Posted in Cannabis Buisness

Acreage Holdings: The Best Investment In The Cannabis Space

 Posted by  Posted on November 24, 2019

All marijuana investments are speculative due to it being a new product category and the uncertainty of worldwide adoption. However, once you have decided you want to have an investment in the cannabis space, I don’t think you can do much better than Acreage Holdings (OTCQX:ACRGF, ACRG-U).

Q3 Earnings:

Acreage Holdings (ACRG-U , OTCQX:ACRGF) reported earnings November 12th after hours and held a conference call and presentation the following morning. Revenue grew 307% this quarter ($22.4 million) vs. the same quarter previous year (15% growth Q2 to Q3). Gross margin improved to 41% from the 34-38% it was running in prior quarters. Revenue and margins are, and will continue to be, mainly driven by expansion of Acreages physical store locations and progress in the product lines it offers. EBITDA was a loss of $44.6 million with $31.1 million of that coming from equity-based compensation alone. This equity-based compensation is ridiculously high and honestly a valid reason not to invest. My thought (hope?) is Constellations (STZ) oversight will eventually bring this down to a more reasonable level but for now they are running under old contracts and agreements that include inappropriately high compensation.

Warning High Risk:

Given ongoing expenses to support high growth plans including the buildout of more locations and products, Acreage is very unlikely to be cash flow, EBITDA, or earnings positive any time soon. I don’t expect it in Q4, in 2020 under GAAP accounting (>50% of shareholders are now US citizens), nor in 2021. Amazon didn’t make an annual profit for its first 7 years and wasn’t consistently profitable on a quarterly basis for at least 10 (some would argue 18 years). These are volatile, long-term, highly speculative, paradigm shift type investments. We can only hope Canopy-Acreage will dominate the world of cannabis in a scale similar to how Amazon has dominated the internet. Eventually, I think they will.

Fundamental analysis cannot support investing in Canopy-Acreage nor really any cannabis stock, so you should not invest money you cannot afford to lose in this sector. Cannabis and hemp derived products may eventually become a $250 billion+ revenue business worldwide with Canopy-Acreage owning maybe 25%+ of that; however, that is just speculation on my part. Ultimately investing here requires a hand waving leap of faith. You either understand and buy into cannabis and hemp derived products having a major place in our society, or you don’t. Further coverage of this important subject is beyond the scope of this article but for those interested I encourage you to read, “Canopy’s Moat: Powered By ebbu”. This article will explain to you why I think Canopy-Acreage has such an advantage in the sector, as well as an idea of the overall sector potential.

In addition to having read that article, a further assumption I am explicitly making here is Acreage (ACRG-U) and Canopy (OTC:CGC) will eventually become one entity. Though the merger deal between Acreage and Canopy has been called an option by many, that is a misnomer. It is actually a contractual commitment signed and approved by all entities involved. Canopy MUST complete the merger if cannabis becomes federally legal in the US. If you have any doubt about this aspect, I also suggest you listen to this CFO Roundtable discussion between the CFO’s of Constellation, Canopy, and Acreage. It both makes it clear the deal is a commitment and further talks about the opportunity presented by this merger.

If after having read this article, listened to this roundtable, and done your own further research you still don’t think cannabis will become federally legal in the US sometime in the next 6 years, I encourage you not to invest in this space. Continued progress in US cannabis legalization is essential to the premise (more on this later), without US legalization many if not all cannabis firms will likely go bankrupt. Thus, it boils down to an opinion that potential cannabis investors either should own at least some shares in Canopy-Acreage, via ACRG-U, or not invest in the space at all. I can’t be much clearer than that.

I however should also point out Acreage and Canopy CAN and likely would complete the merger prior to full legalization. It’s in Canopy’s best interest to complete this merger and further its dominance of North American cannabis as soon as it can legally do so (without endangering its US listing, access to capital, etc.). This should happen with passage of the States Act (depending on the ultimate wording), but that law is now deemed unlikely to pass prior to the US Presidential election (again more on this later). The States Act has significant bipartisan and voter support as does full legalization (see MORE Act), but full passage during a Presidential cycle is unlikely. In the meantime, there are other potential drivers for Acreage that should be considered. Note the least of these is improved access to capital and the progress that can support. Unlike many firms in this US cannabis industry, Acreage is likely to continue to have enough access to capital to support their near-term buildout needs.

