Thesis: Long MSOS ETF to play the bombed out, but catalyst rich, US cannabis sector. Sector is trading near all-time lows with trough valuations, but stands to benefit from LT tailwinds as states continue to transition to adult use, the illicit market shrinks and further reforms/rescheduling likely eliminate punitive taxes and other obstacles to margin improvement. MSOS is heavily weighted toward the largest and most diversified operators, which are best positioned to survive until legalization and thrive thereafter.
Main Highlights
Sector trades near Trough levels on valuation, and is relatively cheap vs 'Sin Staple' peers despite faster growth
MSOS trades at ~7.2x EV/2023 EBITDA and ~5.6x 2024 EBITDA (based on top ~9 positions representing ~95% of holdings)
By contrast, Tobacco peers MO and BTI trade at ~7-8x EBITDA, and Beer peers BUD and TAP trade at ~8.5-10x
MSOS growing Revenue ~mid single digits (’22-24 CAGR) in-line with beer peers, and above tobacco’s ~LSD/Flat growth
Sentiment in the sector is completely bombed out, with most names trading at or near All time lows
MSOS is down ~30% YTD, ~60% over past year and ~80% from inception (~Sept 2020) with many constituents trading below their COVID lows
Shares of 10 largest operators are down ~72% vs election day 2020
This is all despite drastically increased scale with most of the top operators now doing 2-3x Rev vs 2020 lvls
Despite headwinds from Macro, the industry has continued to see volume growth, which indicates healthy underlying demand for cannabis. Margins meanwhile have been impacted by pricing (due to competition and trade down by consumers)
Several states (IL, PA, MA) saw wholesale product pricing down ~30% YoY in May 2023
However, recent commentary indicated that product Pricing is starting to stabilize QoQ in most of these markets
IL state data shows continued strenght in demand, as the # of items sold up ~10% YoY in each month so far in 2023
Tailwinds from continued State reforms and gaining share from the Illicit market should drive growth medium term
US Legal Market expected to grow from ~$30b currently, to ~$70b in 2030
Will benefit from more states converting to adult use which should add ~$20-25b (see section below)
24 states have legalized both Adult use & medical use cannabis, 16 states have only medical use and 11 states have no legal market.
NJ, NY, CT, MN, RI and MD are currently transitioning to Adult use
OH[1], VA[2] and PA[3] look likely to transition near term
Legal market continues to take share from illicit market
Illicit market estimated at $40-70b/yr, thus total market (legal + illicit) is already ~$70-100b vs Alcohol at ~$250b
Illicit market will shrink over time as people prefer legal supply and eventually will go away similar to illicit market for alcohol
Processes decrease, consumers prefer tested product and legal purchases
MSOS is top Heavy and weighted toward larger operators which benefit from Scale and Oligopoly dynamics vs smaller peers
Top 2 holdings (GTII & CURA) are ~46% of overall holdings, Top 5 are ~81% overall, and top 7 are ~90%
Building efficiency gap between MSOs (higher tech machines, techniques, using big data and professional software and tools) and 'Mom and Pop' and illicit (no real capex invested).
Recent macro woes has only accelerated this trend, as Multi State Operators (MSOs) have been forced to get more disciplined on OPEX/productivity and Capex, meanwhile subscale/single state players are under pressure with some being forced to sell at distressed prices and exit unprofitable states/segments.
Punitive taxes, and higher interest rates are already constraining further supply growth
Weaker/smaller producers likely to continue to drop out, which should balance S/D medium term
Meanwhile no AMZN or WMT competition for a long time
Comps:
State Rec Conversions:
Recent conversions (IL & NJ) have been extremely successful despites some challenges
NJ REC began April 21, 2022
NJ went from $250m MED mkt in 2021 to $600m Med + Rec in 2022
NJ expected to hit ~$2.0-2.5b at maturity (per Stifel estimates)
IL went from $250m in 2019 to $1.03b in 2020 (year 1, $670m Rec + $365m Med) and grew to $1.8b in 2021 (year 2, $1.38b Rec + $397m Med)
IL Adult use was $1.55b in 2022 despite disappointing/delayed roll out of new stores
New Conversions look promising (CT, MD, NY & MN) and could add ~$8-13b to legal market
MD $480m market previously and expected to grow to $1.4b-$1.8b at maturity (per Stifel estimates)
NY $150m market now and expected to grow to $6.5b-$9.5b at maturity (per Stifel)
MN $50m market now and expected to grow to $1.4b - $1.6b at maturity (per Stifel)
CT currently run-rating ~$250-300m/yr, and with a similar sized population and GDP as Oregon should represent ~$900m - $1b market at maturity)
Future conversions (VA, OH, PA, FL) represent another $10-11b
VA $50m now and expected to grow to $2b - $ 2.5b at maturity (per Stifel)
OH $480m now and expected to grow to $2.8b - $3.4b at maturity per stifel
PA $1.1b now and expected to grow to $2.5b at maturity (per Jefferies)
Florida $2.2b now (~$5b including illicit) - $6b at maturity including tourism (per Jefferies)
[1] A ballot initiative for legalization of adult-use cannabis in Ohio for 2020 failed but is expected to reemerge on the 2023 ballot
[2] Possession and cultivation of adult-use cannabis became legal in VA on July 1, 2021. However, state lawmakers must still iron out details related to marketplace rules and criminal justice reform before sales can begin on Jan. 1, 2024. Additional delays here seem likely given current Gov Youngkin’s agenda.
[3] PA Gov. Shapiro supports adult-use cannabis, but the main obstacle is the state’s Republican Senate, whose leader has opposed the effort. Still progress here looks inevitable given the state has recently passed bills to increase medical access by eliminating qualifying conditions, and only 1 in 4 PA residents oppose Adult use.
I do not hold a position with the issuer such as employment, directorship, or consultancy. I and/or others I advise hold a material investment in the issuer's securities.
If cannabis moves to Schedule 3 or below, then 280e would no longer apply.
Stifel estimates this would improve operating cashflows by ~40% on avg
Individual states have also pursued reforms to eliminate state lvl 280e taxes
States continue to convert to Adult use
OH, VA, PA highly probable near term
Large southern/red states like FL and Texas are likely to follow medium term as legalization becomes the norm rather than the exception
SAFE Banking
Expands banking and capital markets access
Should lower cost of capital
Allow operators to move away from cash only transactions
TSX Uplisting from Small Canadian exchange (CSE) and OTC
TerrAscend became the first US plant-touching cannabis company to be officially listed on a Tier-1 exchange on the Toronto Stock Exchange, with others expected to follow
Uplisting to the TSX should improve liquidity and availability to at least some institutional investors (this uplisting removed the ban on custody services from MS and BNY)
Federal Legalization
M&A returns post reforms
[1] Section 280E penalizes traffickers of Schedule I or II drugs by disallowing the deduction of “ordinary and necessary” business expenses—such as below-the-line deductions—after reducing gross receipts by cost of goods sold, or COGS, essentially resulting in federal income tax liability calculated based on gross income, not net income. Jefferies estimates that given the impact of 280e (on Federal and State taxes), MSOs are paying effective corporate tax rates of ~70-90%.
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