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Sunday, 02/06/2022 1:28:28 PM

Sunday, February 06, 2022 1:28:28 PM

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Cannabis Stocks Are Beaten Down: Verano Is The Best Cannabis Stock To Buy Now
Feb. 05, 2022 9:36 AMCNBS, CRLBF, CURLF

Cannabis stocks have fallen more than 50% despite generating triple-digit growth over the past year.
Cannabis, once associated with the likes of heroin and cocaine, is now being sought for its medical benefits and abilities to generate taxes and new jobs.
I discuss the ways to invest in the cannabis sector, including an overview of the top operators.
I reveal my top pick in the sector, one with the best limited license footprint.
Addiction to Marijuana
bestdesigns/iStock via Getty Images

Amidst a deflation in tech valuations, you might have missed the beat down that has taken place in the cannabis sector. Many cannabis stocks were trading at reasonable valuations at recent highs and have reported significant fundamental growth, but have nonetheless seen their stock prices drop more than 50%. The poor stock price performances are primarily due to the inability of institutional capital to invest in the sector, something not in their control. Individual investors are not restricted by such mandates and can take advantage of this prolonged buying opportunity. I discuss a couple of the top operators and reveal my favorite name.

Cannabis Stocks Have Crashed
Since the highs reached in 2021, the stocks of US cannabis operators have fallen more than 50%.

Many of these names were trading at reasonable valuations relative to their growth rates prior to the drop. Between then and now, these companies have reported triple-digit growth, such that the stock price declines have led to a complete reset in valuation multiples.

All of the above operators are expected to sustain strong growth over the coming years as more states legalize cannabis for recreational sales. These names trade at between 5x to 9x 2023e EBITDA, surprisingly cheap multiples for stocks that should be garnering tech-like valuations.

The Cannabis Investment Thesis
Support for cannabis legalization has become a bipartisan issue with nearly 70%.

I view legalization as being inevitable. There are three main reasons for that. First, the War on Drugs has disproportionately affected minorities, including Black Americans.

The War on Drugs
Green Thumb Investor Presentation

Second, even though cannabis is illegal on the federal side, the illicit market remains strong and thriving nationwide. This has meant that legalizing cannabis on a state-by-state basis has led to substantial tax revenue and job creation.

cannabis taxes and jobs
Green Thumb Investor Presentation

Finally, cannabis itself is not the dangerous drug that it has been made out to be. When the average person thinks of cannabis, they might associate it with the likes of cocaine and heroin (actually, cannabis is considered to be more dangerous than cocaine by the federal government). In reality, cannabis is arguably safer than alcohol and opioids. Alcohol use has led to nearly 100,000 deaths annually and opioid deaths totaled over 75,000 annually. In contrast, there are no documented cases of deaths from cannabis overdose. Furthering the contradiction, cannabis has been discovered to have numerous medical benefits, addressing issues ranging from chronic pain, anxiety, insomnia, and sexual wellness. The growth of cannabis is like the growth of e-commerce or the growth of video streaming. It's inevitable.

Now let's discuss the investment thesis. While the US federal government has deemed cannabis to be an illegal substance, many states have already legalized the plant for medical or recreational uses. US cannabis companies have seen substantial growth from ongoing legalization efforts. Some companies have focused on states which use a "limited license model" because of the higher profit margins achievable from the exclusivity. The growth is substantial because, as discussed previously, illicit markets exist even without legal markets. Cannabis companies are able to generate strong growth just by taking market share from the illicit market. We can see below that even in states which have legalized cannabis for recreational use, the illicit market still remains very strong.

illicit vs legal markets
Curaleaf Investor Presentation

The strong illicit market suggests low hanging fruit for ongoing growth. Over time, cannabis is estimated to be a $100 billion industry, rivaling the beer and tobacco markets.

cannabis addressable market
Green Thumb Investor Presentation

The longer-term opportunity is even greater. About 20% or less of adults use cannabis regularly. In contrast, nearly 70% of adults regularly consume alcohol. Considering that cannabis is safer than alcohol and has far ranging medical uses, I expect cannabis use to become more "normalized" as the plant becomes more generally accepted. Cannabis has been illegal for a long time - so long that it has gained a negative stigma. The times are changing, and the growth of cannabis can not be stopped.

The Top Cannabis Operators
I now discuss some of the top operators in the sector. Before I do so, I first point out that there are various exchange traded funds carrying cannabis stocks, including MSOS, CNBS, YOLO, and MJUS. These ETFs vary in sector and country concentration and own the US operators only through total return swaps. The last point is due to the fact that US cannabis stocks are not allowed to trade on major exchanges and thus only trade over the counter ('OTC') - this is because of the federal illegality of cannabis. Many brokerage firms like JPMorgan Chase currently heavily discourage investors to invest in these names. That said, many do allow investing in these names. I have found that the stocks trade with slightly less liquidity than typical stocks, but the experience is otherwise no different.

Let's now discuss some of the top operators in the sector. I quickly note that Canopy Growth (CGC) and Tilray (TLRY), two popular Canadian names in the sector, are not in this list as the most attractive opportunity is in the United States.

Green Thumb Industries (OTCQX:GTBIF) is often considered the top operator in the sector. This is because the company has pursued a wide footprint with a careful eye on profitability.

