Here are the latest developments in the cannabis sector over the past two weeks.
The bottom line: States continue to march forward with legalization, but the negative trends of price compression and higher financing costs weigh on weaker players. That will create acquisition opportunities for the stronger companies in the space.
Possible surprise developments on the federal front suggest it makes sense to increase leveraged exposure to cannabis stocks, especially considering how dark sentiment is. (See the “what to do now” section below for details on portfolio moves.)
Here is a closer look.
Potential developments in Washington, D.C.
* Favorable federal reform: Not dead yet I The Department of Justice (DOJ) may still offer favorable guidance on federal cannabis law enforcement which has the potential to create a buying frenzy in marijuana stocks.
U.S. Attorney General Merrick Garland testified on March 1 that the DOJ is still working on an update to its marijuana policy that could reverse a negative ruling from the prior administration.
“I think that it’s fair to expect what I said at my confirmation hearing with respect to marijuana and policy, that it will be very close to what was done in the Cole memorandum,” he testified at a Senate Judiciary Committee hearing.
The Cole memorandum was a 2013 DOJ policy statement from then-attorney general James Cole that directed federal prosecutors to avoid interfering with state cannabis laws. It was later rescinded by Attorney General Jeff Sessions during the Trump administration.
“We’re not quite done with that yet,” Garland said of the cannabis policy review. The statements were in response to questions from cannabis law reform advocate Sen. Cory Booker (D-NJ). Booker said he’s eager to hear more about the administration’s plan for marijuana while “more and more states, red and blue, are moving” to change their cannabis laws. Inactivity by Garland, who became attorney general two years ago, has frustrated reform advocates like Booker, and they are pressuring him for an update.
* Favorable federal reform: Not dead yet II Favorable cannabis sector banking reform (known as “SAFE banking”) recently got a strong endorsement from a conservative lawmaker.
Cannabis companies “have done everything they are supposed to do and they can’t use the banking system. It just doesn’t make a heck of a lot of sense,” said Rep. David Patrick Joyce (R-Ohio) in an interview with Ideastream Public Media last week. He said local banks would garner most of the cannabis banking business, so “getting cash out of the business and into the banks” would benefit local communities.
Joyce also endorsed reform that would level the playing field on the tax front. Currently, a part of the IRS code known as “280e” prohibits cannabis companies from deducting expenses on federal tax forms, because they sell products that are illegal under federal law. This cuts into profits dramatically.
“Let’s do what’s necessary to make sure that those already being regulated by the state enjoy the same tax laws that all the other legal concerns can enjoy,” he said. “We are a country of laws and laws have to have effect or you take the laws off the books.” This was a reference to the increasingly stark contrast between cannabis prohibition at the federal level vs. the steady growth in the number of states legalizing recreational use (see below). Joyce is a member of the Congressional cannabis caucus.
Cannabis investors all but gave up hope on federal reform after lawmakers failed to make progress last December despite hints that banking reform was on the way. Investors got badly burned in the sector ssell-off which has soured sentiment on the group. The Joyce comments are a reminder that reform efforts could spring back to life. This would reverse sentiment and send cannabis stocks up considerably, even before actual reform is approved. Cannabis expert Jason Wilson at the ETFMG Alternative Harvest ETF (MJ) predicts the Secure and Fair Enforcement Banking Act (SAFE) will be re-introduced this year.
Cannabis companies are increasingly vocal about their disappointment with lawmakers. “The lack of progress regarding cannabis regulation from our elected officials in Congress is mind-numbing,” said Green Thumb (GTBIF) CEO Ben Kovler in his company’s February 28 earnings call.
It also creates an unfortunate irony, says Kovler. “The crippling tax burden continues to hurt new operators by greatly reducing their prospects for a profitable and sustainable cannabis business. The very people that social equity licenses were supposed to help are left pretty helpless.”
State developments
While progress at the federal level remains stalled for the moment, states keep moving ahead with legalization and market growth. This is bullish for the sector.
In part because of ongoing progress at the state level, cannabis sales growth will triple over the next decade, predicts Green Thumb CEO Kovler. Near term, he’s most bullish on growth in Virginia, Minnesota, and Pennsylvania. “We think in twenty-four months to thirty-six months, all three of those markets will be significantly bigger than they are today.”
* Missouri Cannabis sales got off to a very strong start in February, the first month of recreational use legalization. Sales topped $100 million. For context, Michigan posted $28.6 million in cannabis sales its first month, and Illinois came in at $40 million. The strong sales start confirmed public support for legalization, and also generated significant tax revenue. Politicians around the country will notice both.
