Goodbye Cannabis Capex…Hello Buybacks?
The Implications of a Plunge in Industry Capital Spending
The capital markets are closed for most companies and especially for anything considered aggressive or speculative. And with cannabis still being Federally illegal with no access to the Federal banking system, the equity and debt markets are really closed for cannabis companies.
I know this because I just helped a private cannabis company in California refinance its debts in which it was paying outrageous interest rates because it had no access to capital.
But it’s not just small companies, the debt of big MSOs like Green Thumb (OTC: GTBIF) are now trading in the 12% to 13% range, and that is for companies with size, scale and substantial cash flows. For the last eighteen months, debt costs were coming down, but all of that has changed.
Debt is not the only financing that is scarce, with equity prices for most major cannabis companies having plunged 70% or more from their highs, equity financing is basically non-existent.
Add in persistent regulatory delays from both the Federal government on reform and access to banking and from states which are slow walking their rollouts of adult use cannabis and you have the perfect storm for cannabis capex to plunge in 2023.
And we are already getting a preview of this by looking at cannabis picks and shovel stocks like Scotts Miracle Grow (NYSE: SMG), Hydrofarm (NASDAQ: HYFM) and GrowGeneration (NASDAQ: GRWG). Take a gander at their stock price charts:
And I believe current conditions combined with worries about a looming recession are going to further pressure major MSOs to re-assess their future capital expenditures. And for shareholders, this may be very good news because free cash flows are likely to soar. And for those with scale and clean balance sheets, that cash could be redirected to buying back stock with potentially dramatic effects.
Consider for example, Verano (OTC: VRNOF). The company is estimated to do $400 million in EBITDA this year, but with taxes of $140 million, capex of $250 million and interest expense of $40 million, the company is actually free cash flow negative. So, where exactly is the free cash flow to buyback shares you ask?
The problem with the above analysis is that true maintenance capex is probably as low as $20 to $25 million. Think about it, the bulk of Verano’s capital expenditures is not for maintaining existing facilities, but for massive expansion in New Jersey and many other states. Indoor grow houses are basically big boxes that are heated and cooled and then you grow plants in them. Once built out and working, there shouldn’t be much in the way of capex to keep them going.
So, instead let’s say because of a recession and falling prices that Verano does not grow sales next year, despite Connecticut and New York turning adult use and EBITDA remains flat at $400 million and you assume the same interest expense, but instead assume $100 million in capex and not $250 million. In other words, they are would still be trying to expand, much more than maintenance capex, but still much less than 2022.
In that scenario, free cash flow explodes from negative $35 million to positive $115 million, even including 280e taxation. And this is where a buyback could be very powerful. With $115 million in free cash flow, at $7 per share, Verano could buy back 5% of the stock outstanding or 16.4 million shares.
What is fascinating is that these stocks are famously illiquid. Verano trades an average of 370,000 shares a day. With 252 trading days in a year, 16.4 million shares may be 5% of shares outstanding, but would represent more than 18% of all shares traded in a year! It would be my guess that any buyback Verano announced would have an outsized impact on the stock. Note that this Verano analysis, applies for every other large scaled MSO that can scale back their capital expenditures.
So, while many investors continue to obsess about the “Big Trade” of legalization, they may be forgetting that being a legal drug dealer with regulatory barriers to competition is actually quite a good business that should generate lots of cash. As the industry brings down capex, we may just see how good their free cash flows really are. So, with cannabis stock prices in the tank, don’t be surprised if we see cannabis share buybacks and to outsized effect.