April 30, 2024
Commentary
Introduction
This month we focus on the significant step forward in US federal cannabis regulatory changes afoot as the DEA confirms that it is in agreement that cannabis should be re-scheduled on the Controlled Substances Act down to Schedule III. In this report, we look at the implications of the announcement; next steps in the process; potential timing, as well as cash flow and valuation implications. For the month of April, US cannabis sector finished strong with noted portfolio positions contributing to the Funds’ performance as follows:
Company |
Portfolio Allocation of the Fund by Company |
1 Month Performance (as of April 30, 2024) |
1 Year Performance (April 30, 2023 - April 30, 2024) |
|---|---|---|---|
Green Thumb Industries (GTI) |
18.5% |
6.7% |
120.4% |
Trulieve (TRUL) |
12.7% |
17.7% |
169.9% |
Verano (VRNO) |
9.9% |
7.0% |
114.5% |
Terrascend (TSND) |
6.1% |
16.1% |
29.4% |
Curaleaf (CURA) |
1.8% |
18.8% |
150.7% |
Source: Refinitive
Ninepoint Alternative Health Fund - Compounded Returns¹ as of April 30, 2024 (Series F NPP5421) | Inception Date - August 4, 2017
1M |
YTD |
3M |
6M |
1YR |
3YR |
5YR |
Inception |
|
|---|---|---|---|---|---|---|---|---|
Fund |
4.4% |
29.0% |
12.4% |
39.4% |
32.1% |
-14.0% |
-6.1% |
8.0% |
We provide the following summary for investors;
What Schedule III Will Do
- Removes punitive 280E taxes, estimated at $2 billion industry wide in 2023
- Provides deductibility of interest improves the economics for levered private equity
- Enables increased institutional investor participation.
- Allows for increased medical research
- Creates a significant step toward getting US operators on the NASDAQ and NYSE
What Schedule III Does Not Do
- Does not change current legalization such that foreign companies (Canopy, Aurora, Tilray) cannot enter the US market
- Does not result in interstate commerce thereby solidifying the moats being built by MSOs
- Could create new issues with respect to the FDA involving the dispensing of prescriptions however we consider that to be lower risk.
DEA Confirms Agreement to Reschedule Cannabis as a Schedule III Drug
The most significant positive announcement to date in US federal cannabis reform took place at the end of April when the Associated Press reported that the Drug Enforcement Administration (DEA), after 7 months of consideration, recommended the reclassification of cannabis consistent with the results of a scientific and medical review conducted by US Health & Human Services from August 2023. In that scientific and medical report, HHS recommended cannabis should be reduced to Schedule III in the Controlled Substances Act (CSA) from its current Schedule I designation. We believe this is the catalyst that many investors have been watching for several years. We believe it is actually the most positive change in US federal cannabis legislation in over 50 years as the U.S. government adopts this new progressive policy.
Our belief is that the entire announcement cycle was planned to ensure implementation of Schedule III before the Presidential election in November since delivering this policy goal is a major platform opportunity in the 2024 Presidential election. Looking back, we see the release in January where Health & Human Services (HHS) confirmed its scientific research that cannabis has a low incidence of abuse and has defined medical benefits, brought awareness to the market of what was originally released but not detailed back in August of 2023. This gave enough time for the DEA (7+ months from August) to review that decision and be able to release its findings early enough in 2024 to be able to run through the public comment period to remove the ability to rescind in the next administration. From a political point of view, this policy objective, though short of full legalization, is aimed at moderate Republicans and younger voters who believe that cannabis should be legalized and not treated like harsher substances where abuse and suicide have been rampant, such as heroin and LSD. Recent Gallup Polls suggest American voters overwhelmingly support cannabis legalization.
Why is this Significant
Moving cannabis from Schedule I to Schedule III places it in the same category as Tylenol with Codeine, greatly reduced from its current Schedule I position equal to Heroine and LSD. Most importantly and the reason stocks reacted so positively is that with re-scheduling, US cannabis companies would no longer be subject to the punitive tax regime associated with Section 280E of the Internal Revenue Tax Code that prevents US plant-touching companies from deducting ordinary business expenses such as rent and salaries. Below we see the effect of eliminating 280E from various MSO cash flow statements.
