PROHIBITION IS EXPENSIVE: SIT OR GET OFF THE “POT”

Many cannabis businesses are struggling, though not all the blame resides in faulty management decisions. In this edition of “The GreenWave Buzz,” we highlight the added costs of federal prohibition and discuss other risk factors that may cause near term volatility for both public and private valuations, giving particular attention to the tax burden associated with Section 280E of the IRS code: 

  • The 8 publicly held MSOs that we reviewed from Q1:18 – Q3:19 (1)  have collectively incurred net losses of ~$(542)M but have recognized income tax provisions (current portion) of $135M and of this amount only ~$77M has been paid through Q3:19.   (1) MedMen limited to  FYE 6/30/19
  • Assuming the full benefit associated with a Net Operating Loss (NOL) carryforward is disallowed by the IRS, ~ $114M would be the potential amount in lost federal tax credits.
  • MedMen’s FYE (June 30) 2018 and 2019 income taxes payable total ~$17M and, based upon our analysis of its financial disclosures, remain unpaid as of 9/30. 

While regulatory uncertainty continues to loom, current valuations may provide an attractive risk/reward profile for investors with an undefined time horizon, able to “sit” patiently until federal laws are modified.  When the added costs of prohibition are no longer necessary, businesses will be better able to generate meaningful free cash flows, become less dependent upon outside sources of capital and ultimately garner higher valuations, in our view. 

Subsequent to the implementation of the first recreational use cannabis market in Colorado (January, 2014), entrepreneurs and investors were enthusiastically intoxicated by the perceived prospects of “once in a lifetime” opportunities.

With the progression of individual state cannabis approvals, augmented with the end of prohibition in Canada, there has emerged a growing pool of investors interested in the U.S. cannabis industry. This interest has been further inspired by the U.S. Federal Government’s heretofore reluctance to aggressively interfere with individual state permissions. 

Nonetheless, government inefficiencies in some cases, has resulted in insurmountable challenges for public and privately held cannabis companies in executing their business plans and meeting expectations.  The recent antitrust scrutiny of the larger M&A deals by the DoJ is one such example that is seemingly nonsensical given that cannabis remains illegal under federal law. 

In May, 2018, a sense of public market “readiness” was triggered when MedMen established itself as the first Multi-state Operator (MSO) to engineer a public market offering on the Canadian Stock Exchange (CSE), and touted itself as the first “cannabis unicorn.”  This apparent paradigm shift encouraged many other MSOs to rush for a listing on the CSE.

After the initial euphoria of runaway equity prices, most companies experienced a series of revenue/earnings misses and other widely publicized issues of concern (including the “Vape Crisis”), the MJIC Index fell ~ 40% since its peak in April 2019 vs a gain of ~10% in the S&P 500.  The precipitous decline relative to the broader market could, in some instances, be attributed to a general “un-readiness” by management teams lacking the experience necessary to run a publicly held company. Furthermore, in our view, the industry has generally not been able to attract the depth of talent that would otherwise be necessary to support a fully functioning executive team — one obvious reason for this may be a perceived stigma of working for a business that remains federally illegal.

Additionally, the complexity of the U.S. cannabis industry has been exacerbated by the consequences of states operating within the confines of closed economies that strive for their own interpretations of legitimacy under the shadow of existing federal laws. This variation of standards from one state to another carries an inherent uncertainty for businesses and investors with respect to how the industry will operate subsequent to the delisting or reclassification of cannabis as legal standards evolve. 

Legalization may have been somewhat predictable in some of the liberal minded western states but the growth extrapolations that we previously assumed would catapult the industry nationwide have undervalued the nuances of regional politics and the ability of opposition forces to bog down the clarity of regulatory reforms.  The notion that a few states would lead with “best practices” for others to follow simply did not materialize.   

