Editors’ Note: This is the transcript version of the podcast we published last Wednesday with Mike Regan. Please note that due to time and audio constraints, transcription may not be perfect. We encourage you to listen to the podcast, embedded below, if you need any clarification. We hope you enjoy!
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Rena Sherbill: Hi everybody, welcome back to our regularly scheduled Wednesday episode, great to have you back. Hope you enjoyed Monday’s special 420 episode, hope you enjoyed 420, hope you are able to find some way to enjoy this very different of all other 420s and in general you are doing well and staying safe out there.
Very excited to have Mike Regan on today. He is Equity Research Analyst at MJBizDaily Investor Intelligence. MJBiz, for all the cannabis aficionados out there know that they run the biggest trade show of the year, obviously lots of plans have been dampened this year, but they run the biggest trade show in the cannabis industry and Mike has been analyzing and investing long and short in equities across many, many sectors for two decades. He covered the internet bubble in the 90s. He covered cable and satellite stocks. He talks a little bit about it and he is currently focusing on the cannabis sector and he is writing for Marijuana Business Daily and lots of really interesting insights he has as somebody who has covered the markets for so long, really interesting comparisons that he makes.
I would say the big three more actionable takeaways for this episode: Number one, Mike talks about the similarities between the internet bubble and what’s going on with the cannabis companies today, also some of the differences and what the evaluations at the end of that bubble can tell us about where we’re at in the trajectory of the cannabis story.
Something else Mike talks about is the Canadian and U.S. markets. We talk a lot about Canada at the beginning, the supply and demand challenges that it faced. Mike also says the U.S. stocks; they access a bigger market with higher margins at a lower valuation, while Canada is suffering from overcapacity.
We’ve talked about the supply and demand issues before on the show, but Mike makes some strong points about the challenges that a lot of the Canadian players are going to face, obviously we’re seeing a lot of those challenges playing out already and what we can expect going forward.
The third actionable takeaway I would say is the importance of looking at capital structure. A number of our guests have talked about you know confusing, complicated capital structure, how warrants are presented. Mike talks about that today. Keep it simple, if you don’t understand something… we’ve talked about this on the podcast before, it’s essential in these days of stock splits and warrants and companies making different announcements, especially as this capital crunch has been exacerbated by COVID and will probably continue to be a real challenge as you know ramp ups in unemployment and economies on the brink of collapse globally.
So, interesting and very salient point to make – how important it is to understand capital structure. We also a little bit get into debt and that I think is a similar topic in terms of you know, if you don’t understand the debt situation or you think that the debt is going to present a problem, it likely will.
So, we’ve got a great talk for you today. Hope you really enjoy. And before we begin a brief disclaimer. Nothing on this podcast should be taken as Investment advice of any sort. And in my model cannabis portfolio, I’m long Trulieve, Khiron, GrowGeneration, Curaleaf, Vireo Health and Isracann BioSciences. You can subscribe to us on Libsyn, Apple Podcast, Spotify, Google Play and Stitcher.
Mike, welcome to the Cannabis Investing Podcast. Really happy to have you on the show.
Mike Regan: Thanks a lot Rena. It’s great to be here.
RS: So, you are at MJBizDaily. Talk to us about how you got there and how your connection to the cannabis world started?
MR: That’s pretty interesting. So, my background is basically in long-short equity investing at a few different hedge funds and way back when about 20 years ago on the sell side covering cable and satellite stocks. So, basically my exposure in cannabis started when I saw this interesting job post for MJBizDaily, which is you know the main trade publication who runs the big MJBizCon trade show, had like 30,000 people last year. They were launching an investor focused product and wanted to – they needed someone who knew investing and analysis and they are like, we can teach you cannabis. I was like, well this is great, because I’ve covered pretty much most sectors from industrials to consumer, retail, tech, what have you, even energy extraction at times.
So, as I view it, the cannabis sector at that time people think like, oh, it’s very, very special and I just saw a consumer product within agricultural supply chain with you know the industrial middle man as well. There is ultimately going to be a consumer product that will be distributed by companies that can effectively brand and market and distribute these products over time. So, I thought well I know basically, sort of the underlying business models that this will be and then I can just learn the cannabis side.
