Cannabis Administration & Opportunity Act
Well subscribers, I would be lying if I did not say we were proud of the research we did to prepare you for what this bill would look like. When it dropped, you folks were amongst some of the best prepared to evaluate what it meant to your portfolio and what actions made sense to you.
This Bill has a steep and rocky path to see the light of day. And even then, implementation would take three years or more. But this Bill will be an overhang on industry and valuations. Even in Draft form it will be a specter until something more concrete takes its place. That does not mean we will not have euphoric runs like we have had in the past. But large sophisticated buyers/investors will be looking at present business models versus probable future business model, just like we have been doing.
For me, the Draft of Cannabis Administration & Opportunity Act (link is to Summary) itself had me holding my US positions. My strategy was twofold:
- Have positions to take advantage of SAFE banking run up and de-risking; and
- Have positions to take advantage of retail investor euphoria should the Draft inspire an industry run like it did again in February 2021. Follow euphoria with trailing stop losses to protect wealth.
The Draft did not alter that. Senator Booker’s comments at the CACO presser regarding SAFE did.
- “I will lay myself down to do everything I can to stop an easy banking bill that’s going to allow all these corporations to make a lot more money off of this, as opposed to focusing on the restorative justice aspects.”
I unloaded over half of my AYR and GTII positions in response to Senator Booker’s comment. These are effectively “in the money” positions, as they are remnants of my original LHS position that I removed initial investment at $2.84/share a looong time ago. And I had made +15% on AYR to GTII rotation approximately 10 days earlier.
I rarely talk about trading (this could be one of the first, if not the first, on this website), as I am a long-term investor on fundamentals. But as items arise that affect your thesis, you have to re-evaluate.
I have had major sales of my cannabis portfolio twice. January 2018, after a huge euphoria run and the day before the “Cole Memo” was rescinded (how is that for lucky timing) I removed all of my initial invested capital in Canadian and US cannabis. February 2021, in another euphoria run, I liquidated over 90% of my Aphria position. I reloaded some positions in between but did not sell.
With Senator Booker putting a stake in the heart of SAFE it changed my strategy.
Why did I not sell my entire position? I wanted exposure to US cannabis. I just thought funds generated from sale could be deployed in a better sector for the time being.
YOU are not me. I am approaching retirement in the next five years and am in wealth protection mode versus wealth creation mode. I have less runway if I screw up. I will take EDUCATED strategic shots at the risk side of my portfolio (and had recently deployed a significant portion of “riskier” capital portion of my portfolio against a new venture outside of the industry that is pre-public). I had already taken my initial capital and some significant gains out of cannabis.
This all to say… be an Adult and make decisions for your portfolio and risk profile. Don’t do me, as you are not me.
Am I bullish on macro cannabis in USA? Hell yes! Market will be enormous and will grow. But my research has convinced me that a major pivot in MSO business operations would be necessary should the Bill pass. The large established players are likely the most prepared to take advantage of this given the head start they have. The head start also has given them substantial goodwill and intangible exposure that could erode. Yes, non-cash, but it affects EPS and cost of capital.
I am not convinced as to management acumen yet, given these companies are succeeding against limited competition in under-supplied markets that allows them to charge a considerable premium for any legal product. These operations are bubble wrapped.
CURA CEO has recently indicated:
- their Gross Margin would be much better off it was not for California operations
- cultivation east of the Mississippi River will be rendered obsolete
- he would not be opposed to holding only “flagship retail”
This is a CEO that knew well in advance what the Draft looked like and started messaging accordingly.
MSO have really built their operations on accumulating and opening retail doors. Retail-Wholesale Mix and Goodwill/Intangibles $’s both at March 31, 2021:
- CURA 72-28 mix, $1,251million
- GTII 67-33 mix, $778 million
- TRUL 100-0 (as they give no disclosure and are heavily FLA vertical based, we are using 100%) and HARV 87-13…as G/I will change substantially with acquisition I have not included it.
- CL 49-51 mix, $675 million
IMO, Retail is not a moat. Revenue is generated by MSO’s from:
- Wholesaling their products
- Selling their own product in their own store
- Selling other people’s products in their own stores: Retail only margin.
IMO 1 and 2 are moats… 3 not so much. Additional stores added decrease the value of existing stores via competition. More stores are going to be added. And the problem is… disclosure around 2 and 3 is not being provided by any save GTII, and even GTII would be skewed by their 100% Florida stores.
Add to the above inflated revenue due to an imbalance in supply versus demand which leads to inflated Gross Margins (which would get corrected quickly via interstate) … and I am wary.
I will be watching acquisition of new retail, versus organic store openings, to see if strategy shifts. Be cautious of MSOs buying retail at premiums. There is a chance that given how retail market responds to the addition of retail like Pavlov’s dogs to the sound of the bell, “Retail Revenue” might become to USA operators what “Funded Capacity” was to Canadian LP investors.
How much of the above is Retailing of other manufacturers’ goods or Florida’s 100% forced verticality?
Given GTII, including their stores in Florida, has 31% share in their stores, I would anticipate market share in non-forced vertical is closer to 20% than 30%. To me, that is not a moat.
How much gross margin does it generate? What happens to GM when interstate happens or of retail is disgorged?
Wholesale… but what if distribution is then federally separated from manufacturing like in alcohol? Does this get cut in half?
Yes, the Bill is going to change, the pathway laid out has some areas for change, but some areas are IMO “hard walled”, and it is these “hard walled” areas that add risk to my portfolio. As an example:
- Areas for change: % of excise tax not that excise tax will be charged
- Hard walled: Excise tax collection at first sale, simply for ease and efficient tax collection. Interstate commerce as it is embedded in US Constitution via Dormant Commerce Clause.
