Long Cresco

Investment Thesis:

Cresco shares have underperformed its other large high-quality MSO peers Curaleaf and GreenThumb YTD, but this should reverse in H2’20.

Highly levered bet on the two most attractive markets for cannabis in the US, IL and PA, where demand has remained incredibly strong despite COVID19 and inventory has been constrained (both states have suffered from product shortages for months).

Cresco has a market leading share in both states, and this should continue to grow as the company has massive capacity expansions due to start contributing to topline and margins in Q3.

Mgmt.’s ability to weather obstacles from COVID and walk away from deals that no longer made financial sense, have put Cresco in solid financial position relative to peers. As a result, Cresco can now take advantage of distressed valuations and grow opportunistically. We recently saw an example of this with their recent Ohio acquisition, and expect similar such acquisitions to follow over coming Q’s.  

Shares have seen limited participation in the market’s rally off March lows, despite expectations having been lowered, several key overhangs now removed and potential upside catalysts now on the near-term horizon.

Cresco shares are down -32% YTD and -54% over the past 1yr, vs. Curaleaf shares down -6% YTD and -27% over past 1yr, and GreenThumb up 1% YTD and down -11% over past 1yr. US operators overall are down ~50% over past 1yr.

Based on our estimates, Cresco’s revenues will triple in 2020 to ~$400m thanks to expansions in IL and PA, and grow another ~75% YoY in 2021 to ~$700m followed by 34% YoY in ’22 to over ~$900m

Assuming in 12 months, Cresco trades at 10.0x ’22 EBITDA of $285m, this translates to ~C$10.30/share representing ~70% upside vs. current levels.

Highlights

Cresco Labs is among the top Multi state operators (MSOs) in the US cannabis industry.

Cresco’s revenue is primarily driven by three core states: IL, PA and CA.

Together IL and PA account for the majority of Cresco’s topline (~65-70% of revenue) and EBITDA.

Both states are widely considered to be the best markets currently in the US, in terms of both growth[1] and overall pricing/supply/demand dynamics.

Cresco claimed a market leading share of flower sales for adult use retail in IL in Q1, and for wholesale as it also sells into 100% of licensed dispensaries in IL.

Mgmt. touts a ~25% market share for medical use PA, and its wholesale business sells into 100% of PA’s dispensaries (which were just under 80 as of April)

Cresco advantage here should only increase, as the company has significant capacity coming online in both states during H2’20 as recent expansions have been completed and are already in cultivation.

Cresco’s IL capacity is expanding by 6x (vs. Q1’20 levels) to 215k sqft, marking the largest cultivation footprint in the state.

Mgmt. expects to open its 8^th and 9^th location in IL by either late June or early Q3 (with its 10^th location’s opening date TBD).

In PA, their cultivation is expanding 4x to 88k sqft.

CL plans to open its 4^th PA dispensary (which will be in Philly) in Q3, followed by its 5^th and 6^th locations by Q4’20. Cresco’s 6 PA dispensaries will be split between 3 in Pittsburgh & suburbs and 3 in Philly & suburbs. They can have up to 15 stores in PA according to current regulations.

Cresco’s large capacity will also better enable them to deliver new forms to consumers, which command higher prices, and is further accretive to margins

The California operations will continue to see improvement as Origin House’s optimization process is now largely complete and disruptions from COVID are in the rear-view mirror. Origin House distribution business had margins of ~18% prior to the deal, contrasted with 36% for selling Cresco’s own brands, which Mgmt. claims are now in >50% of the +600 doors on Origin House’s platform

Likewise, in MA, where Cresco closed its acquisition of MA based Hope Heal Health in Feb, operations should see a notable rebound as the adult use market recovers from the State ordered shutdown during COVID. Cresco’s MA cultivation comes online in Q2 and should contribute meaningfully by Q3. Similar to IL and PA, product shortages were an issue in MA during Q1 and will likely become an issue again later this year. Note, Cresco’s Fall River, MA dispensary is also close (~20miles) to Rhode Island, which is a medical-use only state.

Peers CURA and AYR both made very positive comments re-MA recently. CURA noted that MA had the best pricing of any market of the country, while AYR noted their retail biz in MA has “been on fire” during Q2 meanwhile in Q1 they noted that they were “selling anything they had”.

Remains to be seen what OH can really do – as the state managed to post steady growth in Q1 and Q2 despite COVID, and has a population of nearly ~12m vs. ~13m for PA and IL

Looking forward into 2021, besides the growth in IL and PA, along with improvement in CA and MA, Cresco will also see significant YoY growth in Michigan (already adult use), Maryland (medical only) and Ohio (medical only).

