The CME & Cannabis? Valuation review into 2Q21

by | Aug 11, 2021 | Comp Table, Podcast | 0 comments

8th Revolution and the CME?

In early June, we were interviewed by 8th Revolution’s Kellan Finney and Bryan Fields, where we discussed the California cultivation supply, sustainability and scalability of margins, Weedmap’s investment thesis and narrative, and Cresco Labs thesis.

At the very end, they asked up “what non-cannabis company will be involved in the future”, to which Colin responded the big packaging companies like Ball will enter. Mike gave a low-risk answer of Amazon, but the second we stopped recording he thought of a more interesting higher risk answer: 

The Chicago Mercantile Exchange (CME) will have traded cannabis commodities. 

More generally, the concept is that at some point there will likely be commodity futures or a benchmark of some kind for the cannabis industry on some exchange if not the CME specifically.  

If we assume that some day there is legal interstate commerce (if not international commerce), and a lack of legal vertical integration requirements (such that cultivators and processors and retailers are allowed to be broadly separate), then we would expect to see some kind of traded spot and futures cannabis commodities. 

Why not? Most agricultural products have spot markets and futures so farmers can presell their production and processors can pre-buy their inputs, with speculators greasing the wheels of commerce.  

When you have vertically integrated operators growing their own product in a controlled indoor setting and the market is only as big as a single state, there is less need to hedge the pricing risk. But if there are multiple cultivators without guaranteed distribution, and especially when they are outdoor farms with a single harvest subject to the whims of weather, then need to use futures to hedge is much higher. If the market is a national or global one, the market is also much deeper, bringing in more participants. 

The Dairy market has multiple classes and outputs from raw milk depending on end market: Class I for drinking, Class II for yogurt and ice cream, Class III for cheese, and Class IV for butter.  

One could envision different outputs of the plant, such as THC crude oil extract and CBD crude oil extract being separately traded. In our California supply analysis from May, we noted the potential for increases in outdoor cultivation that will likely lead to increased extraction products. 

Cannabis should also be a large enough market overall. The Oat market is only about $5-6 billion, and it has CME traded options and futures. The dairy market is about $134 billion traded and another $78 billion not traded. 

The legal cannabis market is currently about ~$20 billion and would be roughly $10 billion at wholesale, and with a $70 billion illicit retail market and talk of a $100+ billion plus US market with full legalization, it would certainly be big enough. 

Finally, we do not think different types or grades would be a barrier, as many markets have standardized benchmarks from which participants adjust for their specific product, such as trading heavy sour crude oil from Mexico using light sweet West Texas Intermediate as the benchmark. The main traded benchmarks on this chart are WTI and Brent, and most of the oil in the world is not WTI or Brent.

 The key to such traded commodities appearing will be the market structure, specifically the number of producers vs. buyers. If the entire industry is permanently vertically integrated, this is less likely than if there are separate farms.  

This is a long term idea, and by no means are we saying that the CME is now an ancillary cannabis stock, but we think it would be an inevitable part of the maturation of a free-flowing industry.  

 

2Q Earnings This Week Should Take Over from Political Posturing  

More pressing are the earnings reports for the major US operators this week.  

Our biggest concerns going into 2Q21 earnings have been lapping the difficult COVID-fueled comps of 2Q20, yet data from Headset generally shows continued growth for the industry overall. Jushi preannounced revenue at the high end of guidance, and the stock first dropped to ultimately close up 5.5% since.  

Though stocks mostly have to live up to consensus expectations and typically decline when they miss those estimates, the US cannabis stocks should be viewed more on a longer-term basis than merely 2Q estimates. The question should be “what could they say on their 2Q calls that would question the overall multi-year thesis of a growing market with solid margins?”  

We think only significant disappointment on gross margins due to pricing pressure would compress margins; misses on EBITDA due to investment for future scalability should be looked through. 

The weakness since 2Q began actually has started to reverse in the past week into earnings, with the US stocks up 5% on average, or 3% if you exclude the 56% gain in Glass House after securing a $30 million seller’s note to acquire the Ventura greenhouse. 

Moving through the earnings, the US operators trade at 3.7X 2022 sales and 10.2X 2022 EBITDA. Note also that we have added Gage to the US operators, and Agrify and Hydrofarm to the ancillary services on our comp table.  

Tilray rallied on earnings, but we were still struck that pricing continued to decline. Management claims that the pricing from their brands will matter when they can be sold in retailers in person – which truly begs the question on the power of the brands.

 

Premium Members can download the comp table as of August 6, 2021 below. 

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