This is part of our series “What investors are missing.” In these articles, we highlight contrarian trends, forecasts, and observations from first-hand experience working with US cannabis operators and institutional investors.
Removing 280E taxes would be a big benefit to the industry, right?
Yes, but not in the way most investors expect.
Investors will not keep all 280E taxes via increased free cash flow or distributions.
A tax cut is just another source of capital at a lower cost, and smart CEOs will invest to accelerate growth via higher capital expenditures and marketing spend, and possibly lower prices.
Smart investors benefit from owning a larger business in the future and less dilution today.
The key takeaways for investors are:
- Investors should not expect to simply pocket any tax savings, even if 280E goes away entirely and is not replaced with an excise tax. In 2017-2018 at Roubaix Capital, I deeply analyzed and invested long and short amidst a universal tax cut with the 2017 Tax Cut and Jobs Act. Investors in competitive industries didn’t keep the all of the savings then, and they won’t if/when 280E goes away.
- EBITDA margins will drop and after-tax income margins will expand with the removal of 280E. Free cash flow before growth capex should increase, but this should be reinvested back into the business.
- Cannabis CEO’s that are not strategically prepared to reinvest the 280E savings will lose share to competitors. Smart investors will ask smart CEOs to have a “post tax cut playbook”.
- Pre-tax valuation multiples (EV/S and EV/EBITDA) will need to expand, or investors will need to shift valuation to after-tax multiples (EV/NOPAT or P/E). Those that do not shift the valuation framework will be putting lower valuations on companies that will actually be earning more.
- Debt/EBITDA ratios will increase while repayment risk actually decreases, so covenants will need to be altered.
- A transparent excise tax on revenue would be preferable to convoluted 280E taxes. Of course, paying no special cannabis-only tax would be ideal, but we suspect the IRS will want to replace the lost tax revenue somehow. A transparent excise tax on revenue is preferable to convoluted income taxes, and would be best for industry investment, margin structures, pricing, and valuations, and are common in the tobacco and alcohol industries.
History Shows Tax Cuts get Reinvested in Competitive Industries
(If you don’t know what “280E” is, please read this summary before reading the rest of this analysis.)
History has shown that the tax savings from universal tax cuts in competitive and growing industries will be reinvested into:
- Lower product prices
- Accelerated expansion and capital expenditures
- Higher discretionary costs such as advertising, and nondiscretionary such as wages
Many investors simplistically assume that a tax cut flows to investors. All else equal, cutting taxes from 35% to 21% like the 2017 Tax Cut and Jobs Act should result in a 20-25% increase in after tax profit, right?
And eliminating 280E means I just get to keep 21% of gross profit, right?
This misinformed investor may work up the sheet below and get very excited:
But this investor would be incorrect because they are not thinking about a dynamic marketplace where behavior changes in response to incentives and constraints.
Though investors do usually get some direct one-time increase in after tax profit, competitive industries reinvest most of the savings back into the business.
This is exactly what we saw in 2018 after the 2017 Tax Cuts and Jobs Act universally lowered the US Federal corporate tax rate from 35% to 21%. Call after call in 2018 showed consumer and industrial companies touting how they planned to “reinvest” the tax savings into:
- lower prices & improved product quality, which benefits consumers and pressures gross margins
- marketing and branding, increasing competition
- employee wages, benefitting employees and attracting better talent until all competitors match the new wage level
- and finally, some increased buybacks and increased dividends, which can drive multiple expansion and offset the margin compression
Much of the time, they just accelerated or increased existing strategic initiatives, as shown in these quotes from earnings calls at consumer companies in early 2018.
|We are planning increased brand and organizational investments funded by continued progress on cost savings and efficiency projects and some of the benefit of the recent tax changes||Boston Beer 2/21/2018 Earnings Call|
|As a result of tax reform, we will invest an additional $10 million in our team members in 2018. These investments will cover some labor rate increases, shelter team members from an increase in medical premiums and improve other team member benefits||Sprouts Farmers Market 2/22/2018 Earnings Call|
|Looking at 2018 and beyond, the Tax Cuts and Jobs Act is a catalyst that will enable us to accelerate investments in Restock Kroger. And as we’ve shared a few times since the fall, we are taking a balanced approach to ensure tax reform benefits our associates, customers and shareholders||Kroger 3/8/2018 Earnings Call|
|We’ve been very clear about our intention to invest in superiority across the five touch points… product, package, communication, and in-store. But where we need to sharpen value equations, either at the consumer or the retail level, that could also be a target for investment||Proctor & Gamble 1/23/2018 Earnings Call|
Removing 280E will increase net income and reduce EBITDA margins
Below are income statements for a hypothetical US cannabis company under different tax and strategic response scenarios.
