SAFETY FIRST (OR NOT)
As US cannabis shares continue to make new lows within a six-month downtrend, I’ve been thinking about the specific causes of this price action and the outlook for shareholder returns under an evolving regulatory outlook.
To recap recent events, the long-awaited discussion draft of the Democrats’ Cannabis Administration and Opportunity Act was unveiled on July 14th. The text arguably contains some upgrades for investors like equal treatment under the tax code and access to financial services including capital markets, offset by some potential downgrades including high federal excise taxes and the contemplation of interstate and international trade.
Initial equity market reaction to the draft was understandably muted given that 60 votes will be required for Senate passage and many of the provisions in the sponsors’ wish list are unlikely to attract Republican support. Even Democrats in states with an already-thriving cannabis industry may be unwilling to support a bill that could destroy existing local cultivation and production jobs while saddling constituents with painfully high taxes at the register.
But then sector shares started to materially underperform as the sponsors spoke at a press conference.1
Shortly after 12:30pm, an impassioned Senator Booker displaced Senator Schumer at the podium, and while wagging his finger pronounced that “if somebody in the Senate tries just to do the banking bill […] I will lay myself down to do everything I can to stop [it]”.2
And as some readers will be familiar, prior to the press conference the consensus outlook for legislative reform prior to next year’s midterms seems to have assumed passage of the bipartisan SAFE Banking Act as a base case. The unveiling of the market-neutral discussion draft thus turned into a market-negative downgrading of expectations for banking reform.
What might the economic implications of a delay to SAFE Banking be for equity investors?
A basic banking bill (assuming no capital markets access or 280E exemption) could reduce expenditures on:
Security, payment processing, and cash handling costs which currently may be in the neighborhood of 10% of retail sales. If SAFE can reduce these to 5%, retail-facing businesses could see a 5% boost to EBT margins; and
Interest expense, as debt financing today is predominantly sourced from non-bank institutions that charge rates ranging from high single digits into the high teens. In comparison, high yield borrowers are currently paying around 4%, and CCC’s under 7%.3
The magnitude of impact could vary meaningfully by operator.
The 1st point relating to cash payments suggests that retailers stand to benefit from SAFE more than wholesalers. Though the costs of basic banking services (unrelated to cash handling) have been reported to be very high for all cannabis operators so wholesalers would probably still earn some pickup, just not quite as much.
The 2nd point on cost of debt comes with some complexity. Existing debt may not be callable or prepayable so passage of SAFE wouldn’t result in an immediate reduction of interest expense. But it would help existing borrowers refinance over time, and allow additional borrowings at lower rates. It could also reduce the hurdle rate for expansion projects, incentivizing new capex and M&A.
But some companies today aren’t able to produce positive cashflow from operations and need continuous support from debt and equity markets just to keep the lights on. Here is how one such firm recently described its predicament4:
So, shareholders of firms that are not the most efficient may find that a prolonged deferral of SAFE results in:
The issuance of additional debt at high non-deductible rates;
Non-accretive dilution via equity raises;
Asset sales that reduce forward earnings potential;
The inability to maintain market share as rivals reinvest and expand using internally generated cash or (relatively) lower-cost debt;
The cutting of corners operationally; and/or
Difficulty attracting and retaining talent due to the above.
An extension of the challenges posed by the status quo could result in market share gains and corresponding returns to equity for the more efficient operators, to the detriment of those that are less efficient.
Away from the plant-touching operators, I mentioned that non-bank institutions are currently the sector’s primary source of debt capital. Post-SAFE, they should face significant competition from federally regulated banks that have a large surplus of lending capacity, a cost of funds near zero, and may even originate below-cost loan facilities in order to win fee-generating M&A and equity mandates. Since a postponement of SAFE keeps these lenders at bay, it might not be a surprise that IIPR (which originates high-cost sale-leaseback transactions to plant-touching operators) has outperformed even the Russell 2000 since Senator Booker’s threat and is trading near all-time highs.5
Arguably, some non-financial ancillaries that are thriving in the current environment may be better off too without rapid normalization of the industry and the competitive threats that may bring. Existing access to banking/capital and equitable tax treatment preclude the problems discussed and allow shareholders to continue to benefit from the secular tailwind of a rapidly growing industry. And that’s without returns being impaired by punitive expenses that can necessitate maintenance interest or dilution, enabling a lower hurdle for returns to equity and a continued relative advantage versus plant-touching operators.
This isn’t to say that Senator Booker’s comments should be accepted at face value. He’s already followed up on the topic and some soundbites taken in isolation suggest he has dialed back his position. Corporate lobbyists are also increasing their activity in support of federal reform and I imagine federally-regulated bankers must be pushing their representatives to gain access to the opportunity. Investors in this sector know all too well, though, the futility of trying to predict the timing of political outcomes and for now may be better off taking the approach of GreenThumb’s CEO6:
Stay nimble.
DISCLAIMER
This material has been produced and distributed for informational purposes only. Sources for the information herein are believed to be reliable, but the information is not guaranteed as to accuracy and does not purport to be complete, and no representation or warranty is made that it is accurate or complete. The author undertakes no obligation to provide any additional or supplemental information or any update to or correction of the information contained herein. Securities highlighted or discussed in this communication are mentioned for illustrative purposes only and are not a recommendation to buy, sell, or otherwise transact in such securities. The author shall not be liable in any way for any losses, costs or claims arising from reliance on this material, which is not intended to provide the sole basis for evaluating, and should not be considered a recommendation with respect to, any investment or other matter. Past performance is no guarantee of future results. Securities discussed in this material may or may not be held in portfolios owned or controlled by the author at any given time.
Source: Koyfin.com
Source: Red White& Bloom Brands Inc. Financial Statements for the period ended March 31, 2021.
Source: Koyfin.com