So, I joined back in – this launched back in, the product was launched a year ago, I think back in February 2019 and I joined by July 2019. So, basically like I said, I bring the fundamental bottoms up analysis and experience of covering pretty much all consumer-industrial related business models in normal sectors and applying them to the cannabis industry.
RS: Interesting. So, did anything in your thesis that you thought starting out – how did it change or did it change?
MR: This is, like it’s my – my overall thesis is still sort of more a longer-term and broad in terms of – I keep coming back to the internet analogy. This seems like at least last year the stocks seemed like internet circa 1998 to 2000 where everyone can see that there’s this big new thing that will – big long macro thesis – that will over time change an awful lot in the industry and a lot of companies went public on the dream that sort of weren’t really actually executing well. So, it took a while to get in there, but one thing that has been right was I viewed the cannabis sector as ultimately a commodity that’s driven by supply and demand, so if there is an oversupply of production then prices will drop.
It is not any different than coffee, corn, diamonds what have you. You know, even if there is gradations within a product as most agricultural and I actually mentioned diamonds, they actually have ways to account for the differentiations in quality, they’ll still move together if there’s too much of something then the price will go down and then if there is more demand for something the price will go back up. So, that’s been basically correct and I think maybe some in the industry had missed that. And I still think the long-term thesis will come about because there are – I’ve talked with operators that – you know actually are running business that generate cash.
So, if you run the business right, then it can be done and it should be done. It’s a product that people want and then they are going to pay for and as long as you can make it for X and sell it for more than X, you should be able to make a profit. I think the one thing that’s different than the internet analogy is, you know back in 1998 there was a question of whether people would actually buy things on their phones to be delivered like that was kind of a crazy idea in 1999, but you know we do that all the time now. Whereas with the cannabis market you have this proven demand in the illicit market right, the legal investment cases is sort of two-folded.
First, legal market gaining share from the illicit market and I think Colorado has largely proven that it can be done and with the right regulations, right enforcement, so the right industry structure it’s not a foregone conclusion that the illicit market will always win. And then the second fold of the thesis is, you know just sort of general social acceptance in legality and then product innovation by legal companies will lead to greater penetration of use in the general populations sort of expanding – at first gaining the illicit market into the legal market and then just expanding the market overall and I think at least Colorado has sort of shown that.
I know recently there was an analysis that showed that a lot of sales gains in Colorado was new people buying essentially. So, if you extrapolate that to the whole country, you know that to me makes a pretty compelling long-term investment case and then the question just is you know, which companies have the cash to survive – that are executing well to actually realize that. Because sort of like the internet bubble back then in the second half of 2019, which I was sort of learning all this. You know, there was a lot of companies that raised lot of money, but didn’t really execute very well, investors lost faith, they couldn’t see the path to well it seems like you’re burning money incessantly, which in turn was a strategic decision right if those companies are – if they think the market will always be there, then it’s rational to do that, but then when the market stops with the capital – all those losses then they have to come up with a different plan. So, that might be a sort of long-winded answer to a short question.
RS: No, no. I think it’s a good one. I think it covers a lot of bases and I think it’s interesting to your point about one about the supply and demand part of the equation and then also you are bringing up Colorado. To me, it’s interesting they are like, I think polar opposites of how to rollout cannabis. I would say Colorado as you mentioned did it really well. I would say they are probably the case study for or poster child for rolling out legal cannabis. Whereas Canada, you know the black market has a much higher share because it was such a poor rollout I would say. Would you attribute it also to issues of supply and demand in Canada and what’s your thesis on Canada specifically in terms of those issues?
MR: Yeah, Canada clearly has a supply demand imbalance. I think it goes back to when a lot of the public companies went public; they were valued on capacity produced. So, if you are trying to raise money, then you want to raise more money, well then double the size of the green house and all of a sudden your valuation goes up. So, that incentive was to overbuild the market and then you combine that with as you noted, it’s also sort of the distribution issue, right, in terms of how much all that oversupplies and lot of the dispensaries have been slower to open, so the supply has sort of nowhere to go, but anecdotally we’ve also heard that it’s more also the quality issue with what the legal market is producing – they went for production as opposed to sort of higher quality which is what the market wants.
