MSOS has multi-bagger potential

I’m long MSOS (AdvisorShares Pure Cannabis ETF) because the cannabis sector has a sustainable growth runway with low market expectations and sizable buyers of multi-state operator (MSO) stocks that will invest in the next several years. This is the first of a several part series on opportunities in the cannabis space. Today I just want to cover high-level why I like the cannabis sector as a permanent capital investment (meaning one day I’ll die and pass it onto my kids) and why I’m currently using MSOS as the vehicle to do that.

Cannabis has been in my proverbial backyard for a few years now, and watching the growth firsthand has given me the Peter Lynch-ian “know what you own and why you own it” confidence. I remember when NETA opened in Brookline and watching the unbelievable lines year after year. I remember seeing more and more friends talking about dispensaries in the Boston area. On a recent trip to a wedding in the Berkshires, I saw five billboards for dispensaries. And currently, I’m witnessing people talking about new dispensaries opening near TD Banknorth Garden and the Prudential. Legal weed in MA is here to stay.

Despite the impressive growth I’ve seen in my home state, I was always a little hesitant about investing in cannabis stocks because of the crazy valuations of Canopy Growth and Tilray several years ago (and at present). As you’ll read later, this hesitation is a huge reason why there is opportunity in US cannabis; retail and other investors likely remember the 2018 Canadian weed bubble popping and are permanently scarred. This dynamic is similar to tech investors who looked away from tech after getting burned in the dot com bubble.

I remember in summer 2018 when a few buddies encouraged me to invest in Canopy due to upcoming Canada legalization. At the time, the company had several million dollars in sales and a ~$10 bn valuation (funnily enough, the stock is now flat since then). Tilray was another one that captured the spirit of the retail investor, garnering a ton of attention as the stock was a quick 10 bagger in October 2018 before falling off a cliff.

I could post the stock price charts, but the EV/forward sales multiples are even more insane (note – why am I using multiples to sales here? I think margins for US cannabis could go any number of ways as legislation hits. On the one hand, margins will improve as these companies can get debt tax shields and write off more expenses when cannabis is legal. On the other hand, more competition and the opening up of state lines will bring in competition and hurt margins. For Canada, weed has been legal for over two years now, so make of that what you will):

Koyfin doesn’t have historical EV/Sales for TLRY, but here’s the price chart against sales:

In 2018, TLRY did 43mm in sales and even today only does 210mm against an EV of  $6.7bn – during its peak, TLRY’s market cap got up to $28bn, meaning at one point it was trading 140x sales for what it would do two years in the future. Yep, at one point in time Canadian weed used to trade richer than US SaaS today. It’s no wonder investors are gun shy.

Even today after the bubble, both stocks and other Canadian comps still trade richer than US operators when the US arguably has more growth in the future. US cannabis companies in aggregate trade ~5x EV/sales while Canadian cannabis sits at close to 10. On a forward EBITDA basis, the numbers are even crazier, with Canada at nearly 110x and the US at 15.4x (numbers courtesy of Jefferies and FactSet).

US companies operate in more draconian conditions at present. Institutional buyers can’t provide debt or equity; interest and other expenses provide no tax shield; product can’t be transported over state lines; marketing channels like text messaging aren’t available as Verizon, Sprint and others block mentions of cannabis; weed isn’t legal at the federal level. The richer valuations would make sense if conditions weren’t set to change in the future.

At this point everyone has heard of Schumer’s draft bill to legalize cannabis, but I’m not sure everyone has kept track of how well cannabis is selling in the US states cannabis is legal in.  The cannabis market grew during COVID and state sales are consistently excellent. Let’s look at MA as an example:

Continuing with the MA example, there’s no reason to believe these sales will slow down. Continued growth in licenses and dispensaries opening at higher foot traffic locations are going to accelerate sales. Ayr Wellness has a 4,500 square foot facility near the Prudential Center and got a provisional license to sell adult-use cannabis there.