GTBIF footprint
Green Thumb Investor Presentation

GTBIF is arguably the most strategic operator and is often located in attractive markets long before recreational sales are legalized. With such a long track record of such success, there is clearly more than luck at play here.

Cresco Labs (OTCQX:CRLBF) is another Tier 1 operator with a wide footprint.

CRBLF footprint
Cresco Labs Investor Presentation

Unlike others on this list, CRLBF has intentionally focused on its wholesale business, which makes up more than 50% of total revenues. CRLBF believes that wholesale margins will prove to be the most resilient over time.

wholesale margins
Cresco Labs Investor Presentation

Curaleaf (OTCPK:CURLF) historically has been the biggest operator in the sector. CURLF is the only operator with a coast-to-coast footprint.

CURLF footprint
Curaleaf Investor Presentation

CURLF management had the conviction to aggressively acquire assets long before valuations have steadily risen. CURLF has recently been the first multi-state operator ('MSO') to enter Europe with its acquisition of EMMAC.

EMMAC Acquisition
Curaleaf Investor Presentation

Trulieve (OTCQX:TCNNF) is the last of the original "Big 4" operators.

TCNNF footprint
Trulieve Investor Presentation

The company is best known for its dominance in Florida, where it owns around 50% of the market. I note that the company has since increased its store count to 111 dispensaries in the state.

Florida footprint
Trulieve Investor Presentation

TCNNF has historically been known as the most profitable company in the sector.

sector profit margins
Cannabis Growth Portfolio

Profitability is important to discuss because US cannabis companies face unusual challenges stemming from the illegality of cannabis. US cannabis companies lack equal access to banking, which means that they often pay 10+% interest rates on debt in spite of strong fundamentals. They also are restricted from deducting operating expenses (like rent, interest expenses, corporate expenses) from taxable income, meaning that they pay excessively high tax rates (known as '280e taxes'), sometimes paying taxes even with negative operating income. TCNNF has nonetheless been able to generate significant GAAP net income, totaling $18.6 million as of the latest quarter (the company has a $4 billion market cap). When cannabis is decriminalized, net income will jump across the sector due to resolution of the above factors. For reference, TCNNF might see quarterly net income jump 160% to $50 million just from normalizing tax rates and interest rates alone.

The Best Cannabis Stock To Buy Now
My top pick of 2022 is Verano (OTCQX:VRNOF). VRNOF has a wide footprint which was made larger after its recently announced acquisition of Goodness Growth (OTCQX:GDNSF).

VRNOF footprint
Verano Investor Presentation

The acquisition of GDNSF gave it 1 of 2 licenses in Minnesota, but the key gem was its license in New York. New York is estimated to be a near $3 billion market by 2026.

New York market
Goodness Growth Investor Presentation

Besides New York, VRNOF has strategically positioned itself in all of the important limited license states. Recall that the limited-license model has allowed for higher profit margins due to the inherent cap on competition. VRNOF's core markets are in Illinois and Florida. The main near-term growth driver for VRNOF is the state of New Jersey, which is anticipated to come online for recreational sales sometime in 2022.

Verano state markets
Verano Investor Presentation

In comparison with peers, VRNOF has best in class margins due to its focus on premium products and its lean cost structure.

Verano profit margins
Verano Investor Presentation

VRNOF trades at around 2.5x 2023e sales and 6x 2023e EBITDA. The stock trades at a notable discount to GTBIF and CURLF, but arguably should trade at a premium due to its positioning in the most attractive limited license states. I can see VRNOF trading up at least 100% over the next year, but that would still place it at highly attractive multiples of 5x 2023e sales and 12x 2023e EBITDA.

The main risk regarding cannabis stocks is that of uncertainty. There's great uncertainty as to when legislative reform will take place (though I discuss why it may not matter in the conclusion). There's also uncertainty as to how interstate commerce (allowing sale of cannabis across state lines) will affect the profitability of limited license states. There's the view that passage of interstate commerce might cause prices to fall across the country, as cannabis can be grown at much lower prices in regions like California. My personal view is that interstate commerce will not occur for a very long time as I do not anticipate such broad federal reform coming ahead of reform at the state level. It seems unlikely that the federal government will be able to disrupt as many as 50 different local cannabis economies and systems, as such a reform stands to benefit very few and thus is unlikely to be a popular issue among either voters or politicians. The most relevant risk is the constraints that 280e taxes and high costs of capital have placed on US companies' cash flows. It's very difficult for these companies to generate positive cash flows - though not impossible as we have seen in the case of TCNNF and VRNOF above. I'm not worried about this risk because the top operators have prudently raised sufficient cash to their balance sheets, have demonstrated improved access to debt capital as compared to past years, and have in general made significant progress toward optimizing cash flows in spite of the difficult regulatory environment.

Bottom Line
Cannabis stocks have been beaten down over the past year as investors became pessimistic for the prospects of near-term legalization. The irony is that the top operators have been able to grow rapidly without legalization, or perhaps, due to the lack of legalization. The presence of 280e taxes and limited access to banking has made it difficult for smaller operators to compete with the larger operators. The top operators benefit from delayed legalization because they get more time to build dominant market positions in the meantime. Legalization is inevitable, but any delays may lead to greater value creation over the long term. I have discussed the top operators with VRNOF being my top pick to take advantage of this promising growth sector.

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