A working excel version can be downloaded here; blue numbers are drivers to change assumptions.
The first column is 280E today, using the 2021 consensus average for the US-Focused operators in our comp table at ~55% gross margins, ~30% EBITDA margins, 20% EBIT margins, and a 21% Federal tax rate on gross profit. Note that for the debt, we have assumed that interest rates decline from 15% under 280E (Federal illegality) to 10% as any legal move on 280E requires some federal normalization of US cannabis, which will likely lower the cost of debt.
The second column is the simple analysis with investors pocketing all the tax savings, EBITDA staying flat, and net income increasing 296% – a scenario we do not expect to occur.
We think the third column is more likely, where aggressive (and well-prepared) management teams try to expand their business by investing in brands and price. A 15% price cut and 8% point drop in gross margin, and 8% higher SGA spend, are offset by a 25% gain in units, resulting in a 6% gain in revenue and a 136% increase in net income. But this also results in a 23% decline in EBITDA and a 8% point drop in EBITDA margin to 22%.
Even if a company does not wish to reinvest the tax savings, competition will force their hand. It only takes one actor to reinvest on the hopes of higher market share. Management teams that do not embrace the new reality will likely see price and margin compression forced upon them but no share gains and possibly share losses, as shown in the fourth column.
Yet even this slow-responding operator still sees net income increase 121% because of the tax savings, while sales drop 10% and EBITDA drops 25%.
Investors Should Welcome Greater Investment in Good Businesses
To be clear, long term cannabis investors should want their company management to actively invest the tax savings back into business in the hopes of accelerating growth and building a larger defensible competitive moat.
When the savings are successfully reinvested at high incremental returns on capital, the investors benefit much more from the permanent increase in the size of the business itself than any one-time jump in net income from tax savings.
When competitive dynamics in structurally difficult industries exist (as in brutally competitive grocery), the tax savings don’t really help. Just look at a chart of the four consumer companies quoted above. Lower taxes can’t fundamentally improve a tough business like grocery, and Boston Beer Company (SAM) probably would still done well with Truly at a 35% tax rate, but clearly did better at a 21% tax rate.
Ultimately, this supports a key criteria we use to judge companies and managements: how they allocate capital over the long term.
Cannabis is not an industry with any excess cash (hence why we do not deduce net cash from enterprise values in our comp table), and with much more investment needed over the next decade, the capital allocation acumen of management will determine the amount of long term value creation for equity holders.
The government would also want the greater investment in all forms of expenses, not just COGS, which would result from making all expenses tax deductible. Accelerated growth would ultimately increase total income tax revenue as well.
CEOs, What will you do when you can deduct 21% of SG&A?
Smart CEOs should have at least a reinvestment framework and general gameplan for the day 280E goes away, and smart investors should have an idea of what that gameplan will be.
The questions we would ask include:
- At the very basic level, how much of the savings will go to investors versus the business?
- Where will that investment be? Say in cultivation, distribution, branding and advertising, lower product pricing or higher quality at the same price, greater capex, more employees, etc?
- Do you just accelerate your 5 year plan to 3 years, or do you fundamentally change it?
- Would your vertical integration strategy change if you could deduct SG&A expenses?
We recognize that laws have not actually changed yet and details will be key, but company managements should have a general philosophy about the trade offs in a post-280E world.
It only takes one strategy executive to convince one CEO that “we can reinvest the tax savings in more dispensaries, lower prices, higher advertising spend, and wages and drive unit volumes higher; best case we drive revenue gains, or worst case we see revenue declines, but either way we still see an increase in net income”.
