“It’s good to learn from your mistakes. It’s better to learn from other people’s mistakes.” Warren Buffett
Running a Multi-State Operator (MSO) cannabis business sounds impossibly complex. Imagine running a business in which you are a farmer, manufacturer, distributor, wholesaler, operate kitchens, operate retail stores, and try to create brands in what is effectively multiple countries with wildly different regulatory rules and where you can’t send products across borders because it is against the law. How could any organization possibly hope to succeed?
But this wasn’t my realization when I first started investing in cannabis. It wasn’t clear with MSOs, which had limited competition and abnormally high cannabis pricing in limited license states, that the sheer complexity was a problem. Cash flows were soaring, growth seemed endless and cannabis companies were in a race to build out or acquire their geographic footprints in different states.
The cracks started showing, however, once limited license states became more competitive. Suddenly cash flow growth started to disappear, and companies seemed to be on a hamster wheel of a new market replacing the disappearing cash flow from previous hot markets. And now we can see it in the numbers of almost every large MSO.
And few companies epitomize this problem more than AYR Wellness (Canada: AYR, OTC: AYRWF).
The problem for AYR and many other MSOs is that the company moved too fast and acquired a bunch of disparate companies and licenses. Worse yet, AYR financed many of its acquisitions with debt and without fully appreciating the complexity of managing such an unwieldy enterprise. When competition increased in AYR’s markets, EBITDA stopped growing and the forecasted jump in cash flow and the arrival of actual free cash flow never materialized.
And when interest rates jumped and cannabis reform was pushed out, capital became very tight at the same time AYR was wrestling with the indigestion of too many acquisitions. With a heavy debt load, AYR’s share price plunged from a 2021 high of $35 per share to as low as $0.80 a share earlier this year.
It was learning from the mistake I made investing in AYR that led me to hunt for those companies who could be narrowly focused and could prove to me that they could win in the most competitive states. I wanted companies which were laser focused on operational excellence, and this led me to investing in Grown Rogue (Canada: GRIN, OTC: GRUSF), which is the best performing cannabis stock this year.
Consider that instead of racing to expand into limited licenses, Grown Rogue first set out to win in one of the toughest cannabis markets: Oregon. With very low flower prices, a discerning customer and unlimited competition, if you don’t make fantastic products for a low cost, you will go out of business in Oregon. Grown Rogue is now the #1 flower in Oregon and free cash flow positive. They then entered Michigan for $4 million and are now a top 5 indoor flower.
And Grown Rogue just announced they are entering New Jersey for what looks like an all-in cost of $5-$6 million, a far cry from the $101 million AYR spent not two years ago.
Disciplined, step by step growth based upon operational execution is the Grown Rogue way and I believe it is helping them stand out.
In addition to being all in with Grown Rogue, I also just made a very exciting investment in a private California company focused solely on manufacturing excellence in pre-rolls and edibles and I’m very excited to announce that investment soon. Our investment will enable this company to bring its operational excellence in manufacturing to more limited license markets.
But coming back to AYR, I’m not the only one who was taught a lesson. AYR itself has been licking its wounds from its own experience. The company has been forced to pull back and painfully restructure. First, it took losses and exited Arizona and then it withdrew from expanding into Illinois. It has gone through a few rounds of layoffs and has a new CEO.
And just last week, it announced a debt restructuring which included pushing debt maturities out and issuing equity to debt holders and finally infused new debt capital into the company. As painful as these announcements are to existing equity holders, they are necessary and are the start to giving the company room to turn things around, allow it to optimize existing assets and give the company time for three of its markets, Ohio, Pennsylvania, and Florida to go from medical to adult use states. Ohio just approved adult use and it looks like it will launch by September of 2024.
Finally, it appears that 280e taxation will go away when the Federal government reclassifies cannabis from a Schedule 1 drug to Schedule 3. This could mean an improvement in free cash flow of more than $40 million a year to AYR.
I think there is potential in AYR’s turnaround, and that the medicine they have taken should serve them well. And it is for this reason that my fund has been buying debt in AYR as I continue to hunt for opportunities in cannabis where there is yield plus equity upside. AYR’s debt is senior secured and the restructuring means debt holders will be receiving shares in AYR. Earning a 20%+ yield with equity upside in a senior secured instrument in a company with multiple potential catalysts on the horizon is simply too good of a risk/reward to ignore.
AYR will not be the last MSO to restructure, and rationalization of the industry is a good thing that should lead to a healthier, more sustainable sector. Despite the lack of capital and the hardships in the industry, I think AYR’s restructuring is good news, and its debt is a pretty good value right now. And the more restructurings and the more rationalization that take place in cannabis the more bullish I become.