Checking the Depth of the Moats: Differentiating Asset Quality of MSOs
Share This Post
One of the things we have been trying to do with MSOs is provide our subscribers texture around the various MSO participants. While most investors do not have the luxury to go out and tour the facilities of their investments to determine “Asset Quality”, nor likely the aptitude to differentiate between good and bad assets, the financial statements and peer comparison can tell you a surprising amount about Asset Quality.
Too many MSOs and their cheerleaders are throwing out numbers that fall well on the ear but might be meaningless or might become meaningless overtime.
- Number of states operating is a good example. Not every state is equal in opportunity. Being in Arkansas or South Dakota is a far cry from being in Illinois or Florida.
- Number of dispensaries is another. It is a number that on its own is meaningless. Number of licenses that they could open has to be the worst when not accompanied by number of opened stores within each state (I am looking at you CCHW).
- Total Addressable Market is also very misleading. Yes, TAM is important but if social justice has its way… 50% of new licenses will be reserved for people of color or persons disadvantaged by the fifty-year war on drugs. TAM might be further limited by regulations on segmentation of production, distribution, and retail.
The sell side carnival barkers on the midway (who are advertising to you as they “inform” you) do not want you to be distracted by the nuance. They loudly tout so you buy into their positions, and they will leave those positions without telling you a word. Their avoidance of risk related discussions and amplification of sell side trope is all you need to recognize as to their motives. (Someone should ask these “long” hedge funds if they are trading the “chop”, as they tell you about the “generational wealth potential”.) They are selling you a macro narrative that falls silent on how regulatory end-state impacts current strategy. The macro is likely correct, but they are overlaying on micro economies and operations.
The solid operating improvements and performances, and make no mistake the results are solidly progressing for most in the top tier, of MSO are predicated on operating in limited license, limited competition states, heavily tilted to retail brick and mortar, in markets that are under supplied, allowing a +200% revenue as compared to open competition states.
Folks, that is not a moat. That is the Maginot Line.
The moats are their wholesale revenues to other retailers and their branded products they sell in their own stores. Selling 100% of your product in your own store is Florida is certainly not a moat. Retailing other manufacturers’ products in your stores, in a retail space where competition is likely going to intensify, is not a moat. Even the brands, as they are not competing in an open market, are not truly being tested. So, our definition of “moats” is rather generous.
Cannabis will be a huge market in the USA. How that market is then divided up looks to be much different in the eyes of social justice advocates, and to the Alcohol and Tobacco Tax and Trade Bureau (“TTB”), who will likely manage cannabis regulations as they do for alcohol and tobacco. Unless you believe the federal government will create a brand-new taxation collection architecture for cannabis, it makes far more sense for TTB to manage and audit national producers and distributors tax collection of say 30,000 accounts than 300,000 accounts if they tax at retail level. (Note: TTB has an aggregate of 32,941 breweries, wineries, and distilleries and 30,638 distributors on the alcohol side. And there are 45,541 beer, wine and liquor stores in USA. Most cannabis markets can expect a population to store ratio of 10,000 to 1 if Colorado is an example. That would yield over 331,000 retail licenses that TTB would need to administer. Something so innocuous as efficient tax collection has the potential to play an inordinate role in how the a federally legal system develops.)
Asset Quality is trying to determine what is the quality of those assets (equipment, cultivation, brands…) that produce revenue, gross margin and Adjusted EBITDA as compared to their peers. Asset Quality pertains not only to assets built organically but those acquired too.
So, what are good proxy metrics for asset quality?
Sales are a good indication, but all sales are not created equally. High margin and low margin. High volume and low volume SKUs. Sales is a very good indication for retail asset quality but wholesale/branded asset quality it does not tell as robust a picture.
Gross Margin is a better place to start. It is the nexus of MSO cultivation and processing operations. Retail operations for MSO’s are a strange beast in that they collect Revenue at the consumer level but the bulk of costs are in Opex not CoGS.
Gross Margin is the Revenue produced by a company less its’ Cost of Goods Sold. For vertical MSOs CoGS includes:
- its cultivated and manufacturers products sold in their own stores,
- its cultivated and manufacturers products, where permitted, wholesaled to others stores, and
- other manufacturers’ products sold, where permitted, through their own stores: “Retail Only Margin”.