Until we see and hear change from MSO’s to their present strategy, and only CURA seems to be showing any change in strategic direction and I have concerns regarding their asset quality, I would prefer to have funds on the sidelines. Again, that’s me.
OK… let’s look at the Draft and the Bill for areas that impact operations:
This is not yet 3-Tier Alcohol. They have imported a substantial section of alcohol regulations into the Bill, and the Summary of Bill uses alcohol and tobacco as the jumping off points before they described what they are proposing to do in cannabis.
What is presently silent in the Draft is whether federal permits will be separated into classes like alcohol’s: Manufacturer or Distributor. Page 147 of the Draft “Form of Application” section 2, contemplates “various classes of persons entitled to permits under this title”. This seems to me to be to allow distinct classes of permits at a later date under either more formal legislation or in the regulations to that legislation.
Limiting Big Alcohol and Big Tobacco Entrance:
Senator Schumer has repeatedly indicated he would like to see big alcohol and tobacco not come in and muscle new entrants out of the way. There is nothing in the Bill that would do this.
They might put something in the Regulations that limit federal permit holders in alcohol or tobacco from entering or it might be in revised language in amendments to this Draft.
Excise Tax Timing and Interstate Commerce:
Even though the distinction between manufacturer and distributor is not present, the timing of excise is at “Removal” based on “Removal Price”, and that is effectively first sale.
We modelled Excise at 10% in our article “How Excise Tax timing & Interstate Commerce Impacts the Economics of Verticality in USA Cannabis” At 10% excise on first sale verticality is threatened, at the higher end of 25% proposed it would wipe out verticality except for flagship purposes. Consider this:
- A fully vertical retail in Florida selling $100 in flower, “removal” is sale to consumer, excise tax is $10, so price to consumer if $110.
- A non-vertical retail in Florida buys the same quality flower from another Florida cultivator at $50, “removal” is sale from cultivator to dispensary, excise tax is $5.00, so price to consumer is $105.
- A non-vertical retail in Florida buys the same quality flower from another Florida cultivator at $50 BUT from a small cultivator that qualifies for 50% discount to excise, “removal” is sale from cultivator to dispensary, excise tax is $2.50, so price to consumer is $102.50.
At 25% excise it is $125.00, $112.50 and $106.25, respectively. That is a 10% advantage and 15% for non-vertical and non-vertical small business, respectively.
Substitute California wholesale cost for Florida in bullet 2 and 3 and their cost differential is even more dramatic. Thus, why we believe Florida is the riskiest state in transition from a cultivation and retail pivot perspective.
With the above economic impact, and states not permitted to treat out of state cannabis different than in state manufactured cannabis, verticality need not be legislated out of existence… Adam Smith’s invisible hand will take care of it.
Unfair Competition and Unlawful Practices:
Page 152-160 of Draft they capture the alcohol practices: Exclusive Outlet, Tied House, Commercial Bribery, Consignment Sales, Labeling. The first four are almost verbatim from alcohol.
The Tied House provisions would require vertical manufacturers to consider disposal or acquisition of all their Non-Controlling Interests in retail and severing management service agreements to manage non wholly owned stores.
- “A) Acquiring or holding (after the expiration of any existing license) any interest in any license with respect to the premises of the retailer.”
They may be providing a grandfathering with the portion in parentheses.
This is probably where most retail investors make assumptions that do not hold up when comparing cannabis and alcohol. Do not worry, even investment banks get it wrong. Here is BTIG getting it wrong:
“Explicitly” you say??
Cantor on the other hand:
Looks like Cantor got it right but would prefer interstate gets delayed. Spoken like an investment bank with a stake in the current players.
Draft of CACO:
State’s have been given right to opt out of legal cannabis, but those that allow it look to be subject to Dormant Commerce Clause just like other CPG industries. Opt-out states must also allow transportation through their state.
The thought that State’s can erect barriers to entry seem to have been clarified in the above.
Imports & Exports:
Contemplated, and looks remarkably similar to alcohol and tobacco. BUT the Secretary needs to provide permit. Regulations might be more important than legislation here.
Until various UN level treaties get amended only medical cannabis would likely be permitted to cross the border.
Social Justice Restoration:
As we thought, the feds will provide carrots (excise tax proceeds) to the states that have social equity programs that they approve. They will funnel excise tax receipts to states that meet the to be established parameters. This is another version of States Rights. Sates can meet social justice provisions and get federal money or opt out and not get federal money.
Some sell side analysts are now pushing the argument (with sufficient handwringing and anguish)… “how can you have social justice programs when the entrants cannot get banking because a lack of SAFE? Especially in Schumer’s home state of New York”. Yesterday, Illinois announced a Social Equity Cannabis Loan Program offered via two credit unions, with a first-year goal of deploying $34 million.
Yes, banks have a greater reach than credit unions, but social equity can get done.
That is all that presently strikes me about the Draft legislation.
There is going to be a lot of noise out there about what this all means. It is backdrop until it is in final form and passed, then regulations are written, then roll out. This will take years to happen if it does happen at all. But the Draft does provide a framework for what would likely end up passing … eventually.
You are going to hear a lot of messaging about what this means. You should decide if the messenger is actually an advertiser before you look to interpret their message.
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. The author has a position in GTII and will not increase or divest in the next five days. The author does not have a position in CURA, TRUL or CL and will not start one in the next five days.