* Minnesota State legislative committees continue to approve a marijuana legalization bill. It was most recently cleared by the state’s Senate Human Services Committee. “This allows adults to safely and responsibly use cannabis,” Sen. Clare Oumou Verbeten (D) told committee members. “It creates a regulated marketplace that’s much safer than our current underground illicit marketplace.” Legalization in the state seems increasingly likely. Gov. Tim Walz (D) has voiced support, and his recent budget plan includes funding to implement marijuana legalization.
* North Carolina The state Senate recently approved a bill to legalize medical marijuana. It should soon go to the House, where a key lawmaker indicates a favorable vote is likely. House Speaker Tim Moore (R) says the chamber’s new political makeup foreshadows a green light on the bill. A recent poll found that 75% of state voters back medical cannabis legalization.
* New Hampshire The state House in late February passed a bipartisan bill to legalize recreational cannabis use. Two prior bills to legalize cannabis failed in New Hampshire’s Senate. But the new version of the bill omits parts that were obstacles in the past (provisions allowing home grow and annulment of cannabis convictions).
A recent survey by the University of New Hampshire found that 71% of respondents in the state support legalization. Reform is supported by 86% of Democrats, 62% of Republicans and 53% of independents. Only 18% said they oppose legalization. Gov. Chris Sununu (R) has opposed to legalization, but recent comments suggest he is coming around.
* Washington The state Senate recently approved a bill that would allow cannabis companies there to conduct interstate commerce. The bill would give the governor the power to ink agreements with other states allowing interstate commerce among licensed cannabis companies.
* Hawaii The state Senate recently approved a bill to legalize marijuana. It’s not clear the House will vote favorably on the measure, though Gov. Josh Green (D) has stated he’d sign a bill to legalize cannabis.
But not all state news has been positive. Oklahoma voters just rejected a ballot initiative that would have legalized marijuana.
Public support for legalization grows
Polls continue to show that politicians opposing cannabis reform are increasingly out of touch with voters.
* Conservates coming around A recent poll found that 68% of likely 2024 Republican presidential election voters support federal cannabis reform. This was up ten percentage points compared to results from the same poll conducted last year. The poll also found that 70% of GOP voters think cannabis reform should be up to states. The poll was conducted by the Coalition for Cannabis Policy, Education and Regulation, which is funded by tobacco and alcohol companies.
The poll results are bullish for cannabis stocks, since conservative lawmakers at the federal level are more likely to resist cannabis reform. Given the shifting sentiment among conservative voters, that could change, clearing the way for cannabis reform in Washington, D.C.
“The polling is clear. Federal cannabis prohibition is in direct contradiction to the overwhelming will of the American electorate, including a notable majority of conservative voters,” said Rep. David Patrick Joyce (R-Ohio). “I hope more of my colleagues on both sides of the aisle will heed the call of their constituents and join me in working towards a safe and effectively regulated legal marketplace that respects the rights of the over 40 states that have enacted some varying degree of legality. Continued inaction is no longer tenable.”
Rep. Nancy Mace (R-SC), a proponent of federal cannabis reform, said “it appears the only place where cannabis reform is unpopular is in Washington, D.C. It is time we give states the power to make decisions around cannabis without fear of federal consequences.” Mace has previously introduced a cannabis reform bill called the States Reform Act.
Negative sector trends take a toll but create some opportunities
Cannabis companies are struggling with declining marijuana prices, cash bleed and rising interest rates that have increased the cost of funding. The negative trends are starting to hit companies with negative operating cash flow and weaker balance sheets.
* Dilutive debt offering hits popular cannabis stock Shares of the high-profile cannabis name Canopy Growth (CGC) have fallen 30% since the start of February in part because the company had to resort to unfavorable financing. The company recently issued convertible notes to raise around $95 million. The conversion price is 92.5% of the average share price during the three days prior to conversion, which is less favorable than fixed-price conversion.
Canopy has $797 million in cash against $1.3 billion in debt, and it reported negative operating cash flow of $544 million last year. Canopy is not a portfolio name of ours, and I am not suggesting that you consider owning it.
* Illinois price declines Retail cannabis prices in Illinois are down 18% year over year, according to a recent survey by Cantor Fitzgerald. Despite the declines, Illinois flower prices at $15.17 per gram (for a 3.5-gram package) are still 25% higher than in Massachusetts, 23% higher than in Pennsylvania and 65% higher than in Florida.
Among states surveyed, prices were higher only in Ohio ($17.81 per gram) and New Jersey ($16.68). Illinois prices are down because of new retail capacity and legalization of recreational use in neighboring Missouri, said the brokerage. More dispensaries are coming online in Illinois, so the price compression will likely continue.