Gross Margin % is a good proxy of Asset Quality assuming the production assets have matured to a certain level and are not in ramp mode. Under-utilized full production assets can result in unabsorbed overhead as we have seen in Canada with LP’s, or more specifically with the Hexo Molson Coors JV (Truss) beverage Gross Margin. This unabsorbed overhead depresses Gross Margin, so the proxy remains that GM% is a reasonable underlying metric.
You could have asset quality differential in retail, as well. All one needs to do is look at CL’s two IL Non-Controlling Interest stores versus their average store in the March 31, 2021 Q:
- Rockford Sales $19 million
- Lakeview Sales $10 million
- CL Average Retail Sales per store $3.8 million over 24 stores, of which two stores, Rockford & Lakeview, are 35% of total retail sales.
Sales wise these are two of the better stores in the 24-store fleet. The Gross Margins of these stores are 52% and 48%, respectively, despite the sales levels at Rockford being double Lakeview. These GM%’s straddle CL corporate GM of 49%.
Assuming CL is selling at IL average price of $17.26/gram then they are wholesaling at roughly 50%, so they are selling wholesale at $8.63/gram, which is greater than open states consumer facing revenue per gram in CA, OR, CO and WA.
The above is from Cresco Chicago, Illinois Sunnyside dispensary. Cresco brand is all $63.37 per 3.5 grams or $18/gram or for their High Supply Brand $162-182 for 14 grams or $11-13 gram. Interestingly, their Rockford store sells the above at $64.13. Not sure if there are local county taxes that make the difference. By contracts the Ontario Cannabis Store sells 3.5 grams from C$4.57 to C$19.99 a gram or USD 3.66-15.92. Cresco also sell other manufacturers’ products like Verano Shake for $83.17 for 7 grams of shake or $12/gram.
The asset quality of these two stores is greater than asset quality of the average CL store by quite a large margin.
Let us briefly look at our metric of “Retail Sales per Average Stores Open in the Quarter”:
- CL 24 stores $3.8 million per quarter
- CURA 102 stores $2.6 million per quarter
- TRUL 82 stores $2.5 million per quarter
- GTII 56 stores $2.4 million per quarter
While CURA, TRUL and GTII form a nice tight range, CL is an outlier well above the range. Of CL’s 24 stores 13 are in Illinois and Pennsylvania, very under supplied states. As these states bring on more retail licenses these per store sales will likely wane.
While sales volumes might differ by location, Gross Margin percentage should be less volatile in retail. Stores are going to sell at the price consumers will buy at and they will purchase third party supply at the best price per unit possible. Fairly fixed goalposts. Higher revenue stores might get volume discounts on purchases that move the GM% higher. But the controllable expenses for retail are generally in the SGA expenses. Retail makes money on throughput/revenue spread out over the SGA as economies of scale are achieved on a store or regional collection of stores basis.
And if you think a store in Rockford will pull $19 million in sales per quarter when Illinois dispensaries triple over the next year…then that is a leap. Look at what has happened in Ontario and average revenue per store with the proliferation of retail licenses.
Ontario per store average over the March 2020 to March 2021 period fell from $0.9 million per month to $0.2 million. As comparison, Illinois has 13 million population versus Ontario 15 million. Illinois has 110 stores in queue to add to their present 75. By the time Ontario got to 176 stores in September 2020, the revenue per store fell by half. I understand that Illinois has almost a third of adult use sales going to out of state customers, and that should provide a nice buffer for awhile.
There is also Asset Quality of production, cultivation and brands. We are going to try and back into this as best as we can. In order to do that, given no MSO provides GM segmentation, we will have to model it with assumptions.
There are MSO’s with large retail footprints, ones with concentrations in forced vertical markets (FLA), ones that reside in favourable gross margin states (IL, MA, PA, NV)… what can their gross margins tell us about their asset quality? Fleets with a larger percentage of total stores in favourable GM states should have a better GM% than their peers.
