Cannabis stocks are being driven by market dynamics and not fundamentals, creating opportunities for long term investors that can stomach the volatility.
The rising correlations also present hedging opportunities: are you nervous about valuations after 4X gains in cannabis stocks but want to remain invested in the long term thesis?
A short on a basket of other high margin, high valuation, growthy consumer names like LULU and DPZ could hedge out the market valuation risk.
With market turmoil from rising treasury rates and tech rotation, cannabis was pressured heavily this week along with all growth/long duration stocks, and the daily closes hide the increase in intraday volatility.
For long term investors, these declines provide the welcome opportunity to invest more at lower valuations, and though we suspect tough comps for 2021 guidance could further pressure the industry names absent any legislative news.
This will be a rare publicly-available market commentary and comp table. Free Members have access to prior tables. If this is your first time reading one of our tables, please read this article describing the details and adjustments made.
Market Dynamics take over and correlations spike
On Friday, March 5, many cannabis stocks were down double digits (e.g. Green Thumb Industries OTC down 14.6%, Tilray down 18.4%) as the broader markets were down about 2% midday, when at 1:30 ET the markets and cannabis turned hard (eg Green Thumb Industries OTC rallying to close down only 3.5% on the OTC and only 0.6% Canadian, and Tilray closing down 4.5%).
Why do higher interest rates hit growth names and especially cannabis? The theoretical answer is higher duration – i.e. the weighted average time to receive future cash flows – for growthy stocks like tech and cannabis. Because the cash flows are farther out, small changes in the discount rate increases the present value of near term losses and reduces the value of far out profits. Cannabis is especially growthy and came into March with nominally high multiples.
We get it: cannabis is high beta (and this was published almost exactly 1 year ago), and we don’t dispute that a broad market correction will pressure cannabis stocks as well.
This overlooks, however, that the cost of capital for US cannabis is likely to come down much more with incremental legalization, more than offsetting the theoretical pressure from rising rates.
Lending rates for cannabis won’t be impacted by rising rates, but instead, they will be significantly lowered by legislation giving access to normal capital markets.
The equity market premium may be impacted, but we think (longer term) the secular trends in fundamentals will outweigh the systemic drivers in the markets, and the near term declines from market dynamics will provide entry points at more attractive multiples (that themselves will have a downward bias as estimates rise).
The ability of US cannabis stocks to uplist to higher volume NASDAQ and NYSE following favorable legislation, and then entry of institutional capital into US names (and potentially out of Canadian names), will likely offset any impact from interest-rate duration.
Note this benefit is far more muted for the Canadian operators, which already have good access to capital, do not pay 280E taxes, and are currently the only investable cannabis asset for many retail and institutional investors.
Multiples compress to 6.6X Sales in US and 14.7X in Canada
For the US operators, the 2021 EV/Sales multiple compressed to 6.6X from 7.1X at the end of February, and EV/EBITDA compressed to 23.3X. from 25.5X, as the stocks declined on average of 6% while estimates remained relatively stable.
The Canadian operators saw their EV/S multiples compress to 14.7X for 2021 and 10.9X for 2022, from 16.3X and 11.8X respectively, as their stocks dropped 9% on average and estimates very slightly declined.
Is Cannabis more like Alcohol or Yoga Pants?
What is especially odd is the divergence in the performance of small cap alcohol and cannabis; when cannabis was down double digits on Friday March 5, Boston Beer and Brown Forman were up, ultimately closing at at up 5.5% and 3.7% respectively.
Since we noted cannabis multiples were inline with some other growthy consumers names, cannabis has acted more like these growthy consumer names and less like alcohol. Since February 5, cannabis is down 8% on average; Lululemon and Dominos have both traded down 12%, Nike has traded down 8%, while Boston Beer and Brown Forman are only down 3-4%.
This trend continued on Friday March 5, when LULU was down 5.3% intraday and then closed up 2.8% on March 5, while Dominos Pizza and Papa Johns were also down 3-5% yet closed flat on Friday – despite cannabis being less discretionary than athliesure clothing and has faster growth drivers than pizza. Similarly, LULU’s multiple has compressed nearly 4 turns to 27.7X and Domino’s has compressed 2 turns to 20X.
What is the right multiple for cannabis?
But what is the right multiple for cannabis? We will have more detailed thoughts on this in future Premium tier posts, and ultimately, as any good investor knows, a variant view on the estimates vs. consensus is more important to driving multiple expansion or contraction.
Our past thoughts on downside floors based on consumer/tech cos in prior market corrections can be found on slide 23 here, and the cannabis stocks bottomed at these valuations last year at 1.7X sales for US operators and 3.5X for the Canadian operators.
Yet the fundamentals for cannabis have significantly improved since these analyses: cannabis was deemed essential in the US, state-level legalization is expanding, the blue sweep improves odds of Federal legislative action, and the sector has significantly improved its balance sheet, raising another $2.5 billion year to date.
If it is merely valuation you are concerned with, it is possible to hedge the “excessive consumer valuation” risk with a short basket of similarly valued consumer names, similar to the strategy we noted for isolating Weedmaps/Silver Spike’s core cannabis tech thesis from excessive tech valuations.
Ultimately, we think the most long-term value will accrue to the companies that can execute on a balance of near-term cash flow generation while creating scalable infrastructure to sustain their business models.
Earnings for US MSOs kick-off this week, with the following companies reporting:
- Curaleaf Q4 and FY2020 conference call
- Acreage Q4 and FY2020 conference call
- Date: Wednesday, March 10, 2020
- Time: 8:30am EST
- Click here to listen to the webcast
- AYR Wellness Q4 and FY2020 conference call
- Date: Thursday, March 11, 2020
- Time: 8:30am EST
- Click here to listen to the webcast
Finally, we were pleased to see the Wall Street Journal catching up to the themes today that we’ve been writing about for a year:
- that the Canadian stocks have higher valuations because of greater liquidity than the US driven by access to the NASDAQ higher trading volumes on November 18, 2020
- that the US operators offer higher margins, faster growth, a bigger market, more legalization catalysts, and still trade at lower valuations April 7 2020
- that not all cannabis investments are the same February 25, 2021
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Disclaimer: This is not investment advice or solicitation, and these reports will be provided for free, for a limited time.
As of 3/8/2021, the authors have positions in AYR Strategies, Columbia Care, Cresco Labs, Curaleaf, Green Thumb, Schwazze, and Village Farms, and make no commitment to update holdings in these positions.
MJResearchCo has no business relationship with any of the companies mentioned in the article.