This week, Green Thumb Industries (GTBIF) kicked off a busy stretch of fourth-quarter and end-of-year earnings releases from cannabis companies.
Several announcements have already been released from marijuana stocks that are of less interest due to poor management, balance sheets, capital allocation and business strategy. Those reports have come and gone, primarily forgotten about or noted negatively for continuing with behaviors likely to be punitive to shareholders.
Plenty of ink has already been spilled covering the negativity there, but it reminds us of a quote from the 2022 Berkshire Hathaway Annual Report that was released on Feb. 25, 2023:
"Don't bail away in a sinking boat if you can swim to one that is seaworthy."
With that in mind, let's focus on a few observations from Poseidon's desk through this earnings season.
Green Thumb Industries Q4 earnings, by the numbers
This past week, Green Thumb Industries got earnings for multi-state operators (MSOs) rolling. GTI beat fourth-quarter revenue estimates largely on the back of the legalization of recreational cannabis in New Jersey. The Garden State is poised to become one of the largest recreational cannabis markets on the East Coast.
The total revenue reported by Green Thumb Industries was $259.3 million, up 6.4% year-over-year. The topline revenue number was a bit ahead of consensus, while gross margins were below expectations. Still, Green Thumb's continued execution and cost controls drove a slight beat on EBITDA (earnings before interest, taxes, depreciation and amortization).
There was noise around wholesale price compression as a primary driver impacting gross margins, but it's worth noting how decreased pricing drove comparable sales improvement in the mid-single-digit range. This is a cannabis trend to watch for: As prices decline across various markets, volumes often offset a net revenue decline as the industry takes share from the illicit market.
Green Thumb Industries noted that they continue to focus on gross margins over longer periods. In the near term, they are targeting operating expense efficiencies to continue improving their cash-generative capability and balance sheet. Unfortunately, some U.S. operators repeated Canada's mistakes by building too much capacity, but high-quality teams like GTI are proving more capable of managing through. The management team specifically mentioned how they monitor individual markets (i.e., states) for capital expenditures. They aim to avoid markets that see overspending as it's a likely indicator of coming price declines.
It's also important to note the goodwill write-down Green Thumb Industries took, which had some one-time implications on the results. We expect to see many others do the same, and likely to a larger extent, given the preponderance of M&A around the last cycle's peak, along with higher prices and increased transactions. GTI has largely remained steadfast, steering its own course without getting duped by FOMO (fear of missing out). We'll close MSO earnings observations with another great quote from the Berkshire Hathaway letter:
"The weeds wither away in significance as the flowers bloom. Over time, it takes just a few winners to work wonders."
Innovative Industrial Properties earnings highlight struggles in cannabis industry
In comparison to GTI's thoughtful capital management, Innovative Industrial Properties (IIPR), the leading real estate lender for the cannabis industry, reported results highlighting how some of its borrowers are struggling to pay bills due to overbuilding capacity while taking on expensive lease structures.
Due to the combination of capital drought, price compression and unsustainable lease rates, rent collection on the IIPR's portfolio slipped to 92% at the end of February compared to 97% for all of 2022. While leverage is not an issue for the company and liquidity remains comfortable, the annual filings reflect a stark difference in operating performance among cannabis operators. Where some operators appear to be quickly approaching insolvency, others are producing tens of millions in quarterly cash flows.
The earnings reports from both GTI and IIPR are indications of the greater trends we expect to see from all operators in the industry. There were other earnings out this week from RIV Capital (CNPOF), MariMed (MRMD) and Grown Rogue (GRUSF). Those were not covered in this week's column given the depth of the discussion, but we wanted to point those out for our loyal weekly readers.
What to watch for in cannabis earnings this year
Price compression will continue as a consistent topic. We monitor this closely, leveraging the most detailed insights from data providers like Headset. Although consensus predictions from 2023 will be for continued compression, it's unlikely that management teams discuss how deep cuts to capital expenditures and limited investment capital across the industry could provide indications of price stabilization by Q3 or Q4.
This year, cash flow will be the top priority for every major cannabis company. Cash flow is generally the only path for companies to avoid either highly dilutive financing or consolidation within a stronger-performing peer. We expect to see capital expenditures decline dramatically, as well as cuts made across all operating expenses from lease rates to labor.
Finally, balance sheets will be another trending topic, as the liquidity of firms will be the leading indicator of their ability to survive in this environment. Cash balance and inventory levels will be highlighted as liquidity sources, and tax management and strategy will also be crucial to help avoid investor concerns about liabilities to lenders who rarely negotiate.
Predictions for the next cycle of cannabis M&A
We foresee a healthy phase for cannabis and a unique opportunity for investors. Throughout the COVID-19 pandemic, the U.S. cannabis industry had massive inflows of investment capital with minimal concern towards underwriting. This led to a state in which operators would be forced to focus on cash flow generation for their liquidity needs. That dynamic made it difficult for fundamentally driven cannabis investors to reflect alpha in their strategy as the rising tide lifted all boats. Even worse, when the tide went out, all boats were beached, regardless of who was seaworthy.
As investors that are actively allocating in this operationally focused stage of the industry, we continue to gain a stronger sense of which companies will be consolidators in a challenging environment. Currently, there are fewer dollars buying more equity with arguably less risk than ever before. Businesses that were poor capital allocators and disregarded operational acumen will fall by the wayside. The future leaders of the cannabis industry will take market share from fallen peers and the illicit market and then generate cash for liquidity needs, all while valuations stay dormant amid limited updates on federal cannabis legalization and other policies.
There are countless catalysts that could cause a positive reset in the valuations to compare more efficiently to peers in CPG or alcohol. In the meantime, we have the opportunity to allocate towards cash-flowing businesses in a global, secular growth industry, with the prospects of these companies becoming multi-generational incumbents of a $100 billion area of the market.
Morgan Paxhia is Managing Director and Co-Founder of Poseidon Investment Management. With over 10 years experience in investing and finance, Morgan has developed a deep understanding of individual company analysis, portfolio construction, and risk mitigation. This content is not intended to provide any investment, financial, legal, regulatory, accounting, tax or similar advice, and nothing should be construed as a recommendation by Poseidon Investment Management, LLC, its affiliates, or any third party, to acquire or dispose of any investment or security, or to engage in any investment strategy or transaction. An investment in any strategy involves a high degree of risk and there is always the possibility of loss, including the loss of principal. This content should not be considered as an offer or solicitation to purchase or sell securities or other services. Any of the securities identified and described herein are for illustrative purposes only. Their selection was based upon nonperformance-based objective criteria. The content presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. Past performance is not indicative of future results.
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