Like, well as a commodity it still is, you know if everyone wants Chardonnay and you’re just making nothing but Cabernet, then you are going to have a problem. And that’s sort of what we heard up there was, you know there was a lot of capacity making sort of mid grade products that basically the public were preferring, you know, higher end or higher quality or higher THC product and like you get it pretty easily in the illicit market. And it’s amazing the Canadian Government actually reports in their GDP figures the illicit market, like you can get their estimate of the legal market versus the illicit market in their government figures and they’re pegging it at about, I think it’s about 20% legal and 80% illicit, so that’s the growth case, but that’s kind of it.
I think it’s interesting you saw Canopy (NYSE:CGC), they basically cut their grow capacity by 60% recently. Then David Klein just joined, he was – as a CEO. He was the CFO of Constellation Brands (NYSE:STZ) and seems they are taking a pretty different strategy in terms of reducing capacity in general. I said they are reducing their capacity by 60% and that action single handedly reduced Canadian capacity by my estimate of about 6% or 7% for the whole market.
And it’s also interesting that they are actually increasing their outdoor grow versus their indoor grow, so that’s a lower cost. So they seem to understand, you know we have to get the cost of production down and I think they are also going to, I haven’t heard them say this, but I would guess, especially with the influence of Constellation, which sells – they are basically a branded marketer, distributor of a molecule that changes a consumer experience and that’s essentially the same thing that Canopy will ultimately do or is trying to do.
They may view it more similar to that respect in terms of having a processed product that it can provide a reliable experience to the customer and they just have to get the lowest cost to do that. So there’s the supply, cut down your indoor supply and try to buy it wholesale, which you’ve seen a lot of the Canadian operators start to do in terms of like either just selling their inventory at lower prices or ship to wholesale and use outdoor, which is lower cost, it could be sort of lower quality, but if it’s just going to go into a processed edible it kind of doesn’t matter where it’s grown, so that seems to be the tack they’re clearly taking.
So, for Canada overall, I think as a lot of the companies also start to have cash flow issues, also to be forced, certainly not open to all the planned capacity they were going to open and then maybe cut back on the capacity they have. You’ve already seen larger ones. Canopy is large and well capitalized, so that’s clearly the tack they are taking. So, I guess it will ultimately resolve itself, but…
RS: I was going to say, do you think they are on the right track there in terms of, you know with the management changes and changing some strategies. Do you see Canopy getting back to kind of the top of the food chain there?
MR: I mean, they certainly have a pile of cash and a corporate sponsor that claims they are not going to provide anymore cash, but we will see what happens. When push comes to shove they would have a better shot than most given that I mean I think they still have about $1 billion or so, generally rounding, but it is a lot – to use a technical term.
RS: That’s what you learned with your financial background.
MR: Sometimes you have to simplify things. They will be more well capitalized and they seemed to be doing the things that an oversupply – and if the markets oversupplied, you cut back your own capacity and then try to do more wholesale and focus on the value chain. I mean that sort of goes back to the other point of lot of these companies, you know, I get that early in any industry, we usually have very clear integration right, like even Ford used to actually own forests and sheep to make their own wood and wool and leather, but they don’t do that now, right? And you look at Starbucks, Starbucks doesn’t have like plantations of coffee right. They buy coffee. Now, there is no wholesale market yet for cannabis because it’s still early, but longer term there is more value add in being a branded consumer products and essentially being a farmer unless you are the low cost producer. Sort of like, if you are the Saudi Arabia of cannabis then that’s great, but if you are not, then you want to be more like the Starbucks or the Kelloggs then necessarily doing every asset of the value chain.
Like, I totally get that today that doesn’t exist yet, that’s more looking out probably more decades, but to the extent that you can sort of realize that and sort of say well we are reducing our internal and then trying to buy the swing capacity on the wholesale market and that seems to be a pretty good strategy.
RS: And what about you know a company like Aphria (NYSE:APHA), if you are talking about you know a CPG company that’s really trying to position itself as a CPG cannabis company with you know Irwin Simon with extensive experience in that world and also going more the global route than just Canada. Even though they are all kind of, have their tentacles in the global market, I think Aphria is really positioning itself. A, do you think COVID affects that strategy; and B, what do you think about that strategy of Aphria’s in general?