Market Reaction to the DEA Proposal of Schedule III
On the day of the announcement, US cannabis names were up 20-35%. The next day witnessed a reversal based on what we would suggest are misinformed “sell the news” strategies as some investors believe that implementation could take years. We also believe that the “sell the news” approach in this instance is flawed as there are many direct and indirect benefits to the Schedule III announcement. We believe that this reversal was based on a misunderstanding of the next steps in the process which we outline below. This current trading range sets up an opportunity for upside as the next few months provide a great runway for investing in to the US Cannabis sector.
Next Steps in the Process
US cannabis companies continue trading at pre Schedule III announcement levels (5X to 8X EV/EBITDA) implying that market participants do not think Schedule III will happen. Our view is that this unprecedented development for cannabis reform has been taking place since October 2022 when President Biden requested various agencies to review cannabis scheduling “expeditiously”. When one considers that since that time, HHS has completed their scientific and medical review, published a thorough 250 page report, then allowed the DEA time to review and consider its findings for another 7+ months, the process has already been happening expeditiously. Important to remember that the last time a scheduling review of cannabis took place was in 2016 and that attempt was stopped abruptly when the DEA denied the application to even consider re-scheduling.
In addition to the thorough review noted above, we understand through a Wall Street Journal report that the US Office of Legal Counsel (OLC) has already been called in to provide limits and guidance on what is subject to debate and what is not between HHS and the DEA. As described by the American Constitution Authority “OLC provides legal advice concerning the most sensitive matters of government, and the Office and the entities it advises therefore have an interest in candid deliberation shielded from scrutiny,”. The April 30th DEA announcement in support of the HHS Schedule III recommendation means that legal disputes and interpretations have been reviewed. Our understanding is that there very few areas where undue delay can be inserted into this process.
At this point, we are waiting for the White House Office of Management & Budget (WHOMB) to review the order to reschedule and then publish the order in to the Federal Register. That could take place in as little as a few days to a few weeks. That leads to a 60-90 day public comment period where interested parties can submit questions or legal challenges to the order. However, given the guidelines and rules provided by OLC to HHS and DEA, there is very limited opportunity to adjust the current order. Once the comment period is complete, the DEA has 30 days to draft its final rule taking into consideration any significant comments. It is important to note that rather than having a legal challenge against the government, in this case, cannabis re-scheduling is being supported by the White House, suggesting that all resources will be put forth to bring a positive resolution to this process. Once it is published as a Final Rule, then it erases challenges from future Administrations from challenging its implementation. A future administration would have to begin another rescheduling review from the beginning. We are of the opinion that it will be completed well before the election as this is a platform for President Biden’s re-election campaign, and with respect to the elimination of the punitive tax 280E, the new rules will be applied retroactively to January 1, 2024, thereby allowing enhanced cash flows to be included in current financial statements.
Impact on US Cannabis Valuations
The Schedule III designation on the CSA leads to the removal of 280E taxes and creates a new base for the valuation of US cannabis companies, with the tax removal leading to significant improvement in operating cash flows, enhanced balance sheets and higher valuation parameters. US cannabis companies continue to trade (as of date of writing 050624) at 8.7X EBITDA as a group. Our opinion is that the sector remains significantly undervalued as the impact of enhanced cash flows has not been reflected in the companies. Immediate re-rating of their cash flows should now be taking place. Already most MSOs have stopped paying their quarterly 280E payments, or have re-filed previous tax returns and in one high profile case, Trulieve Cannabis (TRUL) already received refunds of more than $100 million. We note that in 2023, a report from Whitney Economics estimates that the US government received ~US $2 billion worth of tax installments from legal US operators. Even in a conservative review, even if 280E takes a year, current valuations are very attractive.
The chart above illustrates that at historical peaks, sector leaders reached valuations of ~17x to 18x EV/EBITDA back in early 2021 when enthusiasm for federal reform was quite positive. Since then, fundamental performance has been relatively strong, new state markets continue to open yet MSOs have traded to lower multiples, ~50% below those sector peaks. A way to analyze the extent of valuation upside potential is to compare certain industry multiples such as tobacco, alcohol and consumer packaged goods (CPG) to see potential multiples for US cannabis. These noted industries do not possess a catalyst rich growth-oriented future, yet the tobacco companies trade at 10x, alcohol companies tend to trade at 15X (and stats show alcohol has been flat to down as more state cannabis markets come online) and CPG companies trade at 18X. While CPG, Alcohol, and Tobacco companies are expected to grow sales at a 3-year CAGR of 4.2%, 4.2%, and 4.0%, respectively, MSOs have potential minimum three-year CAGRs of 7.8% suggesting a premium multiple. (Source: NYU Stern School, By Aswath Damodaran)
Cannabis is a catalyst rich industry with further federal reforms that can lead to increased liquidity and additional institutional interest. The top five largest US cannabis companies are less than 20% institutionally owned, whereas large alcohol and tobacco companies have approx 75% institutional ownership. In addition, there is a scarcity value associated with limited licensing in various state markets. One of the primary reasons that valuations have suffered is a lack of federal reform that has the ability to loosen banking and NASDAQ exchange or listing rules for MSO's. Moving cannabis to Schedule III reduces the stigma attached to the industry, thereby reducing sensitivities involving custody issues and beginning a process where institutional accounts begin to invest with improved cash flow capabilities on the part of MSO’s. In addition, the sector has new state markets to exploit as the transition from medical to adult use continues, notably this year in Ohio, Pennsylvania and then Florida, three of the larger state markets based on population.
