Cabot SX Cannabis Issue: October 26, 2022

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Election season lurks just around the corner.

The looming midterm outcomes have huge implications for cannabis – since the group is so dependent on legal reform in the hands of politicians.

There are going to be plenty of (tradeable) election-related ups and downs. But for reasons I will explain, cannabis stocks might see some very bullish catalysts near term, no matter which party takes the Congressional elections.

This is a complicated time, especially for a chaotic sector like cannabis. Here’s what you need to know.

* Either outcome in Congress – a shift towards Republican control, or continued Democratic control – could bring bullish stock-moving catalysts.

* Key state referenda on cannabis may have significant implications. Worth tracking.

* Beyond elections, three factors will impact cannabis stocks. There’s a powerful seasonal pattern in the stock market just ahead that may help us. Expect more progress on the international front. And earnings season lies just around the corner.

To simplify the process of thinking (and trading) through all of this, here’s my guide to cannabis stock-moving events that will play out between now and the end of the year. I put them into six categories.

1. The midterm election outcomes

What will happen in the House and Senate this election season? Bettors at the election-related wagering site PredictIt forecast a decisive win by Republicans in the House of Representatives. They also predict a Republican takeover of the Senate, though the chances of this happening are a bit lower. PredictIt election odds do a reasonably good job of forecasting election results.

These outcomes would generally be a negative for cannabis stocks (though there is a silver lining, more below). That’s because many conservatives just don’t like cannabis legalization and banking reform that would help cannabis companies.

For example, a large conservative group in the House of Representatives called the Republican Study Committee opposes cannabis legalization. This group has 156 members, or three-fourths of House Republicans. “If one of the houses of Congress shifts to Republican, it will be very hard to do anything on marijuana,” concludes New Jersey Democratic senator Cory Booker, a champion of cannabis reform.

He’s not the only one who thinks so. The sector could see “further depressed valuations” if Democrats lose the House, agrees CIBC cannabis sector analyst John Zamparo. Though U.S. cannabis names (like our stocks) would fare better in this scenario “because of superior profitability and cash flow generation,” he says.

In other words, cannabis investors need to watch election outcomes closely.

But there are two potentially bullish twists to this story. Even Republican control of the House or Senate might not be disastrous, for two reasons.

One is that polling data consistently show voters favor decriminalization and banking reform that helps cannabis companies – even Republican voters. I could cite a lot of polls stretching back years, but here are four from the past few weeks.

* A Monmouth University poll released October 24 found 68% of Americans support legalizing possession of small amounts of marijuana for personal use, including 76% of Democrats and 52% of Republicans.

* Two-thirds of Americans want Congress to pass a law giving cannabis companies access to banking services in states where cannabis is legal, according to a September 16-17 poll by the American Bankers Association (ABA), which also supports this change.

* A Politico and Morning Consult survey conducted October 7-9 found 65% of voters support President Joe Biden’s pardons for cannabis convictions, and 69% back removing cannabis from Schedule I of the Controlled Substances Act. A majority of Republicans (57%) said they favor rescheduling cannabis.

*An Ipsos and USA Today poll conducted October 7-9 found 74% of Americans favor the removal of marijuana from Schedule I, including 84% of Democrats and 58% of Republicans. And 68% of respondents supported state pardons for people with marijuana possession convictions, while a similar number backed President Biden’s cannabis conviction pardons.

It seems to me that at some point, conservative lawmakers who oppose cannabis reform may have to respond to public sentiment. The tide is definitely turning, in terms of voter support for change. This suggests that even Republican control of the House does not obviate incremental reform that favors the cannabis sector, says Tim Seymour, portfolio manager of the Amplify Seymour Cannabis (CNBS) exchange-traded fund (ETF).

2. Lame duck passage of SAFE banking

There is an even bigger reason why Republican control of the House (or Senate) might turn out to be a good thing for cannabis stocks. This would pressure lawmakers to approve cannabis-related banking reform in the lame duck session. They’d want to get it through before the increased control of Congress by conservatives in January (assuming this happens) makes this harder.