Locations and Funding:

Acreage is expected to have 35 – 40 retail locations and 15+ wholesale locations open in 20 different states by year end.

Source: Company Presentation

The REIT, GreenAcreage, has now been formed with management indicating it has access to $140 million worth of funding. To date $44 million worth of this funding has been committed to supporting existing Acreage buildouts plans in Florida, Illinois, and other states. More will likely be provided as needed. Additionally, once the SAFE Banking Act passes, I expect Acreage via its ties with Canopy, to be able to access reasonably priced debt from major international banking firms. In this morning’s conference call Acreage management indicated preliminary contacts and discussions were already in progress.

Meanwhile, the SAFE Act has also already passed the House by a vote of 321 to 103 and is predicted to be attached to some other Senate funding bill by end of Q1 2020 and passed. The President is expected to sign the bill, having already said he would support the more controversial States Act, much less a bipartisan supported SAFE Act. This bank-based cannabis lending bill would likely enable funding of the non-real estate related intermediate expansion needs of Acreage. Furthermore, if Canopy can legally provide a guarantee for these funds, I would expect low, highly advantageous interest rates. If not, we are likely looking at somewhat smaller loans with high single digit rates.

Products:

On the product development front, Acreage indicates Botanist will remain its primary medical brand, while Tweed will become its primary recreational brand. In addition, Acreage has a wholesale brand called Prime which is doing very well in Pennsylvania and I’m guessing may be utilized more extensively. Canopy and Acreage have both indicated their will also be a low-priced brand, but we don’t have a name yet. Within these brands Canopy-Acreage will offer a wide range of different cannabis derived products—raw bud, oils, sprays, sub-lingual, drops, chews and other edibles, vape, beverages, etc. However, I suspect the logistical challenges of beverages combined with an inability to transport across state lines will limit US beverage expansion at first. Building a bottling plant and means of distribution for beverages is an expensive endeavor that requires critical mass to become practical. Better to start in Canada, get the kinks out, and then eventually roll into the larger US states. Importantly, many of the cannabis derived products are not only going to be trademarked but will also have patent supported active ingredients designed for specific outcomes. Again I highly suggest you read, “Canopy’s Moat: Powered By ebbu” to better understand why I think trademarked products utilizing patented processes and cannabis derived ingredients so key to Acreage-Canopy-Constellations long term success.

Potential Drivers:

