Institutional Research
Is 30% the New 40%
A Look At Evolving MSO Margin Trends
Following the 1st Half of 2022 earnings season, we believe its appropriate to take a closer look at reasonable EBITDA margin profiles to expect of MSOs. While FY2 Street expectation have fallen nearly 10 pts over the last roughly year and a half, we believe current -30% margin expectations (average among large MSOs) remain healthy & that prior expectations near 40% in early 2020 had gotten ahead of their skis, partially attributable to the benefit of high margin newer adult use & medical states having a larger impact on margins, with margin enhancement opportunities pushed out by regulatory delays of sales in new adult use markets or sale opportunities (i.e., IL retail), pricing pressure in markets sooner than expected (MA & PA) & inflation driving lower avg. ticket & downtrading. That said, MSOs still deliver a more attractive margin & growth profile compared to mature consumer categories such as CPG & high-growth retail, but trade at a 50%+ EBITDA multiple discount. While improved fundamentals could help narrow the gap, we view uplisting & 280E alleviation as needed for a more notable multiple rerating-with uplisting potentially coming if the SAFE Act is passed later this year.
Margin Expectations Coming Down
Expectations for EBITDA margins by the Street reached a peak in March 2021, when consensus was estimating FY2 EBITDA margins near 40% among leading MSOs (above $900M EV today) who were public at the time. Since, we have seen margin expectations come down due to a number of factors, including pricing pressure in key markets (such as PA & MA), broader macro trends such as inflation straining the consumer wallet, & supply chain issues causing input costs to rise - with the Street estimating FY2 EBITDA margins of -30% today.
EBITDA Margin Expectations Have Fallen From Nearly 40% to -30%
Updated Margin Expectations May Be More of a Reset to Reality
While FY2 EBITDA margin expectations have fallen nearly 10 points in the last roughly year & half, we would argue that Street expectations may have gotten ahead of their skis. We see this as predominately due a number of key markets being at the earlier stages of its maturity curve, resulting in high margin sales as operators benefitted from higher wholesale & retail prices. Indeed, Street FY2 margin expectations in early 2020 were -30%, roughly equal to today, which one could argue is favorable given macro conditions (when compared to other consumer sectors). Part of the reason for the rise in expectations to nearly -40% average is what we believe to be expectations of new markets margin profiles & prices remaining high in newer markets, with neither dynamic being sustainable & moreso a function of market timing of oscillating maturity curves, in our view. We would also note that the law of numbers, limits the impact of new adult-use state as operators become larger, with the margin lift from new adult use states such as IL (began Jan 2020) in the year 2020 setting higher margin lift expectations for upcoming adult use states such as AZ, NJ, NY & CT, which had begun or legalized in the 1H22 time frame when margins were at peak levels. All of this to say, that in a steady state of diversified markets & oscillating maturity curves, we believe 30% EBITDA margins should still be viewed favorably.
Taking a Longer View, Margins Have More so Returned to Pre-COVID Levels
Comparing to Mature Consumer Categories, MSOS Remain Attractive
In fact, when comparing to mature consumer categories, MSOs EBITDA margin average of -30% still fares higher than that of large CPG companies at 25% as well as high-growth retail at -10%. Furthermore, we continue to note how MSO's are still expected to see greater sales growth over the next two years, despite recently tempered MSO sales expectations recently, with MSOS expecting to grow sales -20% in 2023, compared to -4% for CGP & -8% for high-growth retail. Despite this, MSOs still trade at a more than 50% discount to these mature consumer categories, with MSOS -6.7x EV/EBITDA multiple well below that of CPGs ~15x & high-growth retail's 13.6x. Even in scenarios of assuming incremental margin pressure, MSOS still trade at a meaningful discount, with an assumed 20% EBITDA margin (based off current sales expectations), still resulting in FY2 EV/EBITDA multiple of just 10.5x. While we believe improved fundamentals will help close the gap, we see the need for the ability to uplist to major exchanges and alleviate 280E tax hurdles (so that EBITDA is a better proxy for cash flow) as needed for MSOS to trade more at parity to these consumer categories (or even a premium given its higher growth outlook).
MSOs Continue to Offer Greater Growth & Higher Margins Than Traditional CPG & Retail
Why MSO EBITDA Margins May Now Be Bottoming
There are a number of signs that might indicate the margin outlook for MSOs will start to stabilize & has started to find a bottom, though there could be another quarter or two of near-term margin pressure. We see this as a function of a number of factors including: 1) New Adult-Use States: NJ sales ramping as well as the beginning of adult use sales in CT, NY & RI (along w VA in 2024) should provide high-margin sales to operators in initially supply constrained markets, 2) MSOs Increasing Vertical Integration: During 20 eaming season, a number of MSOS noted proactive steps to increase vertical integration in markets with pricing pressure to maintain margins, 3) Adjusting Spending to the Times: Managements teams spoke to a slowdown or tempered SG&A spending as operators adjust to the current environment, 4) Broader Capital Constraint Could Force Rationalization: As we have called out in the past, broader capital scarcity and difficulties for operators to operate profitably (& more specifically CF positive) could force rationalization of pricing, particularly in mature markets (such as CO), which should help stabilize margins, 5) Increased Cost Efficiencies: MSOs are focused on realizing additional cost efficiencies amid pricing pressure, which we believe could come via increased automation. That said, we remain cautious on prices continuing to decline in maturing adult-use states such as MA, along with broader macro trends pressuring the consumer wallet causing down trading. As such, while we believe there could be near-term margin pressure, we remain bullish on MSOs' ability to generate healthy margins over time, with management teams largely reiterating their long-term EBITDA targets during the eamings season (though more lofty margin expectations may be more difficult to sustain).
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