We continue our look at the nested optionality embedded in the US MSO space
Today it’s Cresco Labs ($CL). Like other MSO’s, leverage within their capital structure is opaque, and requires effort to try and discover the conversions that will impact the cost of capital.
Despite what they’re called, any super/compressed/multiple shares that convert to subordinates at a rate greater than 1:1 can bloat a share count fast. And in the case of some, it currently represents hundreds of millions of notional dollars added to share capital in exchange for far less than market value.
This isn’t theoretical.
Dilution is a well worn subject, and most of our readers are likely intimate (maybe too much so) with the topic. I’m going to use it though to explain how the existence of ‘supers’ in capital structure impacts asset valuation….. as well as a having a dilutive effect. It’s at the bottom of the post for those interested.
Cresco has been as challenging as the other MSOs we’ve looked at so far (in $GTII and $CURA). Disclosure in the MSO space is uneven as it is. With differing share definitions and rates of conversion….analyzing each of these companies can be a ‘one-off’.
The only thing that is uniform is trying to discover what the conversion price is for ‘supers’. It’s almost as if there’s a deliberate effort to make this hard to find (and I strongly suspect there is).
In the case of $CL, they have ‘Supers’ at 1:1, ‘Proportionates’ at 200:1, and ‘Redeemable Units’, also at 200:1. Like others, they’ve used some of the high ratio shares in acquisitions (Valley Ag notably, which were issued at the prevailing market price of the time, and subsequent issues for interest payments appear the same). Other proportionates and redeemables though have been struck via options, with one strike sent out the door at $1.50 for each underlying subordinate…..when share price around $10. One single proportionate issued then brought in $300 USD cash, and the person giving up that proportionate was issued $2,000 USD in equity in return.
I can only find this information in the Annual Information Form, and won’t be able to price other issuances until the next one is published in late April 2021. If you want an example of why TheCannalysts go on about disclosure, that’s a gem.
The following table shows that more than half of the fully diluted outstanding float isn’t on the market, and I have little ability to directly price it:
$CL also likes being ‘long-dated’, with option expiries out past 2030. Notably, they have 11MM options expiring in March 2028 at an exercise price of $1.50 (hella!). They also force the user of the financials to calculate average prices longhand by not including ‘low’ priced options (17MM at <$2.25 strike on tenors from 2025 to 2028) in average values presented, which are only for issues of the calendar year. One could see that two ways: as either being disingenuous, or, simply that’s just how it’s put together.
We’ve examined $CL’s capital structure previously, but, unless their year end offers up some more fulsome disclosure around proportionate share strikes, it will (sadly) will have to wait another couple of months.
Thus, the deficiency of this graph is in pricing the proportionates/redeemables. I suspect there is a lot more overhang than is evident, with my best guess being a range between $75MM – $400MM. This is of greater import now, as share price currently exceeds $15USD/share (an all-time high), which, would triple that range, taking optionality far above G&I:
Capital Structure & ‘Super’ Shares: A Dilution and Asset Pricing Example
As example, take a company that raises $10 by issuing 10 shares. Or perhaps buying another company/asset for $10 by issuing those same 10 shares. In each case, an asset is added to the balance sheet. The cash (or the asset) they got is expected to generate RoR. If that same equity is given out in exchange for less than $10 in value, it still impacts the cost of capital, because there’s no corresponding addition that’ll generate returns. It creates a situation where existing assets need to generate a higher expected return than when they were purchased……to make up the difference. In the case of legal cannabis sector (particularly in the US), every-time there’s additional market expectations priced into the cost of assets (inflation/bidding wars), there’s an equal expectation that that cost will generate a sufficient return to pay for it. It’s all fine and good – unless expectations (or reality) doesn’t bear out.
Assets that are deemed overpriced will be adjusted to where they are seen to be, typically by share price in the case of a company. Thing is, when share prices go down, the cost of the equity it took to acquire them at the time remains. It’s the reason why so many cannabis companies are staring down a ‘billion-shares-outstanding’ barrel now in Canada. What initially cost that 10 shares…..might now be worth 1,000. And that assumes the asset is still worth the same.
Many examples of this abound, and a clear one can be found in Supreme Cannabis ($FIRE), where previously lofty share prices built some $200MM worth of hard assets across some 330MM shares (Sept 2019). Fast forward 18 months and multiple raises, those same assets are now expressed by 750MM shares. The PP&E booked is the same. The expected rate of return has not materialized (there’s still the same embedded cost of capital) which is reflected by the mechanism of share price. Market cap then? $400MM. Now? $262MM. A given shareholder’s piece of those assets have devalued by $140MM, natch. That’s the loss in asset value. And……any claim to them has now been more than halved. Dilution is another mechanism by which shareholder value vanishes.
Dilution is irrelevant where incremental asset addition equals the cost of capital. That’s a strong part of any sell-side sales pitch. ‘Don’t worry about dilution, the assets are great’. In the case of ‘super’ share conversion at lower than market price, there is no corresponding addition to assets, yet, there is dilution. It directly adds to the required rate of return of existing assets. Should expectations about the ability of those assets to generate returns….lookout below.
Aside from ‘super’ shares, it’s also why I go on about non-controlling interests (NICs) and contingent liabilities that attach to asset additions. They often track with increases in share prices, embedding additional cost to the assets via equity disbursements. Higher subsequent share price that attaches to acquisitions embed a higher cost of capital into the asset itself. Equivalently, the asset just became more expensive. This is all fine and well *should* the asset generate sufficient returns to cover it. Sell-side will say it’s ‘paid with equity and the thing’s performing as expected.‘ Ultimately, that it’s ‘costless’. It is if the initial asset valuation was spot on.
And this is where the Risk person in me twitches. Not because I’m a doom and gloom guy, but because I see risk in asset valuation – particularly when valuations are made forward for many years. I also see risk in equity prices that hold great expectations about the future – and decouples from the underling assets themselves. There’s too many variables to give me high confidence that all assumptions about the future will come true. A purchase is made at a point in time. And share price reflects expectations about the future. In today’s exuberance about legal dope, I see risk in not only the assets being unable to support an expected RoR, but also, that share price magnifies the returns expected of those assets.
Hopefully this doesn’t come across as pedantic. I constantly get questions about the subject, and I want to illustrate the linkage between the cost of capital and assets. It’s all fine and well to look at an asset’s cost and what’s expected of it in returns. The other side – the cost to capital of that asset – is often ignored because it’s ‘invisible’. Particularly with the existence of ‘supers’ in a capital structure.
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 does not have a position in $CL.