In our last Structure on Cresco Labs ($CL), TheCannalysts made note of the Byzantine nature of their capital structure.

Previously, I’d spent time researching best practice and governance around use of multiple/proportionate/compressed/super share classes. $CL packs several share classes, and use of them is far more prevalent in US MSO’s than in Canadian outfits. They’ve been around forever though, and there exists a general consensus on how companies *should* deploy and utilize multiple classes.

I’ve been looking forward to the final insertion of the Origin House acquisition (a company that began as a streaming vehicle which morphed into distribution, only to be taken out by $CL for $430MM) and Valley Agriceutical assets.

I expect optionality is going to come up a lot here. I’m gonna wear a mask while doing this one, just to be safe.

To the financials!

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• Cash down $14MM to $58MM. Sales increases QoQ are big. Margin is rocking. SG&A flat despite selling waaaay more product. Inventory looks to be managed well too given the 40% + in throughput. GoBlue mentioned that this was an amazing quarter for them sales wise, I’m gonna defer commentary on the nuts and bolts of operations to him.
• The Origin House acquisition is consistent with the ‘cost per dollar of asset’ that other deals done around that time had. More below.
• $12.4MM in SBC during the quarter. Chunky. $9.4MM prior. $3MM/Q in executive compensation. Management is being looked after well.
• 22.3MM long dated stock options, the o/s number has remained flat despite continual exercise, new grants keep the treadmill turning. RSUs abound.
• Share capital has 5 primary classes, and naturally, there’s proportionates (PVS) and supers (MVS) <with both votes attaching at 200:1 & 2000:1 respectively>. The PVS also convert to into subordinates at 200:1, but there’s no mechanism I have seen to permit conversion of supers. An additional class exists as ‘redeemable units’. More below.
• Holy Hannah. That two thousand votes per super share. There’s 500k of those shares around btw. Unless there’s a change to the articles, they’ll remain in the company. For context, theses supers represent 1 billion votes at the annual general meeting. PVS represent another 37MM. Total subordinates? 177MM.
• Shit, here I thought $GTII had their shop locked down. $CL makes them look like amateurs.
• Yes, there’s a 5th class, and it’s an odd one (there’s only 1,000 of them, and they represent .00001 votes each. They were issued sometime this year as a result of ‘conversion’, although rates aren’t mentioned. Perhaps they’re a tax vehicle for someone, it looks like nothing more than errata.
• $CL’s generous with the PVS – one has to get deep into Note 11 though to strike (someone else’s) gold. More below.
• Professional fees beginning to calm down. Although $21MM has been booked year to date, this quarter came in under $4MM.
• Those 22.3MM in options have an average strike of $3.75, and represent some $300MM in overhang.
• Curiously, these guys use a variety of valuation methods (FVTPL etc) like everyone else, but they also use mark-to-market for some derivatives and investments. I understand the method well. Notable because this is the only company I’ve seen in legal cannabis to do so.
• They’ve been busy with IIP too, executing sale/leasebacks to free up capital. $CL commentary lingers on a $50MM ‘tenant improvement allowance’ granted to them in Illinois…ostensibly ‘cash’ for capital improvements. I’ve seen amounts booked for the same thing by $CURA & $GTII.

Ok.

They reported a very good quarter operationally. They claim that they’ve expanded market share in California (sales in the state increased 21% over the period, $CL increased sales by 50%), they’ll be the first to double digit stores in Illinois, and, offer the prospect that they’ll triple their exposure to recreational consumer dollars over the next year just by virtue of recent state votes on cannabis measures.

This is all offset to me by the fact they have a billion (or two) subordinated shares laying around on the balance sheet, all under perpetual control of the person(s) who owns those 500k ‘super’ SVS.

I like most things I see around this outfit….in a word, that’d be ‘execution’.

MassRoots was a cannabis media asset picked up early on. Bad call. There were some gyrations last year around their continued existence, the most recent news out of them continues to be nothing but air. A long ways back in Cresco’s rear-view now and immaterial, but noted because of how durable a ‘nothing’ can be and still soldier on.

I wasn’t expecting $CL would own 23% of Trichome Financial. I understand that there had been an affiliation between $OH and Stoic Advisory (IIRC) that predate the Cresco acquisition. However it arose, an equity stake in Trichome came along with $OH:

Origin House was a big bite for $CL to digest. Grow-ops, retail locations, and distribution agreements exist throughout California, as well as a nicotine vape company in Canada. I’ve been curious about what exactly came in those assets, and how they are performing. We get a glimpse as $CL needs to split out subsidiary performance in the year of acquisition. It looks like the assets were purchased for their ‘potential’. This quarter, Origin House looks like they laid an egg (from a pretty small chicken):

Taking a look at the acquisition itself shows a net asset gain of some $114MM, with the remainder going to Goodwill of $313MM(b):

Until……one looks at the assets listed, and discovers that $113MM(c) of those assets are in ‘Customer Relationships’ and ‘Tradenames’. Hey, these things have value, particularly if those relationships are contractually defined, and, if the trade names are being licensed (therefore, revenue generating). I can’t see if this is the case in either here. There’s a total of $66MM in ‘relationships’ that have accumulated as assets on the balance sheet. And those customers’ nice-ness is being amortized anywhere between 7 and 19 years. Below lists the total value that those relationships and trade names that came with Origin House.

All together, for $428MM (a) in cash and shares, the net tangible assets added to Cresco via the Origin House acquisition was $1MM bucks [per above…. it equals (a – b – c), or, [($428MM – $313MM – $113MM) = $1MM]

Best they be ‘levering them synergies’ hard from here on. There might be some ancillary uplift to core revenue from the deals and relationships, I can’t tell at this point. Cresco describes Origin House as:

I suspect there’s more contribution to $CL’s business than just the segment’s reported values. ‘Distribution’ revenue brings value beyond delivering product to a store.