We have previously provided a medium term industry outlook over 5 years predicated upon an estimated trajectory of new states legalizing cannabis.  As the structures of current laws are not conducive to industry growth and sustainability, we believe it only practical to assume that federal legalization occurs within 3-5 years – to point to a projection in 5 years that is based upon the status quo is not meaningful in our view.   Going into 2020, our visibility is clearer and we expect a meaningful revenue ramp as newly established state markets are implemented (preliminary estimates +58% YoY ~ $12B ’19 to ~$19B 2020). 

The cost of federal prohibition is expensive and continues to erode cash flows at a time when sources of capital are increasingly more difficult to access.   This, coupled with the ongoing top line pressure from a robust illicit market, among other factors, has brought into question the forward-moving abilities of many companies to remain viable.  Compounding these concerns is the lack of bankruptcy protection afforded to these business due to the federal illegality of cannabis. 

Despite these headwinds, we remain bullish on the long term prospects of the industry, and passage of the SAFE Act this year could serve as the catalyst necessary to shift investor sentiment in a more favorable direction.  

Ultimately, patient investors will be rewarded, in our view, but continued volatility into this year may persist due to the following circumstances and other risk factors associated with prohibition:

  1. The Excessive Tax Burden of Section 280E and Loss of Net Operating Loss (NOL) Carryforwards. As a reminder, Section 280E of the Internal Revenue Code forbids businesses from deducting ordinary business expenses from gross income associated with the “trafficking” of Schedule I or II substances, as defined by the Controlled Substances Act.  This rule applies to state-legal cannabis businesses, since cannabis remains classified as a Schedule I substance. However, businesses are generally permitted to deduct the cost of goods sold from revenues which can include certain allocated overhead expenses. Consequently, plant touching cannabis businesses pay taxes even if operating at a net loss and many of the “280E workarounds” are also costly and rely on opaque structuring further challenging investors.  Additionally, the tax benefit of these operating loss carryforwards is generally not permitted to offset income in subsequent years. Given that many MSOs have recently gone public, there are now financial disclosures available from which we were able to analyze and quantify the impact of 280E (we limited our scope to those with a market cap >$500M with the exception of MedMen).  As we illustrate in Table 1, for calendar year 2018, there were only 3 companies that were profitable. The effective tax rates ranged from 30% to 59%.

Table 1: 2018 – Profitable MSOs Effective Tax Rates

2018 – Profitable MSOs Effective Tax Rates

NOTE: The corporate tax rate is a flat 21% and while there is variation among state rates, we assume an average of 8%. As indicated in the about chart, the MSOs that have operated at a profit in FYE 2018 have effective tax rates that are in excess of a blended 29%. The determination of each MSO’s tax provision is highly complex due to the magnitude variables, including but not limited to, the jurisdiction (differing tax rates) and type of operation (fully integrated, retail etc). Also we note that some states in which cannabis is legal do not impose Section 280E for state tax purposes while some MSOs are also subject to Canadian income taxes.

As illustrated in Table 2, the remaining MSOs have operated at a net loss in FYE 2018 and  quantify a “back of the envelope” potential tax credits from these losses that would otherwise likely be permitted to some extent if Section 280E was not in effect (net loss multiplied by 21% corporate tax rate).  Due to the complexity of income tax accounting rules, we determine the effective tax rates based upon the total tax provision (current and deferred).

Table 2: Tax Provision for Cannabis Companies with a Net Loss FYE 2018

Tax Provision for Cannabis Companies with a Net Loss FYE 2018

The story for the first 9 months of 2019 is a bit different. As shown in Table 3, all the MSOs have incurred losses with the exception of Trulieve which has earned a profit due to a $218M unrealized gain associated with the change in fair value of its biological assets (required under IFRS).  Excluding this gain, the company would also be in the red. We again highlight the potential lost NOL tax credits for each of these companies. Note: MedMen excluded from YTD Q3 2019 as its FYE is June 30. 

Table 3: Tax Provision for Cannabis Companies with a Net Loss YTD Q3 2019

The following illustrates income taxes paid in 2019 ($55M) that presumably, pertain mostly to the 2018 tax provisions (current portion $63M).  Note that from Q1:18 through Q3:19 total current provisions reached ~$135M with ~ $77M paid as of the end of Q3:19. 