And then all the competitors say “our main competitor just accelerated openings, cut prices, increased ad spend, and poached our best employees with 20% raises – how do we respond?”
“Well, we’ve got that extra cash from the tax savings…”
It is better to be proactive rather than reactive.
An Excise Tax Is Preferable for Transparency and Capital Allocation
The Federal government and many state governments seem to view the cannabis industry as a tax cash cow, and we doubt the Federal government let the tax revenue generated by 280E go away entirely.
We think the cleanest and most efficient way to replace 280E tax revenue is with a simple and transparent excise tax on revenue rather than some convoluted special income tax, which would distort industry investment.
It would also help consumers explicitly see how much of the product’s price is the excise tax, which can protect product pricing.
Given that the industry is currently valued on revenue, an excise tax would actually increase gross revenue, which would simplistically increase the valuation, but it would depress margins because this excise tax revenue will be viewed by investors as a zero margin passthrough.
Smart investors will look at revenue and gross profit net of the excise tax, and companies would do well to separate out any excise taxes from both revenue and cost of goods sold.
An example of a traditional company that operates this way is CoreMark, a distributor of cigarettes and food to convenience stores.
In 2020, its revenue of $17.0 billion included $3.3 billion of excise taxes on tobacco, and in their reporting they clearly calculate margins on both total revenue (“% of Net sales”) and excluding the excise tax passthrough (“% of Net sales, less excise taxes”), allowing investors to pick how they want to measure profitability.
This company has optically low margins, but on a percentage basis the difference between gross margins is a significant 25% (6.5% gross margin excluding excise tax revenue vs. 5.2% gross margin with excise tax revenue).
Below is a table that replaces 280E taxes with excise taxes under the same scenarios as before, with the margins broken out by product revenue excluding excise taxes, and total gross revenue with excise taxes (that get passed through at 0% margin in the COGS line).
Note also that the $116 of “280E taxes” becomes only $83 of excise tax revenue because $33 is the normal 21% Federal tax rate on normal pre-tax income buried in the 280E tax.
In the “accepted” scenario, the company keeps pricing flat and the consumer accepts that they are paying another $0.41/unit in excise tax. In the “flat price” scenario, the price to the end consumer remains $5.00/unit, with the company subsidizing the $0.41/unit of tax and effectively dropping product pricing to $4.59.
In the “reinvest” scenario, as before, the company drops end pricing to the consumer to $4.63, of which $0.33 is the new excise tax (which declines with price declines), and enjoys higher volumes.
In these scenarios, the net income increase is much smaller, but still positive, and because the tax is explicit, no company runs the risk that income taxes exceed pretax income.
Greater investment in the business is also encouraged as all expenses and investments become tax deductible, and the IRS would likely see increased total tax revenue from a larger industry, including excise, corporate income, personal income taxes from more employees, and the multiplier effect from a larger supply chain.
Valuation Multiples Shift to After Tax Metrics, or Must Expand on lower EBITDA
Near term, a shift in the valuation techniques and possibly investor bases will need to occur.
Increasing after-tax profits should normally expand valuations, but a drop in EBITDA margins offset by expansion in after-tax margins will require investors and the industry to shift valuation multiples to after-tax metrics from the pre-tax metrics used today.
The below table takes the hypothetical income statements above and shows the valuation impact (it is available in the same excel download above).
The key points to note is in the dynamic scenarios, for a flat valuation the EV/EBITDA multiples increase while the after-tax valuation metrics decline, and the leverage ratio (debt/EBITDA) ratio increases despite the credit profile improving (as debt/after-tax cashflow improves).
Longer term, the cannabis industry will adapt to any tax regime accordingly.
Ultimately, as with all investing, the key will be investing in good management teams that thoughtfully navigate these changes. Prices and EBITDA margins must ultimately incorporate the costs of the taxes assessed, and the dynamism of the market rarely makes the math simple.
Apologies to accountants and lawyers for oversimplifying a bit; 280E is extremely complex and a legal grey area, and this article deals with the general financial and investment implications at a high level, not the legal or accounting details or nuance at specific companies. Call an accountant or lawyer for more specifics; this is not legal or accounting advice.