“I don’t think that’s terribly challenging,” says Seymour, at the Amplify Seymour Cannabis ETF, referring to lame duck passage of banking reform.

Approval of banking reform by early January would be a huge catalyst for cannabis stocks.

Known as the Secure and Fair Enforcement Act, or the SAFE Banking Act, this law in its most stripped-down form would give cannabis companies access to basic, traditional banking services. The SAFE banking bill would help cannabis companies access insurance and use credit cards.

Booker, the New Jersey Senator who is a big proponent of cannabis reform, said in recent press interviews he thinks Congress has a “good shot” at passing banking reform during the lame duck session after the midterm elections – especially if Republicans retake either chamber.

“It’s very likely that during the lame duck, before the new Congress, we’re going to see a really good bipartisan attempt to move it,” he said in an interview with NJ.com. “I think it has a good chance because our Republican allies understand that if one of the houses of Congress shifts to Republican, it will be very hard to do anything on marijuana,” he said in the interview. “We’ve got a good shot. I wouldn’t say it’s a great shot, but it’s on a good path.”

Other politicians like representative Ed Perlmutter, a Democrat from Colorado, and Republican Senator Steve Daines from Montana have made similar comments.

President Biden’s recent cannabis conviction pardons help because they may reduce pressure on Democrats to add several “restorative justice” features to a SAFE banking bill that would take away Republican support, says Cantor Fitzgerald cannabis sector analyst Pablo Zuanic.

A more expansive version of this law down the road could bring more institutional money into the space, clear the way for listing on better exchanges, lower capital costs, and open the door for companies outside the industry to make strategic acquisitions, notes Stifel analyst Andrew Partheniou. The lame duck version of this law might not go this far.

Rescheduling of cannabis under the Controlled Substances Act, which President Biden recently asked government agencies to speed up, remains a more distant catalyst. It might be concluded around the 2024 election season, says Partheniou. No coincidence, since that would be just in time to help Biden’s party in that election.

3. State referenda outcomes

Cannabis legalization measures (for recreational use) go before voters in five U.S. states on election day. Arkansas, Maryland, Missouri, and North Dakota will vote on legalizing sales for adult use. A South Dakota ballot question asks if cannabis possession should be legal, but it wouldn’t establish retail sales.

These states have a relatively small population of 13 million people. But approvals of these measures would do more to advance cannabis legalization than that number implies, for two reasons.

First, if voters passed the measures in all five states, it would come close to tipping the number of Americans in states with legalized cannabis over 50%. Next, since many of these states are conservative, approval in all five would increase the number of representatives from states with legal adult use. This could boost momentum for reform in Congress.

What will be the outcome? Recent polls suggest approval in Maryland and Arkansas, but not in Missouri, North Dakota and South Dakota.

Maryland is the key state to watch, says Parthenio, the Stifel cannabis sector analyst. That’s because it has a fairly sizeable population of six million and a high likelihood of voter approval. He projects approval would create a market eventually worth $1.8 billion to $2.2 billion in annual sales. Jefferies cannabis analyst Owen Bennett puts the market size at $1.4 billion. Note that our Green Thumb (GTBIF) has big exposure to this market, so approval could move the stock.

Maryland approval would also pressure nearby Pennsylvania to legalize. As for the rest, “we see the other states as too small and too competitive to be attractive,” says Partheniou. But approval would send a bullish signal on cannabis to Republican reps in those states. Cannabis investors will also be watching votes on decriminalization in numerous cities in Ohio, Texas and Wisconsin.

4. The Santa Claus rally

When do bear markets end? Often it is in October. Looking at the annual seasonal trends since World War II, Ed Yardeni of Yardeni Research finds that October stands out as the bear market slayer. October turned the tide in twelve post-WWII bear markets. That happened in 1946, 1957, 1960, 1962, 1966, 1974, 1987, 1990, 1998, 2001, 2002, and 2011.

He also points out there’s a favorable midterm election twist this year. Historically, in midterm election years, markets typically do well after the elections. Since 1942, during the three-month, six-month, and 12-month periods following each of the midterm elections, the S&P 500 was up 7.6%, 14.1%, and 14.9% on average. November is Nasdaq’s best month of the year during mid-term election years, returning 3.5% on since 1971.