Additionally, tax revenues come when sales grow. Illinois is doing more tax revenue for weed than for alcohol now. With more and more states racking up enormous budget deficits as the result of programs trying to offset the economic impact of COVID, more sources of tax revenue will be necessary. States have economic incentives to legalize cannabis. In the words of Charlie Munger, show me the incentives and I’ll show you the outcome.

Low Market Expectations Ignore Growth Runway
 

As I’ve talked about in previous posts, price shows you the expectations for the stock. The prices for US multi-state operators are what you see in slow-growth industries – single digit EBITDA multiples where forward multiples don’t change much because growth is basically US GDP for the years ahead.

The reason large US operators can grow at teens and higher EBITDA CAGRs is because the cannabis market has a TAM many multiples of its current size and these operators are in the best competitive situation to capture that growth. Yes, the thesis is that simple.

Jefferies on its recent 300+ page report on US cannabis (note it gave all the major MSOs buy ratings) tries to estimate the possible size of the cannabis market by looking at total possible buyers multiplied by average spend per year. I think their average spend numbers are aggressive (they are going over 1.7K+), but my simple take is I think in a decade the US could have 150mm cannabis consumers who on average spend $700 (that’s buying gummies or other products a couple times a year (~$58 a month) – remember also there is a sub segment of medical and other “power” consumers who are likely spending a few thousand bucks a year). That adds up to a $100 billion market, compared to the current 2020 sales of $17.2 bn (expectations for this year are about $21bn).

So in aggregate, I think the market could expand by 5x. If you think 5 or so multi-state operators dominate the market, that’s $20bn of sales apiece. If each trades at a mere 5x sales, that’s five $100bn companies. Here are the market caps of the top 5 US MSOs right now:

You don’t even need five to win – you only need one. Yes, four of these MSOs could go to zero and if one goes to $100bn, you are up 5x.

There are definitely holes in this simple math argument and I welcome reader feedback. Could an Amazon or large company enter the space and take out the MSOs? Sure, but they’d have to buy licenses (a process which takes months or years), gain core competencies (cultivation, distribution, etc.) and establish brands. This process would take years and in my opinion they’d be much better served gaining a foothold through M&A.

But what if cannabis is never federally legalized? What if legislation is slow or never happens?

In this unlikely scenario, I actually agree with the consensus opinion among cannabis bulls; MSOs will continue to swallow up licenses and gain more competitive advantages. 37 states have legal medical or rec cannabis. These states are seeing strong tax revenues and adoption by consumers. Why would they roll legislation back? Industry growth should continue irrespective of what the federal government does.

As long as no interstate commerce is allowed, MSOs will benefit from the grow facilities they have set up in states. They will keep building brands in these states and opening up dispensaries. And most likely, their success will generate envy from other states who want the tax revenue from consumers and companies. Cannabis is proving to be something consumers and state regulators hungry for tax revenue want. As long as that continues to be true, federal legislation is not a big part of this thesis in the short to medium term.

Federal legislation would help improve demand for cannabis stocks though, because of…

Marginal Buyers of Size

Big institutional buyers can’t touch cannabis right now due to cannabis being federally illegal. Jefferies estimates institutional ownership of cannabis stocks at 4% compared to 45% for global staples. And yes, I think it’s fair cannabis one day could be considered a consumer staple – it was deemed essential during COVID, where sales actually increased.

A good anecdote demonstrating the difficult environment for institutions owning cannabis companies is Credit Suisse’s experience. CS was executing trades for large clients for cannabis stocks and had to stop out of fear of operating outside the law. There are probably a half dozen or more stories I’ve heard just like this while researching cannabis.

I’ve read too many opinions arguing that every major US banking institution needs some crypto exposure. At the end of the day, crypto isn’t a real business that generates earnings that can be distributed to shareholders. It’s a currency play and I don’t trade currencies. I’ve done decent owning real companies and I’ll continue to do so.