MR: Well I guess in terms of the global strategy it makes sense that they are basically stepping back. Canada looks like an awful lot like the size and scale of California right. So, it terms of, if you’re viewing everything in just sort of states, Canada is essentially another California and back I think also when it was legalized and the stocks were more in the heady territories I think the thought was those companies would be have first mover advantages. You know the U.S. is the largest market ever legalized it would have been able to move in on that. If that’s, sort of further off case then you are going to have to look for other markets beyond just Canada. So, in terms of – Irwin Simon coming in from Celestial Seasonings or Hain Celestial it’s basically that, that’s a better strategy then – it’s a good strategy to go the branded routes.
I think they’re still adding a fair bit of capacity and they’re reasonably well-capitalized, so they’ll probably still add that. It’s still adding capacity in Canada where there’s still a lot of supply, but to the extent that they can get the cost down. So, if you’re going to have the capacity just make sure you have the lowest cost production, because that’s ultimately what will win. So, if they can actually achieve that you know that’s pretty good.
In terms of them going international that’s basically, you can try to grow Canada as fast as you can, we can also try to grow internationally. So, it’s sort of, you know if they have the capacity building out, then they’ve got to sell it somewhere and if Canada is oversupplied it makes sense to try to go international.
In terms of international trade breaking down because of Corona, I’m not sure that will necessarily, I guess impact cannabis in the next few months, not withstanding sort of you know talking more of a longer term strategy and who knows what’s happening in the next few months, everything is up in the air, but if there are other countries that are going to trade good on this legalized route, then they have a bunch of capacity they could try to, that seems to make sense. I don’t think, I think if the U.S. is going to legalize, I’m not entirely sure that a bunch of U.S. cannabis would suddenly be coming in from Canada. So, it looks like I could look for other places in the world.
RS: Staying in Canada just for one more second, especially given you know your background, I’m interested with Aurora Cannabis (NYSE:ACB) kind of their downfall, do you ever see something like that or kind of like righting their ship? I mean they announced today what the stock split, do you see in a world where I mean I guess there is always a possibility, but what’s the likelihood of that kind of turning around there?
MR: I mean, so a lot of these turnaround plans you know they look kind of tough in terms if you’re trying to – I forget the exact numbers, I can pull up a written article, but it’s effectively there what they are trying to double revenue while cutting their expenses by like 50% or 30%. I mean I can actually look up the exact numbers, they are actual sound bites, but it’s a pretty tall order to basically get to profitability, mathematically it’s pretty simple, grow revenue and cut expenses. That may look easy on a spreadsheet, but that’s really hard to do. If you are trying to like literally you know double, triple revenue while at the same time cutting nominal expenses like not just having incremental revenue come on at a high margin, but like actually you know more than 100% margin as you cut expenses that you already have that seems like a pretty tall order. I guess best of luck to them, but that’s not – it’s certainly not easy to do.
Usually the path of profitability is, you know you add on additional revenue at high incremental margins or I guess a lot of industrial companies that will say, oh well, you know 80% of our revenue comes from 10% of our SKUs, so we make money on 10% and we lose money on 90%, so we are just going to cut the 90%, and it was like okay like – then you have sort of flattish revenue, but then your margins explode that’s sort of not what they are saying, they are saying we are going to cut these expenses and sell more. Okay, that’s not easy.
I think the split you just mentioned they announced the reverse split, I think that’s sort of also been – that’s a whole another topic, but they are complex capital structures so we can get into, but if you want to go down that route.
RS: You can, let’s get into it.
MR: That’s something I’ve been struggling with and the first thing I noticed when I started looking at these companies is how complex and variable frankly, the capital structures are essentially the shares outstanding, like I’m just looking at Aurora, in my comp table, you know Factset had their shares at 1.17, I actually estimated at 1.35 million shares and then they came out today and said they are actually like 1.3 and change and they are going to reverse split it, but the issue for the sector is, you know with all these warrants and options and convertible debt, you know effectively the shares outstanding changes with the price of the shares, right.
If you do a simple, oh we’ll count everything, the warrants that strike at 20 when the stock is 2, actually really probably shouldn’t include those, since those will never convert, right; but on the other hand if you’re thinking, you know the stock is 10 and I’m going to – I want to invest because I think it is going to worth 20, you actually have to do the math on well, what’s actually the enterprise value that implies and then figure out what’s the shares outstanding, because then it becomes circular. In fact, I think it’s worth 20, but then those warrants at 18 convert. Now there’s more shares, now my valuation is only 17.50 and then they don’t convert.
