Avoiding the Value Trap: Catalysts for 3Q21 & 2022

by | Nov 3, 2021 | Comp Table & Market Commentary, Free | 0 comments

Cannabis stocks cannot catch a bid. As the small-cap index IWM rose 3% in October, the average US cannabis stock declined 13%, the Ancillary operators declined 7%, and the Canadian LPs declined 9%.

A heatmap of stock performance can be downloaded here

The US operators now trade at 2.7X 2022 sales and 7.8X 2022 EBITDA, which as we have noted in the past (we apologize for sounding like a broken record), is where smidcap consumer names have bottomed in past financial crises. Premium Members can download the full table at the button below, while the averages for the industry are provided to all.

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Leading the decline was Green Thumb and Terrascend, falling 27% and 21% in the month, respectively. This was in part a delayed decline as Green Thumb is now 48% off its high, similar to the 47%-65% declines of the other larger operators in the US. We think Green Thumb had been supported in the summer by the “smart money” floor of around $29, after the $100 million of institutional purchases at $30 and $32 justified its premium valuation. However, at 10.5X 2022 EBITDA, Green Thumb is now trading below Curaleaf’s 11.7X with far less integration risk, and it trades about 50% below the prices paid by long-term large investors.

The Canadian LPs and ancillary names continue to trade at significant premiums to the US operators, showing both the benefit of higher liquidity and institutional investment. A legitimate fundamental reason for the US operators to trade at a discount is excessive 280E tax burden, but currently, the discount exists even when adjusting for 280E taxes (Premium Members can access the EV/EBIDA multiples for all names at the button above).

On November 2, Reuters reported that JP Morgan will not allow long or short securities that don’t trade on the NASDAQ, NYSE or TSE related to cannabis after November 8, but existing positions can be sold.

This supports higher valuations in ancillary providers as legalization looks farther off, but should also lead to a continued washout in the US plant touching operators.

So what to expect for 3Q21 earnings?

We think 3Q21 will be muted, as the stocks lap more difficult comps, and increasing supply has pressured prices in California, Colorado, Canada, and Florida. Grow Generation and Hydrofarm already preannounced weak 3Qs, and Hydrofarm cut 4Q21 EBITDA guidance by ~50% on oversupply in California . Our take on Hydrofarm’s decreased guidance can be found here.

2Q21 also already showed that the market currently does not care much for outperformance, and Morgan Paxhia of Poseidon astutely noted the benefit to operators of managing expectations in 3Q21 results for 4Q21 and 2022.

So stepping ahead of 3Q21 means taking on this risk of managing expectations – but that merely coils the spring more tightly for 2022.

Three key differences stand out vs. going into 2Q21 earnings (with multiples from August 6 below):

  1. Multiples have pulled in by about 30%, especially for 2022.
  2. Margin estimates have compressed: US 2022 consensus EBITDA margin is now 34.6% vs 36.1% in August.
  3. We are now two months closer to 2022 being the current year or FY1 estimate, leaving the optically high multiples of 2021 in the past.

Valuation is Not a Catalyst…

Even with bottoming multiples, valuation alone is never a catalyst, and has been the bait of many a value trap. Cheap can stay cheap for a long time, leading the stocks to track purely the rise in profitability, or worse, see multiple compression in the face of rising earnings.

Even the mighty Apple was stuck between 10-15X PE for 8 years as the market viewed it as “one and done” hardware sales and not a recurring software ecosystem (see the green box below for the multiple range).

We wonder what the catalyst for multiple expansion for the US operators will be if the expected benefits of Federal normalization/uplisting to higher volume exchanges and an influx of additional investment is delayed indefinitely, which the market seemed to have priced into the high multiples in the 1H21.

Basically, if SAFE doesn’t pass soon, what drives the incremental buyer?

We think a key catalyst would be modest stock repurchases by the companies themselves – with the qualifier that the cash must be generated by operations.

The conundrum of the US cannabis operators is that it will take additional investment to fully build out the industry, and this should limit the uses of excess cash for buybacks or dividends.

If the US operators can show positive after tax operational free cash flow (not from fundraising) and prove that they could choose to repurchase their own shares– basically buying more of their existing operations rather than buying new operations – that should put a floor in multiples and prove to investors that there is a return beyond an exit at a higher price.

Note that repurchases done with cash raised from equity sold at higher prices will not drive multiples higher, but merely show that the company management is astute at selling their stock at dear prices and buying back at lower prices, and risks using the multiples and prices from the sales as a ceiling.

This is basically the definition of a good business – one that internally generates a lot of cash for a long time, and as Buffett has noted, can generate a return if the public markets closed for 10 years.

With cannabis, we have seen prodigious cash generation in private operators, and we are confident there will eventually be an influx of additional buyers as the industry normalizes – we just prefer to keep this as an option value vs. cash generation.

At MJResearchCo, we will be carefully watching US operators as they move into a soft 3Q21 earnings, tax-loss harvesting, and custody liquidation over the next month. As we approach the potential of further multiple compression from these events, we are optimistic about entering a buying opportunity that’s driven by the valuation transition to 2022 multiples.

 

 

As of November 3, 2021, the authors owned positions in Green Thumb and Hydrofarm, among others not specifically mentioned. They make no commitment to update this in the future.