To this, I would add that institutional investors have to finish tax loss selling during October, which probably helps explain November strength.

“Yes, Virginia, there really is a Santa Claus rally,” concludes Yardeni. “Apparently, it tends to be even more likely during mid-term election years. Instead of a V-shaped capitulation bottom, the S&P 500 may very well remain in a volatile trading range around the June 16 low of 3666 for a while longer before moving back toward the August 16 high of 4305 over the rest of this year.”

Big picture, recall that November through April is typically the strongest time for the market while May through October is the weakest, he points out.

The bottom line: A positive change in investor sentiment and a return of the bulls is extremely relevant to cannabis because it is a “risk-on group” that benefits when investor appetite for risk improves.

5. International developments

A draft version of German cannabis sector reform has leaked. Big picture, the draft confirms progress in Germany which I have been writing about. This is bullish for our holdings with German and international exposure, meaning Tilray Brands (TLRY) and the ETFMG Alternative Harvest ETF (MJ). Cowen analyst Vivien Azer says Curaleaf (CURLF) will benefit because it has been prioritizing capital spending in Europe.

“We are encouraged by most aspects outlined in the draft: retail distribution (including online), realistic taxation, possession limits, at-home growth,” says Zuanic, at Cantor Fitzgerald. He also thinks Aurora Cannabis (ACB) will benefit because of its presence in Europe.

There are some shortcomings in the draft legislation. One is the low potency limit. The draft proposal sets a 15% THC limit for users over 21, and 10% for users age 18-21. Currently, the bulk of medical sales in Germany are in the 20% THC range and demand is particularly strong for THC concentrations above 24%, says Zuniac. “If the proposed limit is applied, we would expect limited sales,” says Zuanic. However, it is just a draft proposal, subject to change.

The proposal also limits sales to domestically produced cannabis. But it declassifies cannabis as a narcotic, which would speed up production development since this would allow greenhouse growth, says Zuanic.

Key takeaways: The signs of progress in Germany are bullish for our Tilray Brands, ETFMG Alternative Harvest ETF and Curaleaf. Expect more signs of progress this year and in the first quarter of 2023. As I have written, progress in Germany could set off a domino effect in Europe, and even lead to a challenge of U.N. opposition to cannabis. All of this could open up lots of progress on the international front.

6. Earnings season

U.S. cannabis spot prices continue to plummet. The volume-weighted average spot price of cannabis in the U.S. (legal markets) for the week ending October 14 was $985 per pound, down 2.5% sequentially and down 30.6% year over year, notes Cowen’s Azer.

Cannabis sales in the 15 states that Azer tracks declined .6% sequentially in the third quarter, compared to a gain of 4.7% in the second quarter. The markets Azer tracks account for 83% of the U.S. legal market.

The upshot: You probably should not expect a lot of upside surprise in sales or margin growth at cannabis companies as they report third-quarter results. On the other hand, the challenging price and sales trends are widely known, so they are probably priced into the stocks.

There are some bright spots despite the weak pricing trends.

* One is that price deflation drives buyers into the legal market from the illicit market, which is twice as big as the legal market, says Azer. She predicts the national market will grow to $42 billion in 2026, from $26 billion in 2022, which remains bullish for the sector.

* New Jersey sales growth is strong. This should benefit cannabis companies with exposure there, like our Green Thumb, Curaleaf, Cresco Labs and Ayr Wellness (AYRWF).

* Overall pricing and margin pressure in the sector will lead to further industry consolidation, notes Zuanic, benefiting the larger and better-capitalized operators (our companies) who can buy weaker players.