For over a year we have been tracking annualized sales and gross margin as a function of Property, Plant & Equipment plus Goodwill & Intangibles. We have now added Right of Use Assets to the denominator, as leasing has been on the uptake over the past five quarters. We have done this to try and better compare roll ups to organic company growth. The idea that sales and then gross margin will show up first and that will translate to net operating profit. We have also added a similar measure but with Adj EBITDA, as we calculate it not how the MSO calculate it. EBITDA should show up after sales and GM is the assumption, otherwise the cash Opex (which includes retail rent, salaries, marketing, insurance,…as well as corporate and head office types of overhead expenses) is eating too much into the GM delivered.
Recently, we looked to strip retail from operations to try and determine the impact if vertical retail becomes uneconomic (due to timing of excise collection and interstate commerce) or regulated out of existence (no or limited tied houses in retail). This time we will add back a 30% in store market share, adding another layer.
Before we dive into the metrics and an example, I think it is important to step back and visualize how gross margin occurs for MSOs, as it is very different than most businesses that can ship across state lines.
Because of lack of interstate commerce production has been localized into state silos. True national economies of scale do not exist. Regional economies of scale exist, but these would likely be inferior to national economies of scale. Within each of these state bubbles demand and supply determine price to consumer with CA, OR, WA, & CO being well supplied at $5-7/gram, and IL, MA, & PA being very under supplied generating $16-17/gram.
Cyto is busy pulling together retail prices of MSO’s across various states and he almost lost his mind when he spotted a gram of milled flower at USD 13/gram. Then he went to another state and found it again.
Canadian LPs have a very different Gross Margin volatility (even with inventory impairments stripped) than MSOs because of largely centralized production. Tilray improves Gross Margin % at Aphria1 and Diamond and it reverberates throughout the business. Tilray improves GM% at Broken Coast and the impact corporately is muted, given the sales contribution from Broken Coast is small in comparison to the entire operation. Given how many states have evolved moving GM% for MSOs is more along lines of BCC operational impact at Tilray than the Diamond or Aphria1 scale.
So, revenue is pretty well defined in many states. CoGS in those states has been held very close to the MSO vest. I think it is fair to assume wholesale price and CoGS in open states are less than half those in limited license states.
If wholesale in Illinois generates a 50% Gross Margin at $16/gram… well that is a $8 CoGS per gram. Retail to consumer prices in open competition states are less than that. In fact, a company from Oregon tweeted the following in reply to a tweet I had on CL’s Illinois margin:
Oregon is knocking out pounds at $800. He has conservatively used $4,000/pound sale price in IL. With that sale price and a 50% CoGS, CL is producing CoGS at $2,000/pound ($4.40/gram).
CURA sells flower in Oregon at $4.16/gram, in Illinois at $11.40/gram, and in Florida at $6.00/gram. This revenue levels will result in different GM%’s in each state.
There is no national pricing for cannabis in the USA.
Each state, with its own cannabis idiosyncrasies, develops its own gross margin. These are siloed and will be impacted by more competition in-state or via interstate commerce when it occurs. What investors should understand is that it is not when interstate or more in-state competition is set to occur that will impact stock price. It is when they announce the intention to allow same. There is likely a three-year gap between announcement and implementation. But sophisticated investors will be modelling any changes immediately, likely as retail blindly stampede into new positions.
In Florida, with forced verticality and no wholesale, gross margins should be greater than other open competition states (CA, CO, WA, OR) or other limited competition states (IL, PA, MA). Ergo, one would think that MSO’s with a greater percentage of their retail fleet in favourable gross margin states should have a more robust GM than peers.
Also, visualize how tough it is to drive a higher gross margin when your production is not centralized but siloed across multiple states.
To improve gross margin across the company, assuming no revenue or price compression, you would need to improve production on a state-by-state basis. When you are in 15-20 states that is like turning an oil tanker. If you only improve gross margin in one state and that state is 20% of your revenue, you get a very muted improvement to overall gross margin.
Should the assumption of no price compression fall away, which it should as states license more canopy cultivation and more retail outlets (even without interstate), then improving gross margin corporately becomes very difficult, as state siloed production improvements must then outpace the price compression.
That is tough enough in the state-by-state environment but WHEN interstate is announced (not implemented) we will see analysts scramble to disseminate what will happen. So, let us get ahead of the curve and try and figure out who has better asset quality.