Then it gets into this complex calculation, you can’t simply just say, Oh! well, I think earnings will double therefore the shares will double, they won’t. The warrants disproportionately take some of the upside. I’m trying to think like, Canopy’s especially because they have those enormous warrants to Constellation, which on one hand I get that they can align the behavior, but you know the shares outstanding currently they are around sort of 380-ish, you know if the stock goes down to 5, they’re 348, the stock goes up to 60, they are you know $660 a share, 660 million shares outstanding.
So, when you are doing your math you have to remember that there is a huge slug of shares at 45 and a huge slug of shares at about I think 55 that you know that marginal dollar all of a sudden goes effectively to Constellation, not you as individual shareholder when you are doing your math.
You basically have to figure out okay, I think the company is going to trade at an enterprise value of like 20 billion and then that implies 660 million shares and that’s when share price so just sort of complicates the math. I think it ultimately, it raises the cost of capital for the sector. The companies that I think will do well are the ones that can simplify their capital structure, so investors aren’t trying to wonder what exactly they own.
Then when you get into the question of the debt, you know a lot of the – we saw with Aurora, and we saw with MedMen (OTCQB:MMNFF) and I guess perhaps now iAnthus (OTCQX:ITHUF) the debt effectively is equity when the debt gets equitized right, and will effectively step ahead of you as the individual shareholder when things stop going so well.
So you have to almost view them as equity – you have the ability to, basically pay that debt versus you know that debt is going to get equitized and you’re essentially diluted, because it’s very difficult for at least in the U.S. for the U.S. operators to like legally go bankrupt, but the way it’s going to look like in the way banks really looks like in cannabis when its federally illegal and you can’t file Chapter 11 because it’s a federal protection, you see like in the MedMen situation where the equity gets diluted down to very little essentially.
I currently have their shares at 2.1 billion shares outstanding when you go through all the math of the recent restructuring is where the – the Gotham Green credit line seems to be almost like a synthetic version of preferred equity in terms of the way it sort of effectively acts. So, it’s a question of what the public shareholder actually own there. I think you’ll start to see more of those.
In terms of iAnthus, I haven’t looked at them too closely, maybe it’s better if I don’t really opine on them, but my understanding is just that’s more, I shouldn’t opine on them, I actually don’t know that situation too closely. I just know it’s more than just like, oh ‘the check is going to bounce so we can’t pay it’ I think. That’s my understanding, it’s like it’s actual disagreements between the various shareholders and bondholders and what have you, but…
RS: Right, I think yes there are other factors complicating it even further. Yeah, I mean I think that’s out there already.
MR: Also, I don’t know anything in particular, it’s more like that it’s you know, it sounds like Green Growth where it seems that they are not even sure they can make payroll or like the employees are complaining their paychecks haven’t been paid, that’s like literally we don’t have the cash to pay you as opposed to, we’re getting into a dispute or there are larger questions of who owns what.
RS: Okay, so we’ve gone over kind of some of the things not to look or to be wary of it at the very, very least. Talking about this path to profitability, which you know it seems maybe only a few of companies that are really in the discussion will be able to achieve. What do you think investors should be looking for in terms of looking at which companies are able to achieve that type of profitability?
MR: I think the first thing is to sort of focus on the underlying business model of the company. Like we were saying before, I think some companies were basically, you know the business model was really selling cannabis companies as opposed to cannabis itself, right. You were trying to like, that’s the whole empire building thing where you are building this empire and sell to someone else who wants that platform, that doesn’t work anymore when if they can’t finance themselves or the market is just not buying those, you have to actually show that you can actually have profits and there are some companies that are profitable like Trulieve (OTCQX:TCNNF), they have positive EBTIDA. Like Medicine Man (OTCQX:SHWZ) they are pursuing a consolidation strategy and they have guided to positive EBITDA once they actually consolidate all these different operators that they are looking to buy.
I think basically just kind of look at what the underlying business model is. Is it sort of a model you can understand where we have so many, you know dispensaries and they do so much in revenue per store and fixed cost are X and they, you know that they will be able to once they are all open, that they should be able to generate positive cash flow versus, you know even if you put in reasonable assumptions what those volumes could be, they still can’t generate positive cash flow than that would be something you would want to avoid.