We’re beginning to see this revenue component of CPG/distribution emerge here in Canada (as example, think of Aphria’s alignment with Southern Glaziers). TheCannalysts have been working on getting a professional from the distribution space to help explain the where and why value exists around the activity, and what implications/challenges/opportunities may exist as time goes on. It’s a very tight lipped space though. We’ll continue to search for the right body, and dutifully report what we come across.

I mentioned the Proportionate Shares (PVS) above.

Packing 200 votes each and converting at 200:1 into subordinates, conversions of PVS into subordinates over the past couple of years has increased the total float by 34MM shares. 54k of them remain, and these represent an additional 39MM subordinates that could appear in the float tomorrow. That’s a lot of shares, right?

We looked at them here as well. Deep in Note 11, we discover there’s 32,000 warrants that are exercisable directly into a PVS, at a strike of $7.73. I can’t find a second level conversion/strike <yet> between PVS to SVS. Sometimes it can be a meaningful number, sometimes it’s just nominal value – like ‘$0.00001/share’, which is implied here. At any rate, if struck, those warrants would see the issuance of some 6.4MM more subordinates to the float, representing ~=$30MM in equity value…..in exchange for $250k in cash:

I’d be really surprised if someone, somewhere, hasn’t taken a moment to ask Cresco Labs CEO Charles Bachtell when the fuck he’s gonna collapse the supers and proportionates. I can’t find any reference to them anywhere <yet>.

The warrants have arisen via acquisition, and from the raise they executed for Origin House back in September of 2019. On this, I’m beginning to think Origin House cost a little more than the $428MM reported:

There’s a ton of hair on the Origin House deal (and a ton and a half of questions too). I will need more time to get take hair off and put some numbers around contingencies. Perhaps a plan has been put forward to stakeholders (any lender/creditor/major shareholder would definitely have noticed these warrants and the existence of MVS/PVS). I’m going to be calculating overhang across the MSOs when I get some bandwidth over the next week or so – I’ll do the research and nail this down.

There’s also ‘Redeemable Units’. These units are convertible into SVS anytime, and held by founders. They went out with the MVS. There exists a ‘non-transference’ condition on the MVS: if they’re sold by the original holder, they convert to the issue price and are cashed out. It was probably put in place to prevent an outsider using the MVS to execute a takeover:

A 143MM redeemable units huh? They convert 1:1 for an SVS. Per below, there’s ~=177MM subordinate shares currently outstanding. There’s another 170MM subordinates via PVS and Units ready to come into existence, whenever they are willed to:

On the face of it: this company’s capital structure ‘as-is’ will not do shareholders well in the long run.

Regarding SBC, $CL was an MSO that went deep with strikes on option grants, notable for issuing 10 year tenors at or near the money – that kind of timeframe brings all kinds of extrinsic value with it (while conversely being a ‘cost’ for existing shareholders). Total overhang from the stock options alone: $300MM.

$CL’s CEO is atypical of most leadership in legal cannabis. He’s a lawyer, he specializes in compliance and regulatory issues, and the highest point he’d been previously was as EVP & General Counsel for a mortgage bank. But, he’s been involved in weed for years, and somehow finds time to teach a law course on cannabis regulation as an adjunct professor at Northwestern.

Look for expansion in $CL’s float next quarter (perhaps into the next few) outside of normal course transactions.

There’s put options around non-controlling interests (NCI’s) that appear to issue PVS as well in distributions. Trailing ‘distributions’ (related to tax) paid to several NCI’s reduces percentages not held by $CL. One could think of $CL’s increasing ownership in this fashion sort of like a ‘lay-a-way’ plan. As time goes on, ownership accretes, and title transfer will eventually occur. Sadly – like margin reported across individual states – these commercial agreements are sensitive commercial information that nobody in the MSO space is reporting.

If/when $CL enacts more PVS’ or related warrant conversions (both timing and amounts unknown) – subordinate share count will blow out. I’m sure the company is mindful of this….I’ve been looking for some sort of mention by management that addresses it.

There has been some noise out of California, and what impact that the wildfires of this fall might have on wholesale supply, and pricing. I’ve heard of many acres being lost and tales of harvest woe. Given their quarter in California was as good as it was, an analyst asked about whether outdoor supply in the state had been impacted by the fires, and. how price reactions might hit $CL’s numbers.

It’s interesting to me because it’s the first formal statement I’ve seen outside of anecdotal hand-waving, and, it’s the complete opposite of what was being talked about in California for 2 months. The answer from Greg Butler, CCO of Cresco? ‘Da nada’ :

As it is, Cresco is over the moon with performance in California (as were the analysts on the conference call). They’re excited about Illinois, PENN, and given the quarter they reported, the conference call was a smooth affair. Public companies everywhere look forward to reporting good quarters, and this one was very good.

We’ll see next time how sustainable gains in California are, and if their presence in Illinois fuels retail margin even more. CEO Bachtell alluded on the call that they are now an actual ‘retailer’. Go-forward, as percentages between their wholesale and retail segments move around, reported margin from the various components of each of these will be the measure of acumen.

I like a lot of what I see in this outfit (at least what is visible). I remain tentative about Origin House…..it’ll need to show some meat over the next couple of years to bear out. As to the capital structure….well.

I really like this quarter. But the capital structure ‘as-is’ precludes me from considering this as a potential investment.

Until management communicates some intent around future plans for it, I won’t look at this outfit seriously…..even if they’re putting up serious numbers. There’s little that good growth and profitability will do in the face of one (or few) individuals having total control of the company, with the ability to ignite (a minimum) of >$400MM in overhang.

They need to deal with this. I have little doubt they know it too.

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 holds no position in $CL.