- State by State Footprints
- Annualized Sales as a function of PPE+G&I+ROU
- Retail Average Sales per Store
- Annualized Gross Margin as a function of PPE+G&I+ROU
- Annualized Adj EBITDA as a function of PPE+G&I+ROU
- Gross Margin %: short term range and directionality
- Percentage of High Gross Margin Stores versus Total Stores Sales
- Gross Margin $’s versus peer Gross Margin IF stripped of Retail GM
- Inventory Turnover
Due to a complete lack of gross margin segmentation by MSOs across retail, we will consider retail stores producing a gross margin of approximately 50% on average (We have kept GTII Retail GM at 57%, as if we back it out at 50% we drastically increase GTII Imputed Wholesale GM%). The 50% is a fairly standard consumer good retail benchmark and also marries up to Cresco Labs transfer pricing with their Non-Controlled Interest MedMar retailers in Rockford & Lakeview, Illinois. Canadian public retailers have a 35-39% gross margin, and that is with provincial governments margin confiscation as central distributors.
Keep in mind that retail also has a bunch of costs in Operating Expenses (rent, salaries, insurance,…) after Gross Margin is calculated. That means expenses, be they CoGS or Opex, hit the income statement at different levels.
We are separating retail gross margin from wholesale gross margin as we think within each state bubble retail GM% should tightly cluster across industry. By doing this we can try and model what remaining gross margin is attributable to production and processing.
We are also stripping retail as we believe this is the most at-risk segment from possible federal regulations. Do you see any stand-alone Bacardi stores, Corona stores, Southern Comfort stores? There is a reason for that (federally and state regulations), and it might just gravitate to cannabis.
Where our modelling is deficient is that only one MSO is providing insight into own brands in own stores market share. That is GTII at 31% market share if its’ brands within its’ stores. I think it is fair to assume if Florida went to an open retail market, Trulieve and others would need to rebalance their stores by offering competitors products for sale in their stores. Trulieve holding 30% of its shelf space for its own product and 70% for others is probably not to far off.
As per our article on Ripple Effects & Moats we believe moats to be the brands that sell through in non forced vertical markets and the wholesale channel. Brick and mortar retail stores, which will devalue with ever new competitor added to the retail space, are the least defensible in our opinion.
Presently, an MSO like TRUL would have a higher amount of market share in their stores, as they have a higher percentage of forced vertical stores in FLA that sell 100% TRUL products, whereas GTII has only 13% of their retail fleet in FLA. So, in GTII’s FLA stores they are 100% market share, which means that the 31% corporately is even less in Illinois or Pennsylvania in order to counterbalance the 100% from FLA.
We will focus on CURA as our example below, but we will provide narrative about TRUL, GTII and CL where it is relevant. CURA are the biggest MSO by market cap, revenue and store count. Number 2 in Florida, with maximum allowable stores in IL, PA, MA, and NJ, all high margin states.
This will be a familiar picture for our subscribers. It is a Venn Diagram of CURA, GTII and CL. I have tried to add TRUL with HARV but it becomes very illegible.
Interestingly, every state GTII is in CURA is in. The overlap between CURA and CL is less than GTII/CURA and includes Arizona. CURA also has operations in nine other US states where GTII and CL have not entered.
Annualized Sales as a function of PPE+G&I+ROU
We use PPE + ROU + G&I as a denominator as those are the assets that were built or purchased to drive sales and operating performance.
NOTE: In a quarter where a sizable acquisition occurs NOT at the beginning of the quarter, this metric can be skewed for said quarter and bounce back the next. That is because PPE + G/I + ROU land on the balance sheet at acquisition and the income statement might not reflect a full quarter of sales, GM, or EBITDA. As such, hiccups can occur. The question becomes what is the rebound and trend.
From this comparison we see that TRUL is the leader but as they layered acquisitions in the last two quarters this metric took a hit.
CL is the next most efficient, generating $0.77 in annualized sales per dollar of PPE+ROU+GI.
CURA is the last in this peer group, a full 17% behind the third place company GTII.
Again IMO, Sales is not the best indicator of Asset Quality, but it certainly is a contributor.