  1. Vaping Crisis: Yes, the vaping crisis is a positive driver for Acreage-Canopy-Constellation (and Chronos-Juul-Altria who I would put second behind Acreage-Canopy-Constellation). Like alcohol during prohibition, cannabis usage and vaping isn’t going away. Thus, what the vaping crisis really does is simultaneously encourage both regulated, taxed vape and a crackdown on bootleg vape. It also helps lead to further research into the issue and encourages full legalization in the US. There is precedence for this. When alcohol was illegal in the US people getting sick or going blind from consuming bad product, as well as the crime supported by illegal sources of “moonshine”, ultimately led to the end of prohibition. As a result, large firms able to maneuver the regulatory landscape such as: Anheuser-Busch InBev (BUD), Diageo (DEO) and Brown-Forman (BF-B) came to dominate the industry. Thus, the vaping crisis while tragic, is likely to end up being a positive driver for these firms over the long run. It highly favors firms such as Acreage – Canopy, and Chronos (OTC:CRON) – Altria (MO) that have the resources to jump regulatory hurdles while simultaneously limiting competition. This is likely one reason why Acreage-Canopy openly encourages such regulation.
  2. SAFE Banking Act: The SAFE Banking Act has been passed by the House and is expected to be attached to another bill and submitted to the Senate during Q1 2019. It has bipartisan support; however, so far Majority Leader McConnell has prevented it from coming up for an independent vote. By attaching it to another bill Mr. McConnell wants passed, it is thought likely the industry will be able to work around this hurdle. Passage would benefit all cannabis firms by allowing them access to banking and their customer’s usage of credit cards. However, it probably helps Acreage more than most because with Canopy-Constellations support and sizeable war chest, Acreage should be able to access more funds at a lower cost than the rest of its US competitors. In theory Canopy could set up a bank to lend to Canopy directly or alternately it may provide some sort of guarantee for an Acreage loan from an existing US bank or banking consortium. On the last conference call, Acreage management even alluded to having already started the preliminaries of this process.
  3. New England – Mid-Atlantic states legalization: The New England and Mid-Atlantic region of the US contains twice as many potential customers as all of Canada (72 million combined population vs. 38 million in Canada). Various efforts to legalize recreational marijuana in this region continue, but have not yet passed. If you look at the Acreage Business Status chart provided earlier, you will see Acreage already has numerous ties even dominance over other MSO’s in the NorthEast region of the US (labeled New England and Mid-Atlantic in the chart). This is a focus they continue to value and seek to expand. In addition, Canopy targeted New York for its $150 million dollar hemp industrial park concentration. Thus, progress in legalization in this particular region benefits Acreage-Canopy more than any other multi-state operator. That states in the region sometimes work together is also thought significant. Once New York or New Jersey legalizes recreational marijuana, the rest of the states in the region are likely to quickly follow utilizing similar legislation and regulation. They may even all pass laws legalizing marijuana in conjunction and coordination with one another. A summit among these states and their leaders to discuss the issue was held on October 17th. Governor Lamont of Connecticut for example indicated he would support marijuana legalization, “if we were doing it in conjunction with other states. If Rhode Island, Connecticut, New York, New Jersey, Pennsylvania ⁠— if we bring in Massachusetts and coordinate our policies there, rather than being an outlier ⁠— I think it’s something I would push.”
  4. MORE Act: The MORE Act seeks to decriminalize and deschedule cannabis, as well as expunge many cannabis convictions. With this latter clause, House Democrats seem to have purposely included provisions they know the Senate will not go for (e.g. freeing of people convicted in the past for marijuana related crimes). Thus, while the act has a good chance of being approved in the House, the real intent is probably not to pass meaningful marijuana legislation but rather to solidify it as a wedge issue going into the next election. Hopefully I’m wrong in this assessment. In the meantime news of its progress in the House, or lack of progress in the Senate, is likely to affect stocks in the sector.
  5. States Act: The States Act has the votes right now to pass in the House with the President also indicating he would sign it (President Trump isn’t a proponent of marijuana himself but adopts a Libertarian viewpoint on many social issues including marijuana legalization). However, its progress in the Senate is also more in question and its thought to be a dead issue until after the 2020 election. The major holdup has thus far been senate majority leader mcconnell preventing it from coming to a vote (purposely not capitalized as a sign of disrespect). If you look up “establishment” and “congress” in google, you will likely see a picture of senator mcconnell. He tends to throw his weight behind whatever the lobbies that support him the most want. He has thus predictably been a strong champion of hemp so far (McConnell’s state of Kentucky is a prime growing region for hemp), while also a staunch critic of broader marijuana reform (McConnell got $25 million in donations from Sheldon Adelson last cycle, a billionaire who opposes marijuana reform). Motivations however can be fluid in Congress. Senator McConnell recently visited a California marijuana facility, and I note his donations from pharmaceutical firms Eli Lilly (LLY) and Pfizer (PFE) thus far in this cycle have been counteracted by an even larger donation from Altria (MO). Additionally, in opening up the possibility of marijuana reform, he may hope to mitigate a potential get out the vote weapon in the Democratic toolbox (e.g. show up and vote Democrat if you want marijuana legalization). Stay tuned on this one. The States Act is probably dead until after the election, but ironically it could be the Republicans who revive and try to push it through before then.

Trading Considerations:

If you are thinking about investing some of your speculative allocation in marijuana, Acreage (ACRG-U) in my opinion is your best bet. Given the volatile nature of the industry however a stepped approach may be called for. One could for instance invest a part now, and more as key drivers either come to fruition or near fruition. My gut call is most investors don’t yet understand how the vaping crisis helps Canopy-Acreage, nor how beneficial legalization in the NorthEast would be for it. On the other hand an investor who doesn’t understand the potential importance of the SAFE, MORE and States Acts has no place being in the space. All cannabis firms should climb in price as passage of any of these becomes more certain.