What to do now

Because of the potential for the bullish catalysts that I have outlined above over the next few months, if you’re a new subscriber, or you’re underinvested in the sector, you should consider owning any of the names in our portfolio that are down sharply with the sector this year. If you are a trader, be ready to add to names on any weakness caused by election outcomes in which Republicans take half or all of Congress. Or else use the ETFs as trading vehicles. Then be prepared to sell into any rally created by passage of the SAFE banking act, which is possible before January. Trading in and out of names successfully can be challenging. Long-term investing may be the way to go, and if that is your approach, just consider simply holding through the near-term volatility, to profit from the bullish long-term sales growth and legalization trends in the sector. I’m going to wait for sector weakness to deploy more cash ahead of possible banking reform headlines. I will send an alert when I do so.

Quick takes

* The Federal Reserve Bank of Kansas City published a bullish study on cannabis noting that the “emergence of the industry has led to higher employment and stronger demand for commercial real estate. In addition, tax revenues have increased as marijuana sales have grown.”

* For the third season in a row, the National Basketball Association (NBA) will decline to test players for cannabis, noting that “society’s views around marijuana have changed.”

* Green Thumb Industries says it will soon start selling cannabis at Circle K Gas stations in Florida, a sign that marijuana is going more mainstream.

* Critics claim cannabis is a commodity, but local soil and weather conditions can create unique qualities in marijuana, notes Cannabis Business Times, a concept known as appellation in wine marketing.

* The ASPCA Animal Poison Control Center reports that marijuana toxicity in pets is rising sharply, suggesting that users need to exercise more care in storing supplies.

* Tweet of the month: “If we are jailing people for plants, I nominate brussels sprouts.” - @JT_in_LA.

Sector performance

The New Cannabis Ventures Global Cannabis Stock Index is down 62.7% year to date, compared to a 38.1% decline in our portfolio.

Portfolio

Current Recommendations

Ayr Wellness (AYRWF)
This is a vertically integrated multistate operator based in Miami with 73 dispensaries in eight states (Arizona, Florida, Illinois, Massachusetts, Nevada, New Jersey, Ohio and Pennsylvania). It makes the #2 carbonated THC beverage in the U.S. (Levia). It has its products in 475 third-party stores. And it has three adult-use stores coming to the high-growth New Jersey market. Second-quarter sales were $110 million, up 21% from the prior year but down less than a percent from the first quarter, while the loss per share was $0.56, the biggest loss of the past two years. The company ended the quarter with $117 million in cash, so viability is not a problem. The problem is that growth is slowing, and profitability now looks farther out than investors previously anticipated. AYR recently appointed David Goubert as President. Goubert previously served as president and chief customer officer at Neiman Marcus Group and he was at LVMH for 20 years before that. Ayr is currently launching brands from its national portfolio in New Jersey, including Ayr’s Lost in Translation flower, Kynd flower, Road Tripper flower, STIX pre-rolls, Entourage vapes, Secret Orchard vapes, and Wicked soft lozenges. Ayr looks cheap with a price-to-sales ratio of .67. BUY

Cresco Labs (CRLBF)
Chicago-based Cresco is on track to become the biggest cannabis company in the world, once its acquisition of Columbia Care (CCHWF) is complete. Cresco has long prioritized the wholesale market, and thus is currently the #1 seller of branded cannabis products in the U.S., with its products in over 1,100 stores. But retail revenue has been growing faster, and the addition of Columbia should create a balanced powerhouse. Second-quarter revenues were $218 million, up 4% from the year before, while EBITDA was $51 million, or 23% of revenue, up 11% from the previous year. Cresco Labs offers exposure to many attractive U.S. markets with an emphasis on Illinois. It holds a sustainable competitive advantage there with production limits 50% larger than its closest competitor and triple that of other large producers. It has a clear brand message that resonates with consumers. Management expects continued growth as seven more high-population states — New Jersey, New York, Pennsylvania, Ohio, Virginia, Florida and Maryland — transition to legal adult use. Cresco recently expanded its Cresco brand vape and concentrate product in Florida. BUY

