers will know of my belief that cannabis is a commodity. That statement isn’t exactly an elevated insight, but up until 2 years ago, it was fought against intensely. And this is where hedging will call home. Should commodity firms step in, using exchange cleared instruments and standardized contracts and derivatives – it will literally change the price landscape. <I dislike the phrase ‘game-changer’. To me, it’s an overused sell-side trope that’s packs an almost Escher Phrase level of meaninglessness>
Commodities are my wheelhouse. And if there’s one thing I’d like the reader to takeaway from this is that they are not and do not behave like equities. If cannabis is formally commoditized, the bifurcation between cultivation and processing and retail will be as expansive economically as any federally enacted regulation could ever achieve.
I hope this has given you some food for thought.
TheCannalysts have seen several boom/busts over the years, as investors have run from one side of the boat to the other in hopes of spotting a whale. The volatility and inherent risk in this sector is far from settled. While some would like to make you think that risk centres around legislation being passed, we believe – and have seen up front and personal in Canada – that the regulations themselves is what will define the economic landscape in the future.
I hope that we’ve illustrated why decrying that “interstate won’t happen for years” is useless from an investing standpoint. As is the notion that a ‘currently vertical-only state is a moat’.
MSO valuations – whatever they be driven by – can be said to be predicated on the notion that it will become federally legal.
We believe that to be equally useless in predicting future asset value. The notion that one can purchase length now and happily wait three years for the millions to accrue – is a multi-billion dollar assumption underpinning future operating states. This, like the DCC and Tier examples mentioned above – have not been surfaced in the #MSOGang froth.
Ask your favorite bull what risks they see in our KISS strawman. Hey, even perhaps just one part of it.
I suspect the answer will tell you alot. Most likely, you won’t even get one.
We’ll be looking at various MSOs and their regulatory exposures over the next couple of weeks. From the relatively pure interstate production play of a Glasshouse ($GLAS.U) to a goldfish that has made bank living in a vertical fish bowl in Trulieve ($TRUL).
I expect there will be much change in the MSO landscape in the event of federal regulation. It’s the type of change that should interest the investor.
The preceding is the opinion of the author and is in no way intended to be a recommendation to buy or sell any security or derivative.
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