But there’s underlying upside for the sector in the challenging trends of price compression and rising capital costs. Cannabis companies in our portfolio point to three benefits.
One is the creative destruction it brings to the space. Rapid sector growth over the past few years attracted “a lot of prospectors and get-rich-quick hopefuls,” said Green Thumb CEO Kovler. “For a variety of reasons, these folks will get caught and eaten by the bear. The days of fat margins and easy money and cannabis are waning. We are in the midst of a washout that will leave the industry with fewer operators.”
Next, damage in the sector may create buyout bargains for financially sound cannabis companies like our Cronos (CRON). Cronos says it is interested in buying successful brands and not supply capacity. This is no surprise given that there’s too much capacity in the sector.
Third, lower prices have increased unit sales growth, which offsets the price declines to some degree. “If we zoom out, we see year-over-year unit growth of 28%, which is the best indicator for us of consumer demand,” said Kovler. “This massive unit growth continues to show us that cannabis is an essential purchase for American consumers.”
Portfolio Company Updates
Green Thumb (GTBIF)
Green Thumb reported $259 million in revenue for the fourth quarter, which was up 6% year-over-year but down 1% from the third quarter. Encouragingly, fourth-quarter same-store sales (stores open at least 12 months) increased 3.4% versus prior year at 65 stores. The company posted losses of 22 cents per share. Gross profit margins slipped to 47.8% from 52.8% in the prior year.
Importantly, given the tough times for the sector, Green Thumb reported quarterly operating cash flow of $70 million, and it ended the quarter with $178 million in cash. That was up $31 million from the prior quarter. “This financial strength provides for both optionality and durability going forward,” said CEO Kovler. “We are confident that our company is in good shape to weather the macro turbulence.”
For the full year, revenue increased 14% to $1 billion and operating cash flow came in at $159 million. The year-over-year sales increase was primarily driven by the legalization of adult-use sales in New Jersey and revenue from acquisitions.
The company projected revenue and cash flow growth this year from store openings in Pennsylvania, Nevada, Minnesota, Virginia, and Florida. It projected around fifteen new stores would open this year, which would boost the store count by over 20%. It also cited strong sales momentum in New Jersey, Virginia, Minnesota, Connecticut, and Rhode Island and the potential commencement of adult new sales in Maryland.
Cantor Fitzgerald analyst Pablo Zuani offered a mixed signal on the name. He kept his overweight rating but reduced his price target to $30 from $32 on lower earnings estimates. He said Green Thumb is better off than most cannabis companies in terms of balance sheet strength and said the company is “more disciplined than most.”
I consider Green Thumb a “buy” in the current pullback.
Cronos (CRON)
Cronos reported 2022 fourth-quarter sales of $22.9 million on February 28, an 11.2% year-over-year decline. The decrease was driven by lower cannabis flower sales in Canada and sales weakness in the U.S. partially offset by an increase in Israeli medical market sales. Gross profits in the prior-year quarter turned to losses, due to a $2.2 million decline in profits.
For the year, net revenue increased 23% to $91.9 million, driven by strength in Canada and Israel. Losses tightened to 45 cents a share from losses of $1.07 the prior year. Gross margins came in at 13%. But the company posted big operating cash outflows of $89 million for the year despite a $28.7 million cut in operating expenses. On the bright side, the company ended the year with $878 million in cash and no debt. What will it do with the cash? “We aren’t really focused on supply chain assets, it’s really on branded products,” said CEO Mike Gorenstein.
The company said it will also continue to focus on “borderless product innovation,” to create brands that can be easily introduced in new markets, like its Spinach brand. This is the third most popular cannabis brand in Canada and the number one edible brand there. It has a 20.9% market share in gummies in Canada.
I consider Cronos a “buy” in the current pullback.
What to Do Now
If you are new to the sector, consider buying Green Thumb and Cronos, and the two ETFs below.
Given that sentiment on the group is so dark, yet there is potential for upside surprise at the federal level, I want to increase our leveraged exposure to the group.
I am selling 1,000 shares of AdvisorShares Plus US Cannabis (MSOS) at $6.82 per share to raise $6,820 in cash. I am using the funds to buy 1,240 shares of AdvisorShares MSOS 2X Daily (MSOX) at $5.50 per share.
This reduces our MSOS share count to 2,658 from 3,658, and it reduces MSOS to around 13% of the portfolio from around 18%. The change increases the MSOX share count to 3,077 from 1,837. The change raises MSOX to about 12% of the portfolio from around 7%.