Curaleaf (CURLF)
Massachusetts-based Curaleaf was the industry leader in the second quarter, with revenue of $338 million from 22 states and 136 dispensaries and its European operations but will likely be surpassed by Cresco once the Columbia Care acquisition is complete. Still, Curaleaf is the clear winner on the perception front. Its market capitalization of $4 billion tells us investors expect a lot from the company — and its price/sales ratio of 3 is among the highest in the group. Curaleaf will benefit from progress on legalization in Germany and Europe. It has operations in eight European countries as well as Israel. It just completed the acquisition of a majority stake in Germany’s Four Pharma, a licensed producer and distributor of medical cannabis that has more than 10% market share in Germany. Investors also believe the company’s R&D will pay dividends as the industry goes more mainstream. The company recently announced the launch of Plant Precision, a curated collection of edibles and a topical gel that contain minor cannabinoids that are non-psychoactive and do not create the euphoric feeling that THC does. They are designed to target specific wellness categories for the growing numbers of Americans who say they would be more likely to use cannabis as a health solution if it came in small, controlled doses. Curaleaf has a healthy balance sheet – $90 million at the end of the second quarter – and good access to capital. Thus, Curaleaf may benefit as a buyer in ongoing industry consolidation. It has a good M&A track record. The company’s executive chairman has a lot of experience rolling up fragmented and distressed industries. Continued market developments in Illinois and New Jersey could be strong catalysts for Curaleaf, says Stifel’s Andrew Carter. Illinois will increase its store footprint by more than 2.5 times. Considerable upside exists in New Jersey as product offerings expand in the second half of this year, he says. Curaleaf owns cannabis assets in several European countries, giving it a foothold as legalization expands on the continent and in the U.K. BUY

ETF AdvisorShares Pure US Cannabis (MSOS)
This exchange-traded fund (ETF) has a large exposure to most of our portfolio names so it may seem redundant. However, I want to put it on your radar as a liquid trading vehicle for getting in and out of the group without having to make a lot of individual stock sales, and as a way to get exposure to many of our names with one purchase. It also gives us diversification beyond our names, to positions like Verano Holdings (VRNOF), Jushi Holdings (JUSHF) and Innovative Industrial Properties (IIPR), among others. BUY

ETFMG Alternative Harvest (MJ)
This ETF has outsized foreign exposure, which means it could benefit more than other marijuana exchange-traded funds if we see progress on legalization in Germany. That could happen in the form of draft legislation by the end of the year, and decriminalization of recreational use in 2023. “Legalization in Germany could be a tipping for global expansion,” according to cannabis experts at ETFMG. This would put additional pressure on other European Union members to move forward with legalization. It could also encourage reform of the 1961 U.N. Single Convention on Narcotics which prohibits the cultivation and sale of recreational cannabis. “Such a result would be momentous and would open the doors to a global market,” says ETFMG. Owning this ETF broadens our industry exposure to names outside our portfolio, like Canopy Growth (WEED), SNDL (SNDL), Cronos (CRON), and GrowGeneration (GRWG), among others. BUY

Green Thumb (GTBIF)
Chicago-based Green Thumb is the portfolio’s largest position. Green Thumb was the third-largest cannabis company in the U.S. in the second quarter but will likely fall to fourth after Cresco’s acquisition of Columbia. Yet it has been the most profitable multistate operator of all the big ones, based on its consistent record of profitability over the past eight quarters – a sign of good management. Second-quarter revenues were up 15% from the previous year to $154 million, while earnings per share were $0.10, unchanged from a year ago. Revenue growth was driven mainly by increased retail sales in New Jersey as the legal market opened, increased retail sales in Illinois, 19 new locations opened since last year, and increased traffic in most of the company’s 77 stores. Green Thumb manufactures and distributes a portfolio of branded cannabis products including &Shine, Beboe, Dogwalkers, Doctor Solomon’s, Good Green, incredibles and RYTHM. The company operates a national retail cannabis store called RISE. Green Thumb is expanding its medical footprint in Florida through a lease agreement with convenience store chain Circle K. Green Thumb trades at a price-to-sales ratio of 2.64, which seems reasonable given its 15% year-over-year sales growth. Ongoing market developments in Illinois and New Jersey could be strong catalysts for Green Thumb Industries, says Stifel’s Andrew Carter, who has a buy rating on the stock. Illinois will increase its store footprint by more than 2.5 times. Considerable upside exists in New Jersey as product offerings expand in the second half of this year. A positive here is that Green Thumb is founder-run. Founder Ben Kovler is chairman and CEO. Research shows that founder-run companies often outperform. Kovler has a 26% stake in the business and holds nearly 59% of voting power. BUY