Canopy Growth (OTC:CGC) remains the leader in the cannabis industry. It is the top firm in Canada, one of the top firms, if not the top firm, in the world. It enjoys by far the biggest war-chest, and has made the most progress in developing where I think the business will be going (Cannabis 2.0 products and beyond). Acreage is the much cheaper back door entry into Canopy thanks to a remarkably large and persistent spread* post announcement of the Canopy-Acreage merger intention. I have no idea when this spread starts to shrink, certainly once passage of the States Act or full legalization becomes more evident, but maybe well before then. That the main page of Acreage’s Investor Relations website is dominated by a calculation of the spread between itself and Canopy is in itself remarkable.

Source: Acreage Investor Relations main page

Acreage management did not choose to highlight how many stores it has or are in development, nor its triple digit revenue growth, nor pictures of new products on its investor main page. Nope, instead they chose to focus attention on the merger spread. This makes it clear how important shrinking that spread is to them, and that an investment in Acreage is really an investment in Canopy. Management wants to be able to use Acreage shares as long-term funding for expansion. However they also made clear in the conference call and other interviews that they don’t have any plans to use the shares at current prices nor while the spread remains so high. Using highly priced Acreage shares tied to and supported by the much larger Canopy market cap was the plan, a plan that hasn’t succeeded yet (an unintended negative consequence of firing Bruce Linton if you ask me**).

However, that original plan is not dead. If Acreage-Canopy-Constellation management can get that spread to shrink and the share prices to rise once again, they will expand their status as by far the best funded marijuana company in the US not just in the short-term but also the long-term. In doing so they hope to continue to take advantage of the, “The Cisco of Pot” effect, using highly valued shares to trade for key tech and distribution. Founding shareholders of the best smaller cannabis firms who believe the most in their technology, brands, distribution and licensing advantages, usually don’t want 100% cash in a merger. They believe in the long term viability of what they are selling and thus want the long-term, tax advantaged growth inherent in getting shares instead of cash. In the meantime, Acreage has successfully enacted a backup funding plan, a REIT for now, and Canopy supported bank borrowing once the SAFE Act passes. This alternate plan still makes them one of the best funded US marijuana firms for now.

Conclusion:

Again, I can’t tell you whether an investment in the marijuana sector is right for you. However, I can say once you decide you want one, Acreage (ACRG-U, OTCQX:ACRGF) is the first firm you should consider.

Notes:

*Reasons why the Acreage – Canopy Spread continues to exist

  1. When the Canopy- Acreage merger might close is very nebulous, depending on cannabis becoming legal or at least federally permissible in the US.
  2. ACRG-U only trades on a small canadian exchange without options. Thus institutions have trouble executing the Acreage side of the pair trade at a reasonable cost and volume for them.
  3. The carry on CGC puts are very expensive, typically in the double digits.
  4. ACRG-U is breaking US law by selling cannabis in the US. Thus an investment in Acreage may cause the firm investing to be breaking drug trafficking and money laundering laws.

Basically, the typical institutional closing of the spread by going long ACRG-U , short CGC clearly isn’t going to happen. Nor do I recommend individuals try this spread due to the costs involved combined with the nebulous nature of the closing. However, if you want to invest long in cannabis or CGC, the best way to do it is via going long shares of ACRG-U.

**Bruce Linton as a private individual could have sold a few million dollars worth of his Canopy shares (OTC:CGC) and used them to buy Acreage shares (OTCQX:ACRGF). Once this was made public, this implicit support would likely have prevented the spread from ever becoming as large as it has. While this became a significant problem for the Acreage – Canopy – Constellation deal, they brought it on themselves. Their error can now be an advantage for knowledgeable individual investors in the space.

Disclosure: I am/we are long ACRGF, CGC, MO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This contents of this article were previously released to members of Cash Flow Kingdom on November 13th. It discusses risky investments that are not yet federally legal in the United States. I do not know your goals, risk tolerance, or particular situation; therefore, I cannot recommend any specific investment to you. Please do your own additional due diligence.

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.

Author: CSN