Table 4: Tax Provisions vs Taxes Paid

Table 4: Tax Provisions vs Taxes Paid

In the case of Cresco Labs, the current income taxes payable at the end of Q3 was reported at $10.7M (2018 and YTD Q3 2019 liability). Due to the “evolving interpretations of Section 280E” as permitted under IFRIC 23, “Uncertainty over Income Tax Treatments,” the company will wait for a final determination by the IRS before it makes payment. Also we note that based upon our review of MedMen’s financial disclosures, it appears that  ~ $17 M is owed as of 6/30/19 for FYE ’18 and ’19.

Table 5: Reconciliation of MedMen’s Income Tax Liability ($millions)

Table 5: Reconciliation of MedMen’s Income Tax Liability ($millions)

2. Accounting for 280E is complex, costly and likely subject to a wave of IRS audits. There are added costs to maintain separate books and records as well as complexities in tax preparation.The methodology for expense allocations to cost of goods sold can be ambiguous with some firms likely more aggressive than others in its accounting.   In addition to the highly publicized audit of Harborside (280E deductions were questioned), we think it is entirely plausible that more IRS reviews are in the pipeline and those firms that are stretched for cash may find difficulty footing the bill for any additional tax liabilities (plus penalties).

3. Banking is Restricted and Operating in All Cash is Costly. Those cannabis businesses that are not able to maintain bank accounts (see our report, “Navigating the Shoals of Cannabis Banking” for further commentary/analysis on this topic) require more robust internal controls with added security. While we cannot quantify these costs precisely, for any business operating at a loss or are cash flow negative, these expenses are material. 

4. Continued Losses in Restrictive Medical Markets in Anticipation of Exercising a “call option” on the Conversion to Recreational Use. In the early stages of the industry’s growth, the appeal of “first mover” in a limited license medical marijuana state, has largely been predicated upon the perceived “first right” for license conversion that would at some future point, permit serving a more lucrative, recreational use marketplace.   With ongoing state regulatory changes in limbo and restrictions in allowable form factors (i.e. capsule only etc) an illicit market has continued to thrive.   

Consequently, we believe losses in some markets will continue until restrictions are further eased and/or recreational use is legalized. A good example is New York State, and in particular, Manhattan, in which medical marijuana licenses are highly coveted. With limitations on allowable form factors (among other challenges) and high operating costs, these storefronts are likely losing money but the silver lining remains in the conversion to recreational use. Bloomfield Industries is a clear example that was not able to sustain its losses after winning one of the five original licenses in New York State. In January, 2016 it announced its sale (at a distressed valuation) to MedMen.

Other Risks to Consider:

The Potential for Dilution as Each State Looks to Expand the Number of Licenses Issued. In some limited license states, we have seen a steady increase in the number of license awards, i.e. New York State and Florida. These regulatory moves result in dilution to existing business owners which could continue as each state continues to evaluate the profitability and effectiveness of its legal cannabis market.

How the Industry will be Regulated Once Prohibition Ends. Even if Prohibition were to end tomorrow, uncertainly remains as to how the industry will be regulated and under what timeframe. A business that may appear as a sound investment today, may not be permitted to operate in the same capacity tomorrow, if at all. Also, the rescheduling of hemp may prove a cautionary tale as many companies remain in limbo awaiting rulings from various regulatory agencies.

Disclaimers
The Controlled Substances Act regulates, among other things, the cultivation, possession and distribution of certain controlled substances, including Cannabis and Marijuana which are illegal under federal law and in many states. This is true whether or not it is possessed for qualifying medical conditions, as provided for in certain state medical marijuana laws or if it is possessed within the few states that permit non-medicinal Adult (Recreational) Use.

There is nothing in this briefing written to offer any legal advice or to suggest any actions or choices the reader may make regarding participation in this industry or in any of the businesses discussed. 

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