Retail Sales per Average Stores Open in the Quarter:
- CL 24 stores $3.8 million per quarter
- CURA 102 stores $2.6 million per quarter
- TRUL 82 stores $2.5 million per quarter
- GTII 56 stores $2.4 million per quarter
CL is in the lead on a fleet basis. The tight range of CURA, TRUL and GTII is likely more representative of CL if it expands its footprint and store count.
Annualized Gross Margin as a function of PPE+G&I+ROU
To me, Gross Margin is more important than sales in determining Asset Quality. An MSO could be selling value ounces versus higher margin premium flower.
GM for MSO is a little deceiving as cost of production and inventory acquired via wholesale contributes. Yet the retail related expenses are buried in Opex.
Again, TRUL is the market leader. No surprise, as they likely have the largest percentage of vertical sales in the peer group, which attaches a larger GM$ and %. TRUL GM% has come down with PA acquisitions and will come down further when HARV is on the books.
CURA comes in second in this metric. Given they have 104 stores last Q versus GTII and CL stores of 56 and 24, respectively, they should generate more GM$’s, and they do. And as retail should be less capital intensive than cultivation and processing, this makes sense. But Retail has more cash Opex that is not captured in the GM line.
Annualized Adj EBITDA as a function of PPE+G&I+ROU
TRUL is again the leader by a wide margin. This gap will change as they onboard HARV. They will likely still lead but the margin of their lead will diminish.
CURA comes in last in this metric as that cash Opex from their higher store count is absorbed between GM and EBITDA.
But let us look at the differential between the previous GM and this EBITDA to see how much of a dollar is leaked in cash Opex.
- CL $0.21 leakage
- CURA $0.36 leakage
- GTII $0.15 leakage
- TRUL $0.36 leakage
Not surprising that the two companies with dominant FL presence, forced verticality and the most stores in MSO land have the greatest leakage.
What is surprising is that GTII with its 56 stores has less leakage than CL and its 24 stores.
Gross Margin short term range and directionality
Recent Q, range over five Q’s:
- CL 49% and 30-52% … Q0-1 had an inventory impairment. GM% had been increasing as Il and PA launched in F2020 (Q0-4 to Q0-1).
- CURA 49% and 48-54%… trending down. Acquisitions dampened GM%.
- GTII 57% and 52-57%… last three quarters all above 55%.
- TRUL 70% and 70-75%… trending down. Acquisitions dampened GM%.
This is an interesting statement from CEO of CuraLeaf:
Cura has no stores in California and has 190,000 square feet of cultivation and processing out of its total of 2,000,000 square feet. Since the CEO is commenting on two things he does not disclose (regional sales and gross margin) let us model this.
I assumed California was 5% of sales and had a GM% less than half of Cura all in GM. I backed that out of March 31, 2021 results. It results in an improvement of 2% GM if Cali is stripped.
If improving your GM to seventh best in the above peer group is “killing it”… You might want to tone down the hyperbole or, ya know, actually provide evidence to support it.
And if you are in CA for strategic reasons (as are CL, GTII and TRUL to varying extents) and you do not plan on leaving… is it a really a reason to be called out by the CEO for why GM is lower?
Percentage of High Gross Margin Stores versus Total Stores Sales
Stores in FL, IL, PA, MA, NV should have better GM%. We could likely add NY and MD to this list and a few more, but we have kept it to larger contributors.
- CL 58%
- CURA 61%
- GTII 66%
- TRUL 98%
This tracks well to GM% in latest Q. TRUL has the highest, as it likely should, given the % of stores of their fleet in FL and PA. GTII is second in GM% and they have the second highest percentage of stores in favourable margin states.
CURA & CL have similar GM%, but one would think CURA should have an advantage given their position in FL. CURA has more stores in FL than CL has total USA stores.
Gross Margin versus Peer Gross Margin IF stripped of Retail GM at 50% AND Prior Retail had a 30% Market Share in Disgorged Stores:
- Take the provided revenue split by Wholesale and Retail and apply an assumed Retail GM% to generate Total GM less Retail GM = Imputed Wholesale GM
- Take Retail Sales at an assumed 30% in-store market share (assumes the stores can open shelves to all suppliers), subtract the retailers GM on that slice of share, which leaves GM on that share = Retained Revenue.