OrganiGram (OGI)
OrganiGram is the number three producer of cannabis in Canada, and number one in dried flower, with its flagship brand Edison. And it’s now the fastest-growing company in the portfolio; second-quarter revenue was $38.1 million, up 88% from the year before, which was in stark contrast to many Canadian producers, who are still shrinking thanks to falling wholesale prices. And the loss per share was just a penny, unchanged from the preceding quarter. Part of the company’s growth comes from the international market. During the quarter, OrganiGram made two shipments totaling $1.3 million to Australia, and since then it has shipped a further $5.4 million of product to Australia and Israel (and it’s looking seriously at opportunities in the German market). But the major reason for growth was expanding market share in Canada, as investments in automation reduced dependence on manual labor and enabled continued price competitiveness. British American Tobacco (BTI) is a big investor in OrganiGram, owning 19.4% of the company, an endorsement of its potential. BUY

Tilray Brands (TLRY)
Tilray is a cannabis and consumer packaged goods company with one of the biggest global footprints in the industry, following its 2021 merger with Aphria. CEO Irwin Simon founded The Hain Celestial Group, a natural food company, which favors brand development efforts – a key factor in cannabis investing. Tilray is a big recreational and medicinal cannabis supplier in Canada, but it also offers medical cannabis in 20 countries on five continents through its subsidiaries and agreements with pharmaceutical distributors. It sells CBD products in the United States. Tilray has been making significant investments in Europe. It has a medicinal marijuana distribution network in Germany. It has production facilities in Portugal and Germany. Tilray recently got approval from the Italian Ministry of Health to import and distribute medical cannabis. All of this means Tilray offers good exposure to European legalization likely to play out over the next few years. Tilray sells hemp food products through its Fresh Hemp Foods division, and it has a craft alcohol business called SW Brewing, the tenth-largest craft brewery in the United States. Tilray also holds convertible debt and warrants in MedMen Enterprises (MMNFF), a U.S.-based dispensary with over 25 stores in six states, including California, Illinois and Florida. Conversion of the debt and warrants could eventually bring a significant outright ownership stake. A risk here is that Tilray fails to produce positive free cash flow, so a dilutive capital raise is possible. On the other hand, the company projects it will turn cash flow positive by August next year, and a strategic alliance with the cannabis company Hexo (HEXO) could bring substantial cost savings over the next two years. Tilray is the kind of “industry flagbearer” that could post big gains if Congress makes progress on cannabis sector banking reform, notes CIBC’s John Zamparo. BUY

Trulieve (TCNNF)
While it has long been the biggest seller of marijuana in Florida, where it has a 46% market share and does 70% of its business, Trulieve has been expanding across the country in the past year (it had seven acquisitions in 2021). It is diversifying its presence into Pennsylvania, Maryland, and Massachusetts, among other states. The upside of that expansion effort (short-term) is that it made Trulieve #1 in the U.S. – a title it will likely cede to Cresco. The downside (again, short-term) is that it ruined the company’s record as the “most profitable” multistate operator, as its record of seven consecutive profitable quarters has now been broken by three consecutive quarterly losses. Long term, however, Trulieve has great prospects and has a unique geographic hub system, with Florida the company’s Southeast hub, Pennsylvania its Northeast hub, and Arizona the Southwest hub, all serving the company’s current operations in eleven states. As of June 30, Trulieve had $181 million in cash, and as of August 10, the company had 175 retail outlets in 10 states. Management expects full-year revenue to hit $1.25 to $1.3 billion this year (that projection is down a little) and expects positive free cash flow in 2023. The company had a busy September, announcing new medical dispensaries in West Virginia, a production license for medical cannabis in Georgia, and the launch of Khalifa Kush medical cannabis products in Florida in partnership with the recording artist Wiz Khalifa. BUY

The next Cabot SX Cannabis Advisor issue will be published on November 30, 2022.