May 31, 2024
Commentary
Introduction
During the month of May, investors witnessed generally weaker markets as some of the key names in the “magnificent seven” sold off as valuations continue to be stretched to unsustainable multiples. While broader market weakness was in focus, the US cannabis sector made another positive step forward as the Department of Justice (DOJ) announced its draft rule to the Federal Register on how cannabis will be a Schedule III drug on the Controlled Substances Act (CSA). Another US cannabis positive from a state market perspective, Ohio, announced that it is opening its adult use or recreational market several months earlier than anticipated. In addition, another breakthrough announcement in US cannabis when the Fund’s largest position, Green Thumb Industries (GTI) initiated discussions to merge with Boston Beer (SAM), a NYSE listed craft beer company that over the last few years has experienced less than stellar sales growth. We discuss growth rates in alcohol relative to cannabis below as some key factors driving this merger rumour. While all of these positive steps forward are taking place for US cannabis, investors are sitting on their hands, and cannabis companies continue to trade at low single digit multiples. Most MSOs in the Fund beat analyst expectations with stronger Q1-24 cash flows. We go over these points in detail and continue to state that US cannabis stocks are coiled springs that are close to springing forward with significant upside in the coming months.
Ninepoint Cannabis & Alternative Health Fund - Compounded Returns¹ as of May 31, 2024 (Series F NPP5421) | Inception Date - August 4, 2017
1M |
YTD |
3M |
6M |
1YR |
3YR |
5YR |
Inception |
|
|---|---|---|---|---|---|---|---|---|
Fund |
-16.3% |
8.0% |
-5.7% |
8.6% |
15.6% |
-18.1% |
-8.1% |
5.2% |
Equity markets have come off sharply during the latter part of May as inflation continues to be a concern for the US Federal Reserve, negatively impacting consumer spending and driving further corporate cost cutting to maintain earnings. We have seen this reflected in recent trading related to large caps such as Salesforce, DELL and MSFT while inflationary indicators continue to keep central banks on the sidelines with higher for longer interest rate policies continuing to challenge investors.
Meanwhile, in the primary sector of the Ninepoint Cannabis & Alternative Health Fund, we continue to see catalysts providing significant tailwinds for US cannabis that aren’t fully reflected in the trading values of the stocks. This month we are providing an update on the US Re-scheduling of cannabis, the facts vs the fiction. We will also look at the timeline to get to the all-important Final Rule being implemented into the National Register. Further catalysts supporting higher stock prices include state level market changes including the early opening of the Ohio adult use market and the enhanced rules regarding the opening of the Minnesota adult use cannabis market. Layered on top of these market openings are Pennsylvania and Florida, both significant medical programs that each represent billions of dollars in revenue to the operators in those markets. It is for these reasons that we strongly believe current share price valuations do not reflect the market opportunity in the coming months.
Federal Re-Scheduling of Cannabis Update:
As a reminder, President Biden requested an expeditious review of cannabis on the Controlled Substances Act (CSA) in the Fall of 2022.
August of 2023, the Department of Health & Human Services (HHS) announced its ruling that cannabis has various medical uses, is less harmful (not lethal) than other Schedule I and II substances, and has a low potential of abuse.
January 2024, HHS released the full content of its 250 page report detailing the findings of its review of cannabis for medical purposes.
April 30th, the US Department of Justice (DOJ), announced that it agrees with HHS that cannabis should be Re-Scheduled to Schedule III.
May 21st, the DOJ released its proposal to re-schedule cannabis to Schedule III in the Federal Register, officially launching a 60-day public consultation period.
This period will end on July 22nd, with the DEA committed to analyzing the comments in order to determine a final ruling. This “Final Ruling” will be published in the Federal Register. Various media sources have stated that the DEA under the direction of Attorney General Merrick Garland’s office, wants a Final Ruling by October.
Its important to review these timelines as each announcement in this recent series of events has led to reduced stigma related to cannabis, brought the sector closer to normalization, in addition to reducing a heavy tax burden related to being a Schedule I substance. During the month of May and despite all these crucial steps forward, the sector was down significantly.
What is Next & Why are Stocks Down?
The DOJ has filed the Draft Rule for Re-scheduling Cannabis to Schedule III. The White House Office of Management & Budget (OMB) has reviewed the language and has initiated the 60 day public consultation period. One aspect of the process that is causing a negative reaction is that the DEA did not affirm the HHS Schedule III proposal. The Draft Rule came from the Justice Department (DOJ). The last time the DEA reviewed cannabis was in 2016, reiterating the Schedule I classification at the time due to “lack of medical evidence”. Some investors seem to be interpreting that as being a further obstacle to overcome, however it is the Attorney General that is the decision maker in this overall process, not the DEA.
