Fundamental Disconnect in Cannabis

How Are Investors Ignoring the News from Illinois?

Imagine a $1 billion revenue opportunity that suddenly unlocked itself and the beneficiaries were four or maybe five companies, each of whom are estimated to earn around $1 billion in revenue this year before this unexpected windfall. These companies won’t have to spend much to take advantage of this opportunity and because of this boon, estimates for next year are too low and probably have to go up by a minimum of 10% to 15%. One beneficiary may see its cash flow go up by 50%. Then imagine that the stocks most likely to benefit not only did not go up in price but went down instead.

Welcome back to the absurd world of cannabis investing. This very scenario just happened last week. There are many absurd things that happen in cannabis, especially since so few investors are allowed or able to invest in these stocks because of the Federal illegal nature of cannabis that keeps US cannabis companies that “touch the cannabis plant” off US exchanges and out of 95% of institutional investors’ portfolios.

Last week, the cannabis industry got surprisingly great news.

Despite a population of almost 13 million people, there are only 110 dispensaries in Illinois, an absurdly low number. There were plans for more dispensaries, but the state wanted the next round of dispensary licenses to benefit those who have been harmed by the war on drugs. The problem is that these licenses were quite valuable, and lawsuits quickly ground the process to a complete halt. These new dispensaries have been mired in endless litigation for over two years.

Despite the lack of new dispensaries, Illinois has been a wild success story, growing cannabis sales to approximately $1.4 billion in 2021, and sales are on track to hit $2 billion this year. In Illinois, cannabis taxes generated $100 million more in revenue than alcohol.

As good as the Illinois market has been, it could be much better for the leading cannabis companies, because of their capacity to supply a much larger set of customers, especially since there is a limit of owning a maximum of 10 dispensaries. Due to the lawsuits, there were worries that it would take years to solve the legal problem and unclog the backlog of dispensaries, thus limiting a very important cannabis market.

And then suddenly this past week as if by magic, a judge lifted the stay of licenses after an agreement was reached on the lawsuit and the 185 dispensaries are now free to open. This is truly remarkably good news. If one were to assume that each new dispensary earns $5 to $10 million in revenue (down from the $17 million current average), this would bring in additional $925 million to $1.8 billion in retail revenue. If we assumed that wholesale took half of that retail revenue total, that means the wholesale opportunity is $460 million to $900 million.

The important thing to note is that there are only four, maybe at best five companies that can supply these new stores. The biggest beneficiary must be Cresco Labs (OTC: CRLBF), which has a major focus on wholesale, especially in Illinois. One analyst estimates that if Cresco were to maintain its wholesale revenue share, that it could see an incremental $145 to $260 million in revenue just from these new dispensaries. Assuming a 40% EBITDA margin on this revenue because it is all incremental in a state with an existing infrastructure, Cresco could earn an addition $46 to $105 million in EBITDA in Illinois alone.

To put this in perspective, consider that Cresco is estimated to earn a little over $900 million in revenue and approximately $220 million in EBITDA in 2022. This one judgement may mean revenue will increase by nearly 30% and cash flow by 50% next year just from Illinois.

And here is Cresco’s stock reaction on Friday:

And it’s not just Cresco, which will benefit, so will Verano (OTC: VRNOF), Green Thumb (OTC: GTBIF), Curaleaf (OTC: CURLF) and even one of my favorite smaller cannabis operators, MariMed (OTC: MRMD), which is building a new 14,000 square foot facility in southern Illinois and re-introducing its award winning edibles to the state.

And they all fell or flatlined on Friday after falling all week while the broader market rose.

So, what is going on?

I want you to consider a few different conversations I have had in the last couple of weeks. A smart investor I know, who has been invested personally in cannabis wanted to buy more AYR Wellness (OTC: AYRWF) on the news that it can convert its three medical dispensaries to adult use in New Jersey after a month delay that saw its stock price fall as much as 61%. But this investor is now prohibited from buying in his Vanguard 401k after the company barred investors from buying any cannabis companies in April.

My second conversation was with a very successful real estate developer who wanted to invest in my cannabis fund but decided against it because he is working on three major loans and is worried that a personal investment in cannabis may scuttle his loans and he cannot take the chance.

My last conversations have been with three different international investors who would love to invest in cannabis but are prohibited from investing through their brokerages and have no real outlet to invest from their respective countries.

Cannabis stocks, as many investors are aware, are in the midst of a brutal bear market. The main reason for the falling prices is that there has been almost no progress on Federal legalization or even safe harbor for banking.

The broader market sell off has taken cannabis with it, as anyone doing anything remotely speculative has been taken to the woodshed. At least three cannabis funds/portfolios have closed or have been liquidated recently and with limited liquidity (the top US cannabis companies either trade over the counter or on secondary or tertiary Canadian exchanges), this has caused near constant selling pressure.

Democrats have played political games with cannabis and most investors who could invest in cannabis obsess about the lack of progress on the Federal legalization front. And if it could be years before anything changes, why invest now, especially if stock prices keep falling.

What we have is a perfect storm, of forced selling and very few buyers to pick up the slack. This is how you get amazing news and few investors caring.

So, go ahead sell Cresco at 8 times this year’s EV/EBITDA growing sales at a 32% CAGR (compound annual growth rate). Go ahead and ignore AYR getting approval for adult use sales in New Jersey while the stock trades at 5 times this year’s EV/EBITDA. Go ahead and ignore MariMed being uniquely positioned to benefit when Maryland approves adult use in November while the company trades at 5 times EV/EBITDA while on the verge of tripling revenue.

Go ahead, ignore the Illinois news, ignore New Jersey worrying there is not enough legal cannabis to supply demand, ignore Rhode Island suddenly approving adult use cannabis. Ignore the entire northeast turning on in the next 12 to 18 months. You are simply ignoring an industry whose growth is about to reaccelerate. Cannabis stock prices are driving the narrative, not the fundamentals. But sometimes when you least expect it, what investors care about suddenly changes. And in the end, all that really matters to an investor is future cash flows, which thanks to news from Illinois are about to leap higher.