Cannabis now and where it goes next
Cannabis sales in the US are continuing their run of impressive growth.
Sales hit $30 billion in 2022, and by New Frontier Data’s account they will reach between $58 billion and $70 billion by 2030 depending on the pace of legal reform. Legal cannabis is still expanding its geographical footprint as it is enthusiastically embraced by the American public. This scenario led cannabis investors to begin 2023 with some optimism, with a dose of caution stirred in given the terrible 2022. As we pass the halfway mark of 2023, it’s time to take a look at how things are going. In this article we look at current conditions and trends, and see how we might approach investing in the sector from this point forward. The focus is on the United States.
Current conditions for cannabis: macro
Discussion must start with macroeconomic conditions in the US economy, which could be the dominant factor in US commerce over the next 12-24 months. Looming above all is what in this writer’s view is the high probability of a national recession. Almost every reliable indicator is signaling a recession is imminent. One of the most glaring is the inverted yield curve, shown in the chart below, which with few exceptions has preceded every recession for decades. Note where the data points are in relation to the shaded areas, which indicate recessions.
Leading economic indicators [LEI], are another reliable measure predicting recession. The pattern goes back further than this chart of 2000-2023.
Eleven out of the last 12 recessions were preceded by a multi-year decline in unemployment.
Numerous other indicators seem to be signaling recession -- these are three of the most powerful. A recession will make operating in the difficult cannabis sector more difficult. Even if we are not now in recession, the non-trivial probability of one in the future is enough to suppress investor participation (and stock prices) in cannabis.
Cannabis industry conditions
Doug Francis, Executive Chair of WM Technology (MAPS) , summed up industry conditions well in the Q4 2022 earnings call (WM Technology, formerly Weedmaps, was one of the first companies in the cannabis marketing and compliance niche):
The cannabis industry is facing additional headwinds as we deal with over regulation, the slow rollout of new licenses across the country, a lack of government support combined with high taxes from all levels of government, commoditization of cannabis products, frozen capital markets, limited access to banking, and a thriving black market.
We see these conditions in the Q1 2023 company earnings reports. Losses were widespread, as shown in this table and chart eight widely held companies: Ayr Wellness (OTCQX:AYRWF), Cresco Labs (OTCQX:CRLBF), Curaleaf Holdings (OTCPK:CURLF), Green Thumb Industries (OTCQX:GTBIF), SNDL (SNDL), TerrAscend (OTCQX:TSNDF), Trulieve Cannabis (OTCQX:TCNNF), and Verano Holdings (OTCQX:VRNOF).
According to Whitney Economics, a leading cannabis economics data and research firm, less than 25% of cannabis operators in the U.S. report that they are profitable, which is down from 42% the previous year.
Over the past few years, many companies explicitly stated the goal of becoming cash flow positive. Positive cash flow is essential to success. There’s no survival if you don’t have more money coming in than going out. Operational cash flow, which excludes cash raised by financing and spent on investing, is a strong indicator of how well the business is being run. First quarter 2023 showed progress in this area, as shown in the chart below.
In first quarter 2023, numerous companies reported they would be cutting back on investment expenses after several years of high expenditures for growth initiatives. Growth campaigns are nearing completion, and in any case raising money has become difficult. The following table shows the cash flow from investing activities from Seeking Alpha cash flow data for Q1 2023 vs. Q1 2022. The lower expenditures for 2023 are clear.
In Q4 2022 there were large charges for what Seeking Alpha calls “Asset Writedowns and Restructuring Costs.” Thankfully, these costs were negligible in Q1 2023, and we probably won’t see many until Q4 as companies typically defer them during the year and declare them in the fourth quarter.
What’s happening in the trenches
Quarterly reports by public cannabis companies are useful, but what’s behind these results down at ground level? How is cannabis doing on the everyday front line?
Companies are going out of business: While the big public companies are still extant, other companies are going bankrupt (I use the term “bankruptcy” because it is the familiar term for financial failure. Cannabis companies can’t use the legal bankruptcy process because they are federally illegal). Readers of MJBizDaily frequently see stories like this one: Big California marijuana distributor Herbl collapses, brands left unpaid, sources say Herbl, had $700 million in revenue last year. One of the major reasons was customers who didn’t pay their bills to Herbl, illustrating the poor state of cannabis retail.
Companies are finally pulling back from money-losing operations: Industry leader Curaleaf announced in January that they are winding down all operations in California, Colorado and Oregon. Ayr Wellness is leaving Arizona, which is one of the three states they originally operated in. Aurora (ACB) has sold numerous assets over the last two years, most recently its second in Denmark. Canopy (CGC) has completely exited retail. There are numerous other examples. Retrenchment is normal in the progression of a new industry, but it’s quite a contrast to previous years when such things were unheard of. Investors need to assess what these moves mean for each company.
Layoffs are piling up: Layoffs are predicted to continue into 2024. This is not a sign of a healthy industry.