We have seen press reports suggest that given the number of submissions to the public consultation website (at time of writing approx. 8,000 submissions), it will be difficult to get the review completed based on the Attorney General’s preferred goal of October. However, analysis from cannabis data firm Headset found that 97% of the comments submitted through May 29 were in favor of the proposed regulation, while only ~3% are in favour of cannabis remaining as a Schedule 1 substance.
From a market perspective these points have not moved the needle, with continued negative pressure on stock prices.
However, when one considers the rules behind who has standing in the consultation period, the process is fairly streamlined. While there is the potential for hearings to challenge the draft rule, legal experts predict that it will be difficult for opposition to show legal standing as opponents would have to demonstrate that they are being negatively impacted by the re-scheduling of cannabis. This is an important point to consider, because if opposition has a high bar to meet, then it increases the likelihood of a quicker decision-making process. We believe that investors are misreading this next 60-90 day period, interpreting a negative and drawn out process rather than a high probability of success in short period of time. From an analysis of cash flows from various analysts covering the sector, most are not even considering passage with a 20% chance of success.
Given the progress in such a short period of time, one would think that the financial benefits would be evident supporting growth and further investment. However, since April when news broke, the cannabis index (Solactive North American Cannabis Index) is down 18.6% while the Fund was down 16.3%. Since Jan 1, just as initial rumours of the Health & Human Services (HHS) 250 page report came out supporting Schedule III, stocks are up 8.7% while the Fund is up 7.5%. (performance results to the end of May). We can go back to Aug 2023 when HHS announced its Re-scheduling, the cannabis index is +17.8% while the Fund is +16.98%.
YET catalysts continue to illustrate a stronger regulatory footing, a path to greater access to capital, reduced taxation and improved cash flow, regardless of the individual state catalysts or operational efficiencies that individual companies may possess. In this case when a rising tide should carry all ships, many boats are on the sea floor, completely disconnected from cash flow valuations in other industries. We continue to state that this is a buying opportunity.
We believe that the low valuations stem from the continued lack of institutional investors participating in the cannabis sector. While many larger funds and institutions in the US are closely watching the sector, very few are active investors due to compliance and custody concerns. This creates an opportunity for other investors to position themselves before the large players enter the market. While rescheduling does not in of itself lead to NYSE or NASDAQ listings, it makes those more likely by reducing the perceived risk.
Ohio is Opening Early
Ohio is one of the top ten most populated states in the US with 12 million residents. It has long been a coveted potential adult use market with such a large population base and what is considered an under-served medical market. Legal cannabis sales reached $484 million in 2023, well below the sales levels of states with similar populations such as Pennsylvania where state-wide sales are well over $1 billion for the most recent year. The committee responsible for establishing rules to govern Adult Use in Ohio have decided that June will mark the opening of the AU market, 3 months earlier than planned. The rules allow for incumbent operators to submit licenses beginning June 7th with initial sales set for middle of the month. Under the rules, existing medical marijuana dispensaries can apply for dual-facility licenses so they can continue to serve medical patients while adding adult locations. Retailers will be able to operate drive-thru locations, online ordering, curbside pickup and self-serve kiosks while the state has created a 10% excise tax in addition to an existing 5.75% sales tax. Also supportive of the new adult use regime is that only 9% of municipalities have objections to locating cannabis stores in their jurisdictions, paving the way for stronger sales rates. Incumbent operators are presently licensed to have 124 medical stores, and will be able to add another 80 stores based on a Level I license that holds 5 stores, adding 3 more while Level II licenses have one and can add one more. There will also be 50 social equity stores in the first phase. Of the 124 stores open right now, one-third are owned by publicly traded MSOs, and based on the additional store licensing rules will represent 80% of the projected 254 stores one year from now. Portfolio companies that have exposure to Ohio include Cresco Labs, Green Thumb Industries, and Verano Holdings each has 5 stores while Trulieve Cannabis has 2 stores.
Cannabis Consumption Overtakes Alcohol Consumption
According to a recent study published in Addiction, daily cannabis use in the U.S. has surpassed daily alcohol use. Rates of use reported to the US National Survey on Drug Use and Health show that consumption patterns between 2008 and 2022 have increased substantially when it comes to daily cannabis usage. Between 2008 and 2022, the per capita rate of reporting past-year use increased by 120%, and days of use reported per capita increased by 218%. A previous survey period review found that from 1992 there were 10 times as many daily or near daily alcohol drinkers as compared to cannabis users. However from 1992 to 2022, there was a 15-fold increase in the per capita rate of reporting daily or near daily use. In 2022, past-month cannabis consumers were almost four times as likely to report daily or near daily use (42.3% vs. 10.9%) and 7.4 times more likely to report daily use (28.2% vs. 3.8%). The study shows that many more people drink but high frequency drinking is less common relative to high frequency cannabis consumption over the last decade.