Cresco’s operations in Ohio, New York, Arizona and Maryland also represent potential upside those states transition to adult use from medical only.

This may be accelerated by budget demands due to the impact of COVID as seen by recent comments from NY’s Governor pushing for state legislators to pass adult use before year end.

Valuation

•       On FD EV/EBITDA basis, Cresco trades at 8.3x 2021 EBITDA vs. CURA at ~11.7x and GTII at ~10.3x

o   For 2022, Cresco trades at 5.8x EBITDA vs. CURA at 10.4x and GTII at 7.7x

•       On FD EV/Sales basis, Cresco trades at 2.4x ’21 sales vs. CURA at 3.1x and GTII at 3.0x

Cresco’s Q1 generated revenue of $66.4m, representing ~$265m on annualized basis, which is below GTII’s ~$410m annualized rate as of Q1 and CURA’s $420m (~$600m on a PF basis), but Cresco should “catch-up” in H2 once the above-mentioned cultivation expansions begin to contribute to topline and as new stores open in both markets.

EBITDA margins currently trails peers, due in part to their larger wholesale presence in CA, but margins will significantly benefit from improving gross margins and overall operating leverage in IL and PA, along with improvement in Cresco’s wholesale and California business (where it is still integrating and realizing synergies from its recent acquisition of distributor Origin House). Further Q1 SG&A was inflated by ~$12m in 1x costs related to the closing of their credit facility and several other acquisitions/transactions during the Q. Cresco closed on the Verdiant (OH), Valley Ag (NY) and HHH (MA) acquisitions along with several sale-leasebacks during Q1’20.

Balance Sheet & Capital Allocation

Cresco closed a Sr. Secured term loan for $100m in early Feb (which is expandable to $200m) and executed several sale leaseback transactions during Q1. Cresco ended Q1 with $69m of cash and completed a sale leaseback subsequent to the end of the Q for proceeds of $16m. Capex for the remainder of 2020 is expected to be between $25-30m vs. $42m in Q1 alone.

Cresco remains in a strong financial position thanks to Mgmt.’s willingness to walk away from cash heavy deals as market conditions changed, and instead choosing to take advantage of sale leasebacks to raise capital from existing PPE assets to fund organic capex. By doing so, Cresco has managed to continue to expand without being forced to divest assets and can continue to pursue M&A opportunistically.

This is in contrast to larger but financial weaker MSOs like Harvest, which recently divested its California assets to High Times in a $80m deal, that included only $5m in upfront cash (along with $7.5m 1yr promissory note and the remainder in stock) and 4Front which sold off assets in PA and MD last month.

Cresco walked away from the $120m all-cash deal to acquire Florida based Vidacann last year. While Florida is an attractive market based on demographics, in terms of competition its relatively crowded and capital intensive given it requires vertical integration.

The Tryke deal collapse in April hurt Cresco shares initially but given the deal was originally formed at pre-COVID valuations (which disproportionally impacted Nevada, especially LVS strip focused operators like Reef’s Superstore) and included a large cash component ($55m of $283m deal) it was arguably a good thing, especially since the break fee paid to Tryke was only $1.25m. 

Besides obvious impact on tourism from COVID, deals in NV have been plagued by state regulatory issues that have delayed license transfers. We’ve already seen competitors call off deals, such as Acreage’s acquisition of Nevada operator Deep Roots and Harvest which called off both the Verano and Falcon acquisitions. We also saw some deals terminated but which were later revisited at a lower price such as Planet 13’s recent expansion into California.

Given the Tryke deal wasn’t cheap (6 dispensaries for $252m plus another $30m for real estate assets) and the troubling environment in NV, Cresco is in a better position now to find a more attractive assets in NV and elsewhere.

Cresco’s recent deal to acquire OH based Verdiant in late May illustrates this, as that acquisitions bolsters their position in Ohio by adding 4 dispensaries and was much cheaper than Tryke.

On the Q1 call Mgmt. flagged Michigan (10^th most populous state) as a potential target for adding depth via M&A

[1] Medical sales in IL are up 71% YTD to $141m as of May and Adult use sales for YTD through only April were already $147m. Overall medical sales in PA were up an estimated ~30% in Q1 alone.

Federal Legalization

State transitions from medical-only to Adult use (PA, NY AZ, MD, OH)

STATES Act

SAFE (Banking) Act

Tax Changes (Section 280e)

Relaxed Listing Requirements for NYSE and TSX