RS: And what about sometimes when they’re dependent on these deals coming through? You know, you talked about Medicine Man with their consolidation and then there is, you know there is a slew of examples you know with failed acquisitions that you could have said oh this deal was going to bring them you know X amount or this looks to have been, you know this would bring this to their balance sheet and then those don’t work out for whatever reason. What would you say to investors like needing to do their due diligence on those deals? What’s kind of the best approach to them?
MR: I think it’s just understanding what the actual, I guess what the deal brings or what the purpose of the consolidation is. If it’s combining a bunch of any, sort of what changes when there is new ownership. Is there an ability to when you combine two companies that they can leverage, they can reduce the corporate overhead and maybe improve buying power, does that then turn what’s a negative into a positive or is it more just well they are losing money and we don’t see a path that this store is fundamentally too large or needs to quadruple volume in order to actually get to a positive EBITDA margin, then that’s not going to change when then someone else owns it versus the current order.
So, it’s sort of understanding what’s the logic behind the deal. If it is just to enter sort of new states, does the existing operator have any advantage in that state or is it just them getting exposure to that state versus like going back to the Medicine Man example, you know they are basically combining the Los Suenos… you know they’re basically making a vertically integrated operator focused entirely on Colorado by buying the largest grower, buying some of the larger dispensary chains and combining them to be the biggest dispensary chain and then buying a couple of processors and edible producers. It makes sense that when you start vertically intergrating those, the overhead can be shared and the costs can then be rationalized across a lot of those that then the margin which is guided to be positive at the outset should then also be able to go up once you start to integrate those and share costs across them. That seems to make sense.
If it is just you know entering a new state, then you are just buying a new asset in the state and maybe there is some diversification from the additional states, but it’s sort of what this pro forma company going to do differently than the current owner essentially.
RS: Right, kind of measured, measured reasons for growth as opposed to just kind of expansion at all costs, which I think we’ve seen a lot of breakdowns in that over the past year I think.
MR: Exactly.
RS: Yes. So, what’s your vision? I know, as we said, you know the next few months are kind of impossible to predict, but kind of notwithstanding COVID, but in the phase of COVID with the knowledge that we don’t know for certain, but in terms of the kind of themes that we’ve been dealing with which I would say is capital crunch and looking at companies that are able to be profitable, how do you see kind of the eco system shaking out over this coming year?
MR: I think you will see a lot more – I think you are going to see a lot more restructurings with the capital crunch, because the capital crunch in cannabis already started before COVID, right. I mean these stocks were already down last year and the capital crunch has already started and COVID certainly doesn’t really help. This is overall when the S&P drops 20%, almost kind of doesn’t matter what your cannabis company is doing like your valuation will go down as well, it’s just investors have you know more lower risk traditional companies to invest in at cheaper prices. But that now withstanding, I think if anything sort of medium-to-longer term the governments, at least the U.S. Government you know ramping up expenses and needing to find jobs probably favors additional cannabis legalization in the medium-to-long term. They need to foster domestic industries and domestic jobs and domestic tax revenue, in the near term if there is anything on the ballot I think that gets delayed as governments are distracted right now, but you know looking out beyond this it probably actually helps if anything.
But with the actual companies, there is the question of do you have the cash to actually survive to realize that and you basically have the cash, either the cash in the balance sheet and the cash generation to help you survive to realize that longer-term possibility and realize a long-term investment. That original long-term investment thesis that I had outlined, you need to have the cash and the cash generation to actually be the company that exists in 2025 to realize that opportunity, right. I mean, you just look back at tech, a lot of the leaders today didn’t even exist.
Facebook was found in 2004, they didn’t even exist in the internet bubble, so the overall long-term trend was right, but there wasn’t a lot of companies that existed in 1998 and 1999 or 2000 that actually realized that opportunity. I think you are going to see a lot of that in cannabis that the giants in 2025 or 2030 may not even exist today or there may be small private ones that are just sitting there generating cash flow biting their time.
RS: Yeah, I was going to ask, like how do you see a company kind of, or do you have favorites that you think might rise to the top or what you think it’s dependent on other than you know it’s too soon to tell exactly.