When cannabis begins generating real free cash flow, the story will be so overwhelmingly obvious that every US banking institution and institution with investable assets would be hard-pressed not to own. I would be willing to own many of these companies right now with no mark-to-market and feel confident I would be paid back on cash returned to shareholders over time.

Another concept worth bringing up as to why institutional buyers of size would come in is uplisting. Many institutions can’t hold OTC or non-US major exchange stocks (and all the big MSOs right now are OTC or Canadian exchange traded). I think it is highly likely as these cannabis companies generate billions of sales and EBITDA and US cannabis becomes legal there will be a lot of interest among Nasdaq, NYSE and others to get them listed. The uplist will generate visibility (can you imagine these companies on CNBC now?), which will generate buying, which will generate more visibility and so on.

If you’re skeptical of uplisting being possible, consider that psychedelic company MindMed – which has a close to a billion dollar market cap on close to zero revenue and a much more difficult regulatory environment – was able to uplist. I am extremely confident we’ll see the MSOs trade on a major US exchange. Once again, as Charlie Munger has said, show me the incentives and I’ll show you the outcome. US cannabis companies are growing at SaaS-like CAGRs and can be structurally profitable. There is money to be made by being the exchange of choice for them.

Finally, I brought up before investors are gun-shy because of their experience with Canadian cannabis companies. Many invested at the height of the 2018 bubble and were badly burned. There is likely a historical stigma here that will only go away once these companies start posting earnings that prove these businesses are too cheap. And again, Canadian companies still trade richer than the US despite the US having a better growth trajectory ahead.

Why MSOS?

MSOS I first found out about it after a friend sent me this interview with the portfolio manager, Dan Ahrens, on the Cannabis Investing Podcast. Dan had managed several sin stock like mutual funds prior to this and is extremely knowledgeable on the history of alcohol and cannabis legalization – he sees many parallels between the two. I recommend everyone check out his book, appropriately titled Cannabis Investing.

Here are MSOS’s top holdings, and you can get an updated version of this at any time via the AdvisorShares website:

You have exposure to all the big multi-state operators via this ETF. You might be asking how a US ETF can own these stocks when cannabis is illegal and I told you earlier US institutions can’t own cannabis companies. The answer is that MSOS has worked around these rules by using equity swaps that imitate the behavior of the underlying stocks. The swaps work such that if a stock like Curaleaf gains 1%, the institution on the other side of the swap owes MSOS 1% on the value of the swaps, all else equal.

Is there risk to owning swaps and not equities? Yes – in practice it’s not a perfect instrument because of counterparty and other risks, but I judge this risk to be minimal enough (Ahrens and AdvisorShares based on my research have excellent reputations). Once cannabis is legalized, Ahrens has said they’ll cash out the swaps and own the equities directly.

Resources

If you’re interested in the cannabis space, I’ve been finding a few sources extremely helpful. The regulatory environment here is changing quite quickly so staying up to date helps. Here’s my list of podcasts, Twitter feeds and Substacks to read:

Podcasts:
– Cannabis Investing Network
– Cannabis Investing Podcast

Twitter:
– Graham Farrar (President of GlassHouse)
– Jon Sandelman (CEO of Ayr Wellness)
– Ben Kovler (CEO of GTI)
– Todd Harrison (investor)
– Aaron Edelheit (investor)

Substacks:
– Aaron Edelheit
– Todd Harrison

Some closing thoughts and what’s up next

I think the math on the cannabis industry just makes sense. Expectations are low and growth is high. The market is dislocated in my opinion because institutions can’t own US cannabis stocks. Company EBITDA and eventually profits look low because of draconian legislation, but I feel confident the regulatory environment will improve as evidenced by Schumer’s draft legislation. I also think this thesis works without federal legislation. States are incentivized to legalize cannabis due to tax revenues. Finally, while I can’t say which large US multi-state operator will win, I like MSOS due to Dah Ahrens and feel he’ll run the ETF the right way.

This post was pretty high-level and I’d like to focus in on individual companies and specific legislation / industry dynamics going forward. Shoot me topics you’re interested in if you have them! That’s all for now.