Despite Challenges in 2021, Strong Cannabis Operators are Capitalizing for Long-Term Future Success


Co-Written by Morgan Paxhia (Poseidon) with data provided by Cy Scott (CEO of Headset)

When we started Poseidon back in 2013 we had no data, no benchmarks for valuations, and a very limited opportunity set. We truly had a blank canvas as we went about investing our first fund. We tried to focus on good teams and areas of the industry we felt were essential to building what would become the fast growing, multibillion dollar industry it is today.

We had to build frameworks for valuations depending on what parts of the industry we were putting capital to work. We studied external markets as guides to considering inputs like TAM (total addressable market), profit margins, growth rates, to give us some basis for determining valuation. Today is a far different experience. There are dozens of analysts covering Canadian LPs and more and more covering US cannabis operators (“plant touching” businesses) and ancillary cannabis companies. The quality of the analysts’ work is quite varied with many exhibiting the biases of their investment bank sales team.

We note this limited understanding of the cannabis industry as a symptom and opportunity of an early stage industry. For example, earlier this year analysts defended Canopy Growth trading at 16X sales with a very weak fundamental business while only offering nominal valuation credit to much stronger US companies. We believe this behavior was further exacerbated by media like Jim Cramer on CNBC, who continues to give air time and support to David Klein (CEO of Canopy Growth) rather than addressing the much bigger opportunities right in the US. According to Headset, a cannabis analytics firm, the Canadian cannabis market is projected to generate $5.56B in sales in 2022 vs. $30.54B in the US, with Canada representing only 15.4% of total legal cannabis sales across both countries.

Source: Headset Data

The fourth quarter of 2020 and the first half of Q1 this year can largely be summed up by the typical ebbs and flows of retail enthusiasm. There are great companies in our space that now seem cheap in the summer and fall of 2020 and then the stock price momentum kicked in fueled by the hope of federal legalization post the Blue Wave. The enthusiasm topped out in February 2021, which seems to also have coincided with other areas of the capital markets from the SPAC mania blow off, high flying tech companies falling significantly, peak option trading, etc etc. The last several months has shown rotation on a macro level and a significant cooling off in cannabis interests and therefore trading volumes. We believe there is a long way to go for our industry and very attractive returns within specific public and private companies. Moments like mid-February can be frustrating knowing what comes next, weeks or months of digesting. Here we are in 4Q with US cannabis stocks reversing their early 2021 gains and most are negative for the year. Though stock prices may not be going up, there is plenty going on under the hood that gives insight into future returns. Growth is driven by consumers entering the category amplified by new market legalization producing significant tailwinds to the industry. For example, Headset Analytics recently reported that Arizona, which legalized adult-use sales in January 2021, saw $1.6B in total cannabis sales in the first nine months of the year alone. On the east coast, Headset reports that in Pennsylvania, a strictly medical market that recently generated over $300M in sales (after discounts) in Q3 2021 alone, growing 40% y/y, and all that with one-third of retail licenses going to just three MSOs positioning them well for organic growth of the market as well as future adult-use legalization in this state and others nearby.

Here are some great points from Stifel’s Andrew Carter from back in 2Q21:

  • The U.S. operators have been able to raise equity on attractive terms with the top four U.S. MSOs raising roughly $600 million priced at a roughly 5% average discount to the previous day’s close.
  • We now estimate the US state-licensed cannabis category will grow to $23.8 billion in 2021 sales, up from $17.8 billion in 2020, +33% YoY. State reports suggest a strong start to the year with our estimates suggesting the U.S. state licensed category grew over +50% in 1Q21 with Headset insights suggesting 31% y/y growth in calendar 1Q21 for the markets we estimate account for roughly 50% of the U.S. state licensed market (California, Colorado, Nevada, Oregon, Washington).
  • While the U.S. market is in the early innings of its development, leading U.S. multi-state operators have established an early lead leveraging limited licenses in key medical and adults use states with our estimate suggesting the top 15 public companies command 25% of the U.S. overall market. Outside California, we estimate key states for the MSOs (Florida, Illinois, Maryland, Massachusetts, New York, Nevada, and Pennsylvania) grew 113% y/y in 4Q20 with our estimates suggesting 85% growth y/y in 1Q21 from these markets.

Another industry analyst we follow is Matt McGinley at Needham & Company LLC. He seems equally perplexed by the stock market action relative to the fundamentals. This chart is from his September 2021 and it really captures the current environment:

The chart below is an attempt to conceptualize the notion of US Multi-State-Operators (MSOs) public cannabis stocks opportunity zone (GAARP = Growth At A Reasonable Price), when there is good underlying growth and good capital allocation happening within specific companies. We believe the resulting drawdown in stock prices supported by positive tailwinds sets up for the next leg of returns.

This GAARP Zone chart can also be supported by the capital raising activity experienced in 2021. We have seen a large increase in debt issuance that has been readily absorbed by the market, as shown by this Viridian Capital chart:

A good colleague of Poseidon put it very straightforward — “credit almost always leads equities”. We agree and also believe this ties back to our earlier writings around the “Darwin Phase”. 2021 has proven to reward the stronger, better managed, and discounted those with headwinds like weak balance sheets, poor execution or in challenging regulatory markets (ex. Canadian Limited Producers).

The final piece to this cannabis drawdown ending is growth. Our final chart comes from Vivien Azier of Cowen who noted a revenue growth acceleration after months of slowing. This chart is very helpful in contextualizing our theory that we were in a mid cycle slowdown, coming off very robust COVID driven sales in 2020.

Overall, we see a market that has experienced a challenging 2021 with strong headwinds from valuations and growth. However, we see strong operators capitalizing on this environment by staying focused on building their businesses, improving their costs of capital, and positioning themselves for years to come.

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