Green Thumb Industries (GTI) Merger Rumours with Boston Beer Co (SAM): Why Now and What will the NYSE do?
On Friday May 31, it was reported in the WSJ that Boston Beer (SAM), listed on the NYSE was the target of a takeover rumour involving Japanese spirits company Suntory (STBFY). Over that weekend, Ben Kovler, CEO of GTI sent the CEO of SAM a letter (leaked to X) which outlined the potential merits of a merger between SAM and GTI, with the combined entity listed on NYSE. If approved, this type of transaction would significantly improve the institutional participation in the sector by outlining a path to achieving a listing on a senior stock exchange. Putting aside the operational benefits or merits of the business combination, we believe its noteworthy to address this from the standpoint of what’s happening in US Cannabis in response to the DOJ led re-scheduling of cannabis. GTI’s approach, we feel, is opportune as the DOJ is clearly in the re-scheduling camp whereas previous Attorneys General and White House Administrations have not been overt champions of cannabis the way the Biden Administration appears in 2024. GTI has taken this opportunity to see how far regulators will bend given all the factors described above.
As stated previously, we are not outlining the potential synergies or cash flow impact of a merged SAM/GTI. What is important in this case is the interpretation of NYSE listing requirements and compliance than it is about federal law. Our view is that given the currently listed companies such as IIPR (NYSE) that can stay on NYSE, a merged GTI/SAM is at a minimum theoretically possible. So what are the implications? IIPR was allowed to list on NYSE when the DOJ was more lenient relative to current federal law vs NewLake Capital which cannot up list to NYSE. There is a grey area now as federal regulations are being relaxed. At the same time, there is the proposed merger of RIV/Cansortium that brings into question the NYSE listing of Scott’s Miracle Gro’s (SMG). SMG is a controlling shareholder of RIV, they will be structuring the merger in order to receive non-voting non-economic exchangeable shares so as to make their equity investment compliant with federal laws, simply to prevent de-listing. A convenient structural manoeuvre but it does not remove ownership of a federally illegal business. At the same time, Canopy Growth (CGC) listed on NASDAQ has closed on its various US cannabis transactions, acquiring Wana and Jetty while it is also exercising its option to acquire Acreage. To our team, these transactions are testing the resolve of regulators while the DOJ goes through the re-scheduling process. To us, this is only the first attempt at testing the resolve of regulators as the cannabis industry becomes more mainstream.
Q1-24 Financial Results
With all the positive regulatory changes and catalysts taking place in the US cannabis space, investors have not paid attention to the stronger than anticipated financial results that many of the Fund’s leading portfolio companies have achieved in Q1-24. Multi-State Operators (MSO’s) generally posted strong results in Q1/24, with many companies in the portfolio beating analyst estimates on both margins and cash flows. Green Thumb Industries (GTI) the Funds largest position beat both revenue and adj. EBITDA estimates, with Q1 revenue up 11% YoY to $276 million. Gross profit for the first quarter was $144.9 million or 52.5% compared to 50.2% of revenue in Q1-23. Adjusted EBITDA of $91 million or 33% of revenue increased 19% over the prior year period. Finally GAAP net income for Q1 was $31 million or $0.13 per share increasing 240% year-over-year. With its exposure to new and future adult use markets including Ohio, Minnesota, Florida and Pennsylvania, along with a strong balance sheet and ample cash for growth into these markets, GTI continues to be the bellwether for US cannabis.
Another Top holding is Trulieve Cannabis (TRUL) that also beat analyst estimates and provided strong Q2/24 guidance above consensus. Q1/24 revenues were $298 million (+4% QoQ) well ahead of consensus $285 million while strong gross margins at 58% assisted in the generation of adjusted EBITDA of $106 million, representing a 36% margin above consensus $83 million. Key to TRUL margin enhancement is a new loyalty program that has translated into both traffic and basket size increases, all combining to provide cash flow from operations of $139 million and free cash flow of $124 million. The company operates 196 retail locations and over 4 million square feet of cultivation and processing capacity in the United States. Again with exposure to potential adult use market openings in Pennsylvania and Florida, there is significant upside near term.
Another key portfolio company to highlight this month is TerrAscend (TSND). One of the keys to growth for this focussed 5 state operator is its ability to transact accretive acquisitions just as new markets come on. Last year it was Maryland, this year we anticipate expansion into Ohio while a broadening of other existing state markets are possible. Revenue reached $80.6 million, which was an increase of 16.1% YoY led by wholesale growth of 92% in New Jersey and 80% growth in Pennsylvania. Adjusted EBITDA from continuing operations was $16.2 million, compared to $12.2 million in Q1 2023, which also represents a significant increase of 33.0% year-over-year.
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 |
41.0% |
Standard Deviation |
27.3% |
Sharpe Ratio |
0.08 |