Prices are collapsing: The decline in wholesale prices for cannabis has been breathtaking. Prices are down 51% in Colorado, 36% in Massachusetts, 46% in Missouri. In Michigan, prices have gone from $400 to $100 an ounce, a drop of 75%. This is the natural result of overproduction. Prices will rebound, but their collapse can be a crisis for companies whose business was predicated on much higher prices.
Legislative and regulatory progress is slow: Cannabis legalization has had a remarkable record of success on ballot initiatives, but in the November midterms multiple ballot measures failed for the first time (North Dakota, South Dakota, and Arkansas). Oklahoma rejected adult use in March. Regulators in places like New York and California continue to make life difficult for cannabis entrepreneurs. In other states, such as Virginia and Florida, officials opposed to already enacted cannabis legislation are dragging out implementation.
Less coverage by Wall Street: Fewer research analysts covering cannabis is another part of industry woes , MJBizDaily’s Kate Robertson, reports that Cantor Fitzgerald, Cowen, and BTIG have all stopped coverage of the industry. Readers may remember the top quality research notes on SA by Jon DeCourcey, who was with BTIG. Jon is now reportedly the head of investor relations at Ayr Wellness. The number of analysts participating in quarterly earnings calls has gotten embarrassingly low.
Some sunshine and rainbows
The state of cannabis is not all bad. Access is still expanding in more states than not, with progress in Delaware, Hawaii, New Hampshire, Minnesota, Nevada, Maryland, Missouri, and others. SAFE banking is back on the Congressional agenda, although its prospects are uncertain at best. The adult use referendum in Florida, if allowed on the ballot, will be a huge boon to the industry.
The industry continues to grow by leaps and bounds. Revenue passed $30 billion in 2022 and is still expected to grow at a 12-15% CAGR through most of the decade. The ex-North America trade is just getting started. In addition, as shown in the tables above, cash flow and capex trends are moving in the right direction, .
What to expect in 2H 2023
We can look for performance similar to 1H 2023 as the forces above take time to play out. Stock prices will wander around current levels. There may be some pops in individual names if a Q2, Q3 or Q4 report has a big upside surprise, but investors have learned such price moves are usually transient.
Investors should be alert, though, to events that could signal a sizable and possibly durable improvement in conditions and stock prices. SAFE banking is one known possibility, progress on federal de-scheduling is another, or an unexpected development might occur that's not presently on investors’ radar (recall that Biden’s announcement to study legalization issues was a surprise to everyone). There are many federal agencies that are involved in cannabis' future. The odds may be long, but the possibility must be considered.
We must also consider the possibility of an unknown negative development. One possibility is a federal court decision striking down state laws preventing interstate commerce in cannabis (known as the “dormant commerce clause”). If this happens, cultivators would be free to sell product across state lines. This would upend business models, creating a new set of winners and losers as states with the best growing environments would flood other states and strand cultivation assets across the country. What are the states with the best cultivation environments? Opinions may differ, but Asana Recovery offers five for consideration:
- Northern California
- Washington
- Oregon
- Maine
- Florida
Cannabis in 2024 and beyond
From the time I started writing on cannabis in 2019 I have said that it is a generational opportunity, the success of the industry is inevitable, and that it is a long term investment. All three of these things are still true. It’s inconceivable that an industry that may reach $70 billion in revenue by the end of the decade will still be limping along with few players eking out profits and many flirting with bankruptcy. We are experiencing the normal maturation process of any new industry. I am also certain that down the road the industry landscape will be very different. The way to profits will become known, weak companies disappear, and a small number of successful companies begin to dominate. Those companies could come from outside the industry.
The investors who reap the rewards are those who have a tolerance for uncertainty and patience beyond the average person’s time horizon. They must be able to ignore the commentary from “I told you so” people who point to the current plight of cannabis stocks as if nothing will change. The industry has some very dynamic, talented leaders who have the ability to guide their companies successfully through the present troubled times.
Investment Recommendations for Cannabis
Those who invested at much higher prices can continue holding in anticipation of an eventual industry recovery. If your loss is already 80%, for example, the dollar amount of further losses is likely minimal. The exception is that weaker names should be jettisoned from the portfolio, because bankruptcies are part of the future. In a risky sector this is one way we can reduce risk.
Investors wanting to allocate new money to cannabis should likewise concentrate on the stronger companies. Under the present conditions of elevated risk it makes no sense to invest in a company whose long term survival is in doubt. Size matters, cash flow matters, financial strength matters. Companies meriting consideration include Green Thumb, Verano, Trulieve, and perhaps a few special situations like MariMed (OTCQX:MRMD).
Summing up
Conditions for cannabis companies, and investors, have been poor for some time, and most likely will continue that way for the rest of 2023. We are in a very uncomfortable phase of the development of the industry, and the irrationally exuberant days of 2020 and 2021 are now history. But the industry is not frozen at this point in time; the process of change will continue.
We can predict a few things about the future of the cannabis industry. First, it will continue its powerful growth trend. Second, it will look different than it does today. Third, there will be winners and losers. There are actions we can take based on these facts: Be patient, stay invested, accept volatility, concentrate on quality. By doing these things, we can improve our chance for success in this challenging industry that is so full of potential.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
