Trulieve Cannabis Corp (TCNNF)

[FUNMAN]

Cannabis Companies Ranked From Most To Least Financially Leveraged

Dec. 14, 2020 10:38 AM ET

By: James V. Baker
Long/Short Equity, Special Situations, Banks, Cannabis
(1,558 followers)

See the graphics at this address:

https://seekingalpha.com/article/4394593-cannabis-companies-ranked-from-to-least-financially-leveraged

Summary

* Financial leverage measures the degree to which a company uses debt to fund its operations.

* Leverage can magnify gains as well as losses.

* The balance sheet shows the amount of debt a company has relative to its shareholders' equity.

* Cannabis companies exhibit an incredibly large divergence in the use of financial leverage.

Financial Leverage in United States Cannabis Sector

Financial metrics of publicly held cannabis companies show wide disparity in profitability, cash flow and financial leverage. This brief article focuses on the use of financial leverage by publicly traded United States cannabis companies.

Cannabis Companies Financial Leverage

The data presented in this article are from the most recent quarterly reports filed with either SEDAR in Canada or the SEC in the United States. Twenty-one (21) companies are listed in descending order based on market capitalization shown on Yahoo Finance as of the close on December 11, 2020.

In this balance sheet analysis, debt includes current taxes owed, notes, loans, and bonds. Tangible equity is shareholders' equity minus intangible assets and goodwill.

Innovative Industrial Properties (IIPR) is excluded, since it is a REIT and defies comparisons. MariMed (OTCQX:MRMD) is presented in the table, but is ignored in calculating averages. Including it would have distorted the averages, because it only has $84,000 in reported equity.

GrowGeneration (GRWG) is included in this study, and is another picks and shovels example that has been a huge success. It supplies cannabis companies with cultivation supplies including lighting fixtures, nutrients, seeds and growing media, systems, trays, fans, filters, humidifiers and dehumidifiers, timers, instruments, water pumps, irrigation supplies, hand tools, and other things.

Debt to Equity and Tangible Equity Ratios

Debt as a percentage of shareholders' equity ranged from 2.7% at Vireo Health (OTCQX:VREOF) to a high of 170.2% at 4Front Ventures (OTCQX:FFNTF) and averaged 44.6% for all companies presented. Debt as a percentage of tangible equity ranged from 3.2% of tangible equity at Liberty Health Sciences (OTCQX:LHSIF) to 226.4% at Curaleaf (OTCPK:CURLF) and averaged 80.5% for all companies.

Interestingly, seven (7) or 35% of the largest cannabis companies have negative tangible equity. All seven have exhausted their capital, because they are losing money and/or they booked intangible assets and goodwill in the acquisition of other companies.

MedMen - The Zombie

MedMen (OTCQB:MMNFF) stands out with negative shareholders' equity of $192.3 million and negative tangible equity of $364.6 million. MedMen's co-founders proved uniquely gifted at burning money. In March 2019 I wrote a Seeking Alpha article, "MedMen Hovers On The Brink As Its Co-Founders' Learn On The Job". That article compared MMNFF to the Powerball Lottery and its founders to on the job trainees. By the way, the trainees are gone and the company looks like it is unsuccessfully winking at a Sadie Hawkins dance.

Prevalence of Leasing

The shortage of capital in the cannabis sector has led to extensive use of leasing. Numerous companies in dire need of cash resorted to selling their facilities and leasing them back.

The major source of such funding via lease has been Innovative Industrial Properties, a REIT out of San Diego, CA. IIPR took a page out of the playbook of the people who got rich renting picks and shovels to miners in the halcyon gold rush days.

IIPR targets medical-use cannabis facilities with tenants that are licensed growers under long-term, triple-net leases. IIPR has carved out a lucrative business with outsized returns for its shareholders. IIPR has about $1 billion in leases outstanding and has a market capitalization of $3.6 billion.

Actual Financial Leverage: Debt + Leases

The fact is that there is very little difference between a loan and a lease. A company must use cash to satisfy either obligation.

When leases are added to debt, the financial leverage of the cannabis sector rises dramatically. Exhibit 1 shows debt + leases to shareholders' equity ranges from 10.2% at GrowGeneration to 212.7% at 4Front Ventures and averages 71.3% for the companies shown. Debt + leases to tangible equity ranges from 12.8% at GrowGeneration to an enormous 440.9% at Curaleaf and averages 158.7%.

The negative impact of this debt on shareholders is exacerbated by the fact that cannabis companies are paying extraordinarily high explicit rates of interest on loans, notes and bonds and extraordinarily high implicit rates on leases. On December 4, 2020, AYR Strategies (OTCQX:AYRWF) announced it would issue $75 million in 12.5%, 4 year notes and on December 9th, the transaction had been upsized to $110 million.

Acreage Holdings (OTCQX:ACRHF), a much less worthy credit, in November 2020 had to pay 15% for a 4 year term loan facility and attach warrants as an equity kicker. That was actually a cheap source of money for Acreage, since they had to pay 60% on a $15 million loan on June 17, 2020.

In contrast to the above companies, GrowGeneration has not had to pay any interest to finance its growth. It has benefited from a soaring stock price and a decision to use very little financial leverage. GRWG stock rose 127% from $15.06 on September 25th to $34.17 on December 8th. On December 9th, GRWG sold 5 million shares of stock at $30 per share in an upsized $150 million offering.

Book value of GRWG is $2.17 per share, so GrowGeneration was able to sell stock at 13.8 times book value. GRWG is an exception that suggests the thirst Wall Street has for cannabis related investments that are traded on exchanges other than the OTC. At its current price of $32.74, GRWG trades at 136.4 times its latest quarter earnings per share annualized! If Mel Brooks was a broker, he would probably be singing "It's Great to be GrowGeneration."

Uncle Sam: My Financier

To make matters worse, the interest paid on the cannabis company debt is not deductible under Section 280E of the Internal Revenue Code. I cannot recall another emerging industry in history that was as severely handicapped as the cannabis sector has been in the United States. Cannabis companies stand alone in that most are reporting losses yet are paying large tax bills to the IRS.

Without question, the cheapest source of funds for US cannabis companies is Uncle Sam. The penalty assessed corporations for not paying taxes in a timely fashion is ½ of 1% per month, which equals 6% per year. Cannabis companies need to take full advantage of this source of funds.

Conclusion

Most publicly held cannabis companies continue to produce negative free cash flow from operations. At the same time, companies are growing organically and accelerating their acquisitions. The need for cash to finance operations and expansion carries extraordinarily high capital costs for cannabis companies. The interest rates paid either directly on debt or indirectly on leases and the dilution attendant to issuing stock make external financing extremely expensive.

Companies that ignore their cost of capital and the availability of external funding do so at their own peril. Whether or not companies were wise to use financial leverage to achieve their growth objectives will be determined by results they achieve going forward. The appetites of CEOs to plant their flags throughout the United States far exceed their ability to fund those dreams.

An examination of data presented in this article shows which companies have room to add to their financial leverage either through debt issuance or via sale leasebacks based solely on balance sheet comparisons. The actual amount of debt that any company can comfortably service depends on the free cash flow generated from operations.

A cannabis company losing money and experiencing negative free cash flow from operations may not be able to service any additional debt even if it has below average financial leverage. On the other hand, a profitable cannabis company with positive free cash flow might be able to take on debt even if it is already highly levered. The degree of financial leverage and capacity to service debt are not perfectly correlated.

Disclosure: I am/we are long TCNNF, GWPH, LHSIF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.