- Add 1 and 2 to try and determine a Total Imputed Wholesale and Retained Revenue.
Note, that I handicapped GTII in the first assumption. I used a 57% retail GM versus others 50%. The 57% was their actual all in gross margin last Q. If I used 50% then they would have had a 71% GM on wholesale. IMO this would likely be too high.
Is the assume 30% in-store assumption accurate? I am using GTII’s disclosure as a proxy. Would a fully vertical TRUL store in Florida, if sold off or even if they had a chance to operate the store but with ability to sell other products, hold greater than 30% of their own SKUs? Possibly, but even CL Illinois stores carry a wide selection of SKUs from other manufacturers.
Running this model… CURA comes out with the most Revenue, followed by CL and GTII. But GTII comes up with a better absolute GM$ and GM%.
What this does not tell us is how much SGA for retail gets jettisoned if they sell off retail operations?
So, what are the modelled Moats of CURA, GTII and CL if we strip everything save branded sales? Sales would drop 76% for Cura, 71% for GTII and 67% for CL. The revenue moats as we have modelled them would be 24% CURA, 29% GTII and 33%.
They might need to add water. The above could be why we do not see any disclosure around branded sales by MSOs. MSO operations today are retail brick and mortar revenue and margin dependent.
Low inventory turnover is efficient. But too low inventory could impinge on sales in fully vertical markets (eg. Not enough product for the shelves.)
Think of Candian LP’s with inventory turnover of 3-4 quarters. That inventory might not sell and might need to be impaired. All of the above MSO’s are very efficient.
TRUL and CURA have 77 and 37 stores in Florida. As FL is fully vertical these companies need to maintain a higher amount of inventory as they cannot supplement their store shelves by buying wholesale.
What do all of these metrics Asset Quality metrics tell us about CURA in relation to its peers?
Simply put, they do not seem to be as efficient with their assets as GTII, TRUL and CL. It could be that those nine states that GTII and CL are not in that CURA is in looks to provide little benefit other than in raw revenue and GM$’s.
Further, pivoting to improve GM% would take efforts across multiple states for CURA all coming together for meaningful movement.
CURA might be the biggest in several metrics that retail investors gravitate too, but they are not the most efficient. If they are not the most efficient now, what is the argument for them being the most efficient in the future?
And to be clear… the stock market does tend to reward size over efficiency. But that gap closes when the quality of investor (institutions) start coming in.
It is also important to look out to see where the company’s metrics will move in the future as they expand.
TRUL has a huge lead in some of these metrics. This is driven by the forced vertical in Florida. As they expand outside of Florida these will see pressure. And… can you imagine what opening up of Florida retail would mean to TRUL? They better hope the room they make on their shelves that displaces their products will find a spot on other retailers shelves. The problem is… the margin they receive on this new wholesale will likely be half of what they presently generate through a full vertical.
Using a 30% market share of TRUL products in TRUL stores should Florida eliminate verticality… TRUL would have to find a home for 70% of the products they move through other retailers. That is quite doable. What makes it difficult is that 70% product will no longer generate the same revenue and gross margin. They would likely have to double wholesale revenue to produce the same revenue as they do presently.
If you wonder why, with the great operating metrics TRUL sports they trade at a discount to their peers, the reliance on Florida and the commensurate risk identified above is the likely culprit.
It is interesting that CEO Rivers purchase $1 million shares on June 16, 2021. The date is meaningful. June 14, 2021 and May 27,2021 , the Florida Supreme Court provided rulings that bolstered verticality. TRUL looks significantly different if verticality gets dismantled.
And for all the MSO’s… the gameplan for federal legalization and regulation might be kept in the filing cabinet until a pathway is laid out. But there better be a gameplan!
Is there a pivot away from what has been the main driver to date, being bricks and mortar Retail? CL has indicated they want to be wholesaler. CURA CEO has also indicated same. Regulations, or the economics of regulations, could force the pivot. The retail portfolios, protected by limited licenses and demand outstripping supply, are at their peak value presently. More competition in cultivation will drive down prices and resultant revenue, as will adding more stores.
Investors should understand how companies generate their profitability and where the risks to that profitability lie. I hope the above has helped in that regard.
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.
You must be logged in to post a comment.