Friends and fellow investors, after a four-year hiatus it feels great to write about investing again and a lot has changed. Four years ago, I’d spend my day analyzing technical charts, discussing Fed policy with clients, and using valuation multiples and economic policy to inform my investing decisions without the full appreciation of everything that goes into operating the companies I was investing in. The executive experience gained running a public company made a profound impact on the way I think about investing and, come to find out, businesses are far more than multiples, margins, and revenue growth! They’re a living and breathing organism which requires teamwork, vision, culture, pragmatism, empathy, and communication to solve problems with incomplete information. For me, the transition from reading 10K’s and listening to polished earnings scripts to managing an operation is like comparing a Kentucky Derby sports bettor to a jockey in the race. And as someone who subconsciously overweights the value high-finance folks bring to an organization, witnessing a team of Six-Sigma black belts set up a new distribution center or HR professionals recite state employment law from memory makes for a humbling experience. Mr. Finance know-it-all didn’t have the first clue on how to get reimbursed for in-transit inventory that fell into the Pacific Ocean or the internal control infrastructure needed to become SOX Compliant. Fortunately, I was in the trenches with other professionals with very different backgrounds who were at the top of their game and united around the same mission, vision, and values. Truth is, a company’s performance isn’t linear the way most investors would prefer, and the non-linear reality is quite messy for a company in hypergrowth mode. And unlike the way most investors think (my old self included), management teams are far less concerned about stock price and far more concerned about delivering purchase orders On-Time-In-Full, delighting customers, enhancing employee morale, and staying compliant with regulators all while ensuring the long-term value proposition of the company is intact. It is with this newfound appreciation and humility that I share a few of my investment themes for the cannabis industry for 2022.
Regulatory “Goldilocks” favors Tier-1 Multi-State Cannabis Operators (MSOs) in 2022
My 2022 prediction for the cannabis sector are as follows:
1. Incremental federal reform passes ahead of midterm elections
2. Equity catches up to credit and valuations reset higher for publicly traded MSO’s
3. Ancillary companies rebound as new states legalize
4. M&A continues its torrid pace as smaller operators get gobbled up at accretive multiples by MSO’s
Like most investors, I was disillusioned by the Democratic Party’s whiff on cannabis reform in 2021. Having spent some time around politicians over the years, I appreciate the fact that most politicians are playing a game the rest of us civilians do not understand. However, after a clean sweep of both chambers of Congress plus the Executive Branch, myself (and the market) expected something greater than a goose egg after the Georgia run-off victory January gave the Democrats full control. There was an easy win on the table with SAFE Banking in Q4, which was squandered in favor of a larger, more sweeping Schumer cannabis reform bill that probably lacks the bipartisan support garnered for the SAFE Banking Act. When it comes to cannabis reform at the federal level, politicians continually make bipartisanship the enemy of partisan perfection at the expense of the American voter. There are some in the industry who say, “the heck with the politicians!” and choose to ignore how the sausage is made – which is sound advice from an operator’s perspective – however, the correlation between cannabis equities and federal reform is too strong to ignore as an investor. Given the misalignment within the Democratic wing, the GOP very cleverly introduced the States Reform Act last November to presumably steal federal cannabis reform away from the Democrats ahead of the 2022 midterms. I don’t claim to have any additional insight than what is already reported (and there are many in the industry who are all over this topic), but my hunch is the stakes are too large to squander an easy win ahead of midterms. With the pressure ratcheted up and overwhelming voter support (68% per recent Gallup poll), I expect the Democrats will get something incremental across the finish line prior to the midterms and claim victory for their constituents.
Meanwhile, the stalemate in Washington is giving the well-capitalized multi-state operators more time to build their moats at the expense of smaller startups. While the equity markets are fixated on the political progress, credit spreads (the difference between cost of debt compared to US treasuries) reflect improved fundamentals and have become ~600bps cheaper for Tier-1 operators over the past year. It’s widely believed within capital markets that credit investors are the “smart money” and that the direction of credit spreads inform future equity returns: credit spreads widening indicates equity pressure while tightening signals more favorable equity conditions. The tightening of cannabis spreads throughout 2021 demonstrate debtholders appreciate MSO’s improved balance sheets and the fact they can now self-fund with free cash flow. My bet is equity prices will soon reflect this new reality.
Given the recreational ballot initiatives for seven states including Ohio, Maryland and Missouri, capex deployment will be vigorous as companies rush to get vertically integrated within new legal jurisdictions. This will be a boon for the ancillary companies who finance real estate, equipment and provide branded packaging, accessories, and agricultural products. This should be benefit the leading picks and shovels players in the Green Rush, many of whom are publicly traded on major exchanges.
Lastly, license holders and smaller operators within the new limited license states can expect to be on the M&A shopping list as larger operators consider whether a build vs buy strategies to penetrate new markets. I anticipate stock will be large component of these transactions and expect larger players will scoop up smaller operators at accretive multiples to their prevailing valuations. This will benefit many private single state operators and keep the service providers (bankers, lawyers and auditors) very busy in the New Year.
I’m extremely excited about the investment potential for this sector going into 2022 and will be looking to put capital to work as opportunities present themselves. I also look forward to investing significant human capital with family and loved ones in the coming year.
From our family to yours, we wish you a happy and healthy New Year!
Stephen Christoffersen, CFA
Managing Member, Range Ventures LLC