Cannabis’ Nuclear Winter
Andrew Carnegie Can Teach the Industry How to Thrive in Tough Times
Carnegie obsessed over cost because it was the one part of his business he could control. “Carnegie never wanted to know the profits,” an associate said. “He always wanted to know the cost.” Carnegie himself explained: “Show me your cost sheets. It is more interesting to know how well and how cheaply you have done this thing than how much money you have made, because the one is a temporary result, due possibly to special conditions of trade, but the other means a permanency that will go on with the works as long as they last.”
Publicly traded cannabis stocks have been in a brutal bear market for almost two years, but the removal of SAFE Banking yet again from Federal legislation set off a wave of selling and liquidations that have caused a plunge in most cannabis stocks and has driven the main cannabis ETF (MSOS) down almost 73% this year.
Capital is already scarce for anything speculative, but it is even more so for a Federally illegal sector. Based on my conversations and research, there is basically no equity capital available unless it is at very punitive terms, and even then, it may not be available in any significant size. On the debt side, there is limited ability to access debt, and it is probably for smaller amounts and only to those few cannabis companies with clean balance sheets and clear growth opportunities. In summary, capital is almost non-existent.
While the capital spigot has turned off, the pricing of cannabis flower has been falling in many states and in some cases precipitously. What started out 18 months ago in California and Oregon has spread to other states like Michigan, Massachusetts, Arizona, and Colorado. And this may not fully reflect how a potential recession could impact pricing in 2023 as well.
The problem for many publicly traded large cannabis companies is that they have been built for limited license markets (aka limited competition) and built for growth. Even worse is that many of the largest multi-state-operators (MSOs) have financed themselves through expensive sale/leasebacks that have escalating annual rents. An environment where capital costs and rents go up, but the sales price of your product is going down is not a pretty one.
And even for those who avoided expensive sale/leasebacks, they have steadily increased their leverage to a point where pricing coming down has punishing effects to their cash flow and ability to service that debt.
With limited or no capital and pressure on the cost and pricing side, we have entered a nuclear winter for the cannabis industry. While this pain will hit most participants in the market, others should thrive and be able to take advantage of this situation. In my opinion, the ones who should benefit the most are those who have been the most aggressive at removing costs from their business.
And primarily from what I see, it is the smaller companies in the industry that have been the most aggressive, most transparent, and most efficient at cost reduction, especially those companies that have been forced to operate in the most competitive markets, not the limited license markets.
Consider how much this current environment benefits Grown Rogue (Canada: GRIN, OTC: GRUSF), which is free cash flow positive and can produce high quality indoor cannabis at below $600 a pound and is outcompeting everyone in Oregon and Michigan. With a clean balance sheet, this environment could not be more promising. How many potential partners are out there that need operational excellence or have excess capacity they cannot operate? My guess is a quite a few. Grown Rogue could soon have its pick of where to grow next.
Another company very close to being in Grown Rogue’s position is Glass House (OTC: GLASF). They have been relentless at driving down the cost to produce a pound of cannabis and can produce greenhouse cannabis at $134 a pound. In their last quarter, Glass House announced a 36% wholesale gross margin at $200 a pound cannabis pricing when others in the state are seeing negative gross margins. Through a relentless focus on driving down COGS and leveraging its structural cost advantages at their state-of-the-art greenhouse, when Glass House achieves free cash flow profitability in 2023, it too will be in the same position as Grown Rogue and can take advantage of the distressed environment in California.
These are not the only ones who will benefit, but to me they stand out as the clearest examples. There are surely other small companies as well and I’m spending my time researching and understanding them.
My wish for the larger publicly traded cannabis companies is that they share more detailed information on cost of production, breakdown of profitability by state and other granular data that helps investors understand their unit level and state level economics. Too many of these companies are simply black boxes. My bet is that in 2023, the market rewards the more transparent companies that disclose more details about their operations.
Clearly, there is no way to control or predict for cannabis political reform and there is little or no control to cannabis pricing, especially during economic weakness. What a company can do is control its costs and ruthlessly drive down the cost of production and the cost to operate. And as an investor, I can focus my investments into those companies that have already positioned themselves for an environment where costs matter.
The nuclear winter is here, and the big question is who takes advantage of the distress and becomes even more valuable on the other side? If Andrew Carnegie, John D. Rockefeller and Jeff Bezos are our guides, in new, but volatile industries, the ones that succeed are the ones whose relentless obsession is achieving the lowest costs.
Here is a great podcast to learn more about Andrew Carnegie based upon his autobiography: