Trulieve Cannabis Corp (TCNNF)

[FUNMAN]

Trulieve's $5.4 Billion Enterprise Value Isn't Justifiable
Oct. 19, 2021 4:47 PM ETTrulieve Cannabis Corp. (TCNNF)

Forest Hill Capital
Contributor Since 2021

https://seekingalpha.com/article/4460670-avoid-currently-overvalued-trulieve?mail_subject=tcnnf-trulieve-s-5-4-billion-enterprise-value-isn-t-justifiable&utm_campaign=rta-stock-article&utm_content=link-0&utm_medium=email&utm_source=seeking_alpha

Ex-institutional sales at a top investment bank. I used to cover central banks, hedge funds, and private bank clients. Throughout my career, I've traded repo, credit, cash rates, & rates derivatives (e.g., swaps, caps, etc.).


Summary

• While Trulieve's revenue growth and operational discipline have been impressive, its stellar performance has failed to translate into positive free cash flow.

• As Trulieve invests to expand its operation outside of Florida, its investments will exacerbate its already negative free cash flow.

• Trulieve's assets outside of Florida are either immature or insignificant compared to local market to generate meaningful immediate return.

• Investors should expect lower margins as the company enters into markets without full vertical integration and increase expense associated with M&A.

• After considering Trulieve's profitability within each market segment net of necessary capex and discounted by current WACC of 8.88%, it is difficult to justify its $5.4 billion enterprise value.




Trulieve (OTCQX:TCNNF) has been one of the best-performing cannabis companies in the United States. Trulieve generated consecutive years of over 100% in revenue growth while maintaining a consistent, strong gross margin. From 2018 to 2020, Trulieve's revenue grew from $102 million to $521 million. However, Trulieve wasn't able to generate positive free cash flow despite its operational success. As the company expands its operations outside of Florida, Trulieve will be spending a considerable amount of investment capex. This would exacerbate Trulieve's current negative free cash flow. Investors should be prepared for future lower margins as the company enters into new markets without full vertical-integration, along with heightening competition in the Florida market and increase in cost associated with M&A.

After considering Trulieve's profitability in each market segment net of necessary capex and discounted by current WACC of 8.88%, it is difficult to justify Trulieve's current valuation of $5.4 billion in enterprise value.

Background

Trulieve is an industry-leading, vertically integrated cannabis company in the United States. Trulieve operates in 11 states with a market leading position in Florida. Trulieve employs over 72,000 employees.

Trulieve has recently announced the opening of its 93rd dispensary in Florida. While Trulieve only operates 1/4 of Florida's total dispensary footprint (93/350), it consistently maintains half of Florida's market share. In 2020, Trulieve sold 47% of total oil products and 55% of total smokable marijuana in Florida.

Trulieve's vertical "seed to sales" business model in Florida has made its market leader position difficult to contest. The "seed to sales" model provides Trulieve with the capacity to quality control every segment of the cannabis business, from cultivation, to production, to sales and distribution. This experience in operating within all segments of the cannabis business will prove to be tremendously beneficial as Trulieve expands its business outside of Florida.

Despite that Trulieve currently operates in 11 states, the company generates 100% of its revenue from Florida. Trulieve's management has stated in its financial statement that other regions' revenues are immaterial:
As of December 31, 2020, substantially all of our revenue was generated from the sale of medical cannabis products in the State of Florida. To date, neither the sale of adult-use cannabis products, nor our operations in Massachusetts, California, Connecticut, Pennsylvania and West Virginia, have been material to our business.

Trulieve management's vision to lead the company forward is to capture revenue opportunities outside of Florida through M&A and license applications while maintaining its market leader position in Florida:
We see Pennsylvania as an important state for our northeast hub strategy and we'll continue to look for additional M&A opportunities to expand. [And] maintain our market leading performance and we fully intend to do so.

Recent Financial Performance

As mentioned, Trulieve is a leading performer in the U.S. cannabis industry. Through rapid growth in the Florida cannabis market, Trulieve generated 106% in revenue growth in 2020. Trulieve's revenue was $521 million in 2020, which significantly exceeded management's expectation. Management had originally guided revenue to be within the range of $465 million to $485 million. Trulieve achieved similar outstanding revenue growth the year prior. Its revenue grew by 146%, from $102 million in 2018 to $252 million in 2019.

What's more impressive though, is that while Trulieve generated consecutive periods of over 100% revenue growth, the company kept its gross margin consistent. This suggests that Trulieve's operation in Florida is both highly successful and scalable.

Trulieve's gross margin was 72%, 76%, and 74% in 2020, 2019, and 2018, respectively. Also, Trulieve's operating expenses improved as its operations scaled. Trulieve's total operating expenses excluding D&A improved from -43% of revenue in 2018 to -29% of revenue in 2020. G&A expenses maintained an average of -24% of revenue. And total S&M expenses as a percentage of revenue decreased from -19% in 2018 to -7% in 2020.

The fact that Trulieve's operating expenses improved as its revenues 5-folded in three years (from $102 million to $521 million) suggests that Trulieve's business model works, and its operation can scale. Trulieve's leading retail footprint in Florida works in complimentary with its vertically-integrated assets.

However, it is important to point out that recent years of rapid growth and stellar operational improvements failed to generate positive free cash flows for the company. Trulieve suffered negative free cash flows of -$75 million, -$76 million, and -$28 million for 2020, 2019, and 2018, respectively.

Trulieve's reported cash from operations was $100 million, $19 million, and $23 million, for 2020, 2019, and 2018. However, half of 2020's improvement, $43 million, was contributed by adjustments from warrants issued; it was not driven by operational improvements.

Also, Trulieve has been consistent in increasing its cash spent on investments. Trulieve had cash outflow in investing activities of -$175 million, -$95 million, and -$51 million for 2020, 2019, and 2018, respectively. As the company continues to grow, it will spend more on investments. Trulieve's cash spent on investments tripled in the last three years, and it is expected that investments will continue to increase as the company expands its operation outside of Florida. These expansions will be discussed in greater detail later.

While Trulieve's revenue growth and operational discipline has been impressive, its stellar performance failed to translate into positive free cash flows. As management expands Trulieve's operations outside of Florida, the company will invest additional, substantial amounts of capex, which will further exacerbate Trulieve's already negative free cash flows.

Valuation Considerations

In this section, I'll discuss Trulieve's operation in states that it's currently licensed to operate in. These states include Pennsylvania, Georgia, Connecticut, and California. I will provide the regulatory framework for each state and discuss Trulieve's current and future revenue prospects within each state.

The purpose of this discussion is aimed to 1) provide the basis to my valuation assumptions, 2) explain why Trulieve's assets outside of Florida are not likely to generate meaningful return in the near-term, and 3) explain why Trulieve's increase in investment is imminent.
Pennsylvania

Pennsylvania has 3 license types for cannabis operators: marijuana dispensary, grower processor, and clinical registrant. The Department of Health in Pennsylvania has been authorized to issue a total of 25 grower processor and 50 dispensary licenses. To date, all licenses have been awarded. A total of 50 dispensary licenses will permit up to 75 dispensaries across Pennsylvania. Trulieve's competitors such as Curaleaf and GTI, each operates 12 dispensaries in the state of Pennsylvania.

In 2020, Trulieve announced it has acquired 100% of two Pennsylvania cannabis operators, PurePenn and Solevo Wellness. Trulieve paid $46 million for PurePenn and $20 million for Solevo Wellness.

PurePenn operates a 35,000 square feet cultivation facility in Pennsylvania. And it wholesales two brands and captures 100% of Pennsylvania wholesale market. Meanwhile, Solevo Wellness operates 3 dispensaries in Pittsburgh with total retail space of 15,000 square feet.

The Pennsylvania market is forecasted to grow at CAGR of 10.6% to $776 million market by 2025. Given that Trulieve has 4% (3/75) of the total dispensary footprint, I forecast Trulieve's Pennsylvania segment to generate approximately $31 million in revenues by 2025.

This estimate might seem oversimplified at first but it aligns with Trulieve's current dispensary run rate. Trulieve management guided its dispensary to generate $2,300 per square feet of retail space. Multiply the run rate with total of 15,000 square feet of retail space, Trulieve's Pennsylvania revenue should generate an approximate $34 million in revenue per year as the market matures in 2025. The two forecasts align rather closely!

In the short-run, however, Pennsylvania's dispensary revenues should continue to be immaterial. Trulieve doesn't disclose segment profitability but we can infer insights from comparable transactions.
Terrascend recently purchased a dispensary operator similar to Solevo Wellness. Terrascend purchased Keystone Canna for $55 million, which operates 3 dispensaries in locations across Pennsylvania. And Keystone Canna currently generates $60,000 in revenue. Given the similar transaction price and dispensary footprint between Keystone Canna and Solevo Wellness, it is reasonable to assume that Trulieve's dispensary business in Pennsylvania will not generate an immediate meaningful return.

In regard to Trulieve's PurePenn cultivation facility, given Trulieve's "seed to sales" business model, I expect it to function as support to Trulieve's dispensaries rather than as a stand-alone revenue center. The rule of thumb for yield figure for cannabis cultivation is 45 grams per square foot. Or 0.1 pound per square foot. Given the current U.S.
cannabis spot price is traded at $1,343 per pound, Trulieve's PurePenn facility in Pennsylvania can support revenue of up to $1.5 million. To realize the potential $31 million of revenue in Pennsylvania, I expect Trulieve to invest heavily in the next years to expand its cultivation capacity.

I hope this conveys to readers that while Trulieve has great potential in Pennsylvania, its assets are unlikely to generate immediate returns. And Trulieve is likely to spend additional, considerable amounts of capital to expand its dispensary and cultivation capacity to meet demand. This is a consistent theme across Trulieve's assets outside of Florida; they're capital intensive investments with little to no immediate return.

Georgia

Trulieve's management has been very motivated with its Georgia development. In Georgia, a total of 6 cannabis operator licenses have been awarded; 4 regular licenses to cultivate up 50,000 square feet and 2 type 1 licenses to cultivate up to 100,000 square feet. Trulieve has been awarded a type 1 license and is permitted to cultivate up to 100,000 square feet.

While Georgia is the 8th most populated state in the U.S., there's currently only 18,000 patients registered in the medical cannabis program. Given the immediate low participation and Trulieve was just awarded with the permit to construct its cultivation facility 3 months ago, it is unreasonable to expect Trulieve to generate meaningful revenues before 2023.

The company, however, will be spending a considerable amount of cash to develop both its dispensary and cultivation capacity in Georgia. Median construction cost for cannabis cultivation is $240 per square feet. Multiply the construction run rate with total capacity permitted, I forecast the company to spend at least $24 million on construction in Georgia next year.

Connecticut

In Connecticut, Trulieve operates through the Healing Corner, which will be rebranded to Trulieve soon. Trulieve operates 1 of the total 18 dispensaries in Connecticut. Trulieve maintains approximate 10% of the total Connecticut market share. I forecast Trulieve's Connecticut operations to maintain between 6% (1/18) to 10% of market share to reflect its retail footprint. Connecticut's cannabis market is forecasted to grow to $335 million by 2025.

California

Trulieve operates through its subsidiary, Leef Industries in California. Leef Industries operates one dispensary in Palm Springs, California.
Despite California being the largest cannabis market in the United States, competition is fierce and profit margin is low. The California market is forecasted to grow to $7.4 billion market by 2025.

However, Trulieve management currently has no plans to expand or invest further into the California market. Without capital support and investments, it is unreasonable to expect Leef Industry's single dispensary to generate meaningful market share within the competitive California cannabis market.

Valuation

I believe by now we can agree that in the short run Trulieve is not likely to generate meaningful revenue outside of its Florida operation. While Trulieve has great revenue potential in states such as Pennsylvania and Georgia, its assets are at an early stage and requires substantial, additional investments. And in states such as California and Connecticut, Trulieve's presence is insignificant compared to the total local market to generate meaningful market share.

Also, investors should expect lower margin for Trulieve in the coming years. As the company expands, cost associated with M&A will lower the company's margin; transaction costs, share-based comps, and integration costs will all negatively impact the company's profitability. And, there's a price war going on in Florida's cannabis market.

Management warned investors on the potential lower margin as the company enters into new markets without full vertical-integration during the Q2 earnings conference call:

There's going to be downward pressure on gross margin as we enter into new markets without full-vertical integration. As we have in Pennsylvania through the earn-out period in 2021. Similar to the Massachusetts process, we are now ramping our infrastructure in West Virginia.

Going forward, there will be increase in depreciation on aggressive capex ramps increases, in share-based compensation, fair value flow-through of inventory from acquisitions and the amortizations of intangibles. There is going to be a downward impact on EPS.

By incorporating Trulieve's segment profitability as discussed above, I arrived at revenue forecast as shown in the two charts below.


Source: Both created by author using data from the company's financial statements and investor presentations.

I forecast Trulieve to generate $780 million, $1,515 million, and $2,270 million in revenue for 2021, 2025, and 2030, respectively. I believe my forecast is already very generous. If you were to straight-line Trulieve's growth with the U.S. cannabis market CAGR of 26.5% for the next 10 years, you'll arrive at $2,570 million of revenue in 2030. The difference between the two forecasted figures are rather small.

For investments, I forecast Trulieve to increase capex spending substantially in the next three years to realize the potential $1.5 billion increase in revenue. My estimate is a total outflow of -$600 million for the next three years. This forecasted figure is based on my previous discussion on Trulieve's operational segments. Holding everything else constant, I have arrived at net free cash flows per the below screenshot for the company. In my forecast, I have assumed a consistent percentage for depreciation and amortization.

Source: Created by author with data from past financial statements.
While you may or may not agree with my forecasted cash flow and revenue predictions, the same story holds. Trulieve operates with negative free cash flows of -$75 million in 2020. After incorporating the necessary increase in investments, free cash flows will reach at least -$100 million per year for the next three years. Considering the company's current WACC of 8.88%, Trulieve's next three years of negative cash flows will be magnified with future positive cash flows heavily discounted. For example, the positive cash flow at year 6 (2026) will be heavily discounted by a multiple of 0.6. Or 60% (1/1.0888^6).

I used a terminal multiple of 12x, which is equivalent to major Canadian cannabis LPs such as Tilray and Canopy Growth. This again is a very generous assumption given its federally illegal status as an American cannabis operator.

The WACC of 8.88% I have used is calculated with a cost of equity of 8.87% and cost of debt of 9.29%. Cost of debt was derived based on Trulieve's current 5% coupon bond trading at $97.5 cash price. After incorporating the above free cash flow, WACC, terminal value, and discount rate considerations, my forecast suggests the company's enterprise value should trade close to $3.5 billion instead of $5.4 billion.

Conclusion

My article is not to criticize Trulieve as a company. I think Trulieve is a great company. And I've acknowledged several times Trulieve's recent stellar performance in my article. However, I do believe Trulieve is overvalued at a $5.4 billion enterprise value, as the figure considers its potential revenue opportunities without considering its assets' readiness. The time and capex that's required for Trulieve to reach its potential profitability is not reflected in the current valuation.