What Schedule III Will Do
- Removes punitive 280E taxes, estimated at $2 billion annually
- Deductibility of interest improves the economics for levered private equity
- Schedule III will enable increased medical research as well as increase the investor base.
- Schedule III is a significant step toward getting US operators on the NASDAQ and NYSE.
By moving cannabis to Schedule III, the stigma around cannabis businesses has been greatly reduced and can lead to more open discussion and acceptance of regularized banking. If cannabis is equal to Tylenol with codeine, then why should MSO’s not be treated the same as J&J or other pharma companies that produce similar substances? This move symbolizes a very significant step forward for the cannabis industry in the United States with major implications for further normalization in the years to come.
What Schedule III Does Not Do:
Schedule III does not change current legalization such that foreign companies such as Canopy, Tilray, Aurora cannot enter the US market, they would be forced to restructure and work within the state by state structure currently in place.
Schedule III does not result in interstate commerce; that is the cultivation and processing of cannabis in one state, and then shipping the finished product to other states is strictly prohibited and enforced by federal authorities. This solidifies the moats being built by MSO’s.
Schedule III could also create some new issues with respect to the FDA. Although we consider it lower risk, it is possible the FDA could take a more aggressive stance with respect to medical cannabis.
COSTCO Membership Benefits: GLP-1 Discounts
Two top ten holdings for the Fund, Costco (COST) and Eli Lilly & Co (LLY) have come together to offer access to weight-loss medical programs for its members. Normally the GLP-1 medications are expensive at approximately $1,000 per three-month dosage. Costco is offering members GLP-1 medications for $179 and $195 for non-members. The three-month subscription is provided with Costco’s telehealth partner, Sesame, that includes consultation, an individualized treatment program, and access to GLP-1 drugs. Sesame’s weight loss drugs include other investigational drugs such as Qsymia, Xenical, Contrave, and Adipex-P, in addition to the injectables such as Zepbound, Wegovy, Saxenda, and Imcivree. A significant reduction in the price of weight-loss drugs expands the patient population and can make it more affordable overall within the US healthcare system.
Canadian Federal Budget Did Not Provide Tax Relief
Canadian Cannabis industry watchers were anticipating some form of tax relief within the recent Federal Budget after a consultation between Canadian cannabis executives and the Finance Department. At issue is what many observers deem an excessive Excise Tax paid to the government making many operators unprofitable. The industry lobbied the Finance Department at the same time that industry-wide information continues to show that despite the establishment of a national cannabis program, the number of cancelled cannabis business licenses has soared alongside the amount of “uncollectable” excise tax due in Canada. During 2023 at least 123 cannabis business licenses either were cancelled or were pending cancellation, according to data released by the Canada Revenue Agency (CRA). That figure is almost triple the number of licenses cancelled in 2022. Once there is a loss of a license, companies are unable to cultivate, produce, or package cannabis. The latest CRA data shows that at least 212 licenses were cancelled between federal marijuana legalization in late 2018 and Feb. 29, 2024, with 58% of the cancellations happening in 2023 alone.
The Ninepoint Alternative Health Fund, launched in March of 2017 is Canada’s first actively managed mutual fund with a focus on the cannabis sector and remains open to new investors, available for purchase daily.
Charles Taerk & Douglas Waterson
The Portfolio Team
Faircourt Asset Management
Sub-Advisor to the Ninepoint Alternative Health Fund
Statistical Analysis
Fund |
|
|---|---|
Cumulative Returns |
68.5% |
Standard Deviation |
27.4% |
Sharpe Ratio |
0.11 |