MR: I mean I think, I don’t have sort of specific ones, I guess just, it goes back to I think just sort of investing in general, you have to understand what the underlying business is, what the underlying strategy is and then find a company that has a strong balance sheet to realize it and kind of at the end of the day, you are usually investing in sort of similar stories and the actual details matter less and less, it is sort of viewed as what widget are you making and what’s the return on it and what’s your comparative negotiating leverage etcetera versus your suppliers and your customers and how do you expand and maintain your margins and it kind of doesn’t matter if that’s cannabis or alcohol or cereal or auto parts or what have you, you know sort of understand what the dynamic is and then invest accordingly.
But the key things are it doesn’t matter how great your idea or your business is if you have too much debt, then the debt holders or the equity holders really, so that’s always the first thing is just look out for how aggressive the capital structure is as the equity holder you are the last in line, so make sure that it’s well capitalized and it is not the debt holders, or the future equity holders that are gonna actually realize that return. That’s always the first one.
And then just understand the strategy, the margin potential and what takes to get there. I would also highlight just sort of gauge the quality of the management team, because at the end of the day all you are sort of really actually investing in is, there is the assets and then there is the people actually running it, in terms of picking the fiduciaries to essentially manage your capital as a shareholder you know try to make sure that you do your due diligence.
RS: Does that extend, I mean do you look at CBD focused companies as much?
MR: So, in terms of CBD companies, ya, we have looked at them as well in some depth. That’s proven at least initially to be sort of a tougher market when there was a lot of excitement as the FDA legalized it, but then well the USDA legalized the production of it, but the FDA as I view it, sort of didn’t really establish how exactly you can consume it.
So, you sort of have the production side all ramped up and then the FDA is saying well you can’t really eat it and you can’t put in food essentially, you can put in like topicals and balms because that fell under effectively the sort of like cosmetic regulations versus ingestible regulations, but then they say don’t worry we are going to figure it out, but then we haven’t seen how long it has taken to figure out.
So that’s sort of the issue with that overall market, we are still waiting the description of what exactly you can do and it seems that if you don’t make too crazy claims maybe they wont they won’t sort come out for you. But that goes back to just stepping back and just remembering that consumer products are inherently competitive business.
Consumer tastes are pretty fickle. Consumer brands are more than just a logo and a name, it’s essentially repeated, you know repeated consistent experiences by consumers over a long time, so they know that whenever I buy a Coke I know exactly what it is going to taste like. Whenever I go to Starbucks I know exactly what is going to taste like. I know exactly what I experience when I get to sort of in a nascent market, it is tough to establish those brands at first.
And you saw that with CV Sciences (OTCQB:CVSI), I guess the quarter in November and I think still having the quarter now, you know they faced a ton of competition from basically upstarts who were buying shelf space and they were losing their shelf space, so even if they actually had a reasonably stronger brand, consumers were still – they are still losing distribution and shelf space against competitors and having to cut price and that just hit their sales and the margins, so it goes back to doesn’t matter sort of what the widget is, it is still a brilliantly competitive consumer business.
I think a lot of reality on the THC side as well, especially on CBD side it’s a very competitive consumer product with sort of no sort of established brand yet and ultimately if you are a smaller company, the larger established consumer brands get more comfortable and you are going to start competing with them, right. But I think the Procter and Gamble’s of the world they are not easy to compete against.
RS: Right, is that something, you know when you are covering the internet stocks back in the day, was that something that they were talking about then in terms of well look the top internet stock could be, I don’t know GE let’s say, you know they could want to get into the internet business, who knows. Was it like that or did you kind of have a sense that the top internet company was going to be you know like you said like a Facebook or a Google something that started just because of this, is that how you see kind of the cannabis, do you see it may be doing something similar there?
MR: I think the difference is you know the internet was a little newer… I mean I think there were definitely plays and well I actually do remember the cell phone companies where you know part of the Tech Telecom bubble right. I remember Sprint PCS giving a presentation showing that they were going to get like or maybe it was a sell-side analyst saying and this is an anecdote going back twenty years, but saying that they were going to get like a dollar per subscriber in purchase revenue. What exactly are they buying on their phone that you are going to get a cut of a dollar a month from that sub, Sprint?
So that ultimately turned out to be true, right. But is Sprint getting a cut when I buy something on my iPhone from Amazon, I don’t think so. Maybe indirectly that I am still subscribing to the service, but, you know so there were a lot of sort of larger more traditional companies that were bid up in sort of the exposure to this new trend.
You think it’s like a lot of the larger tech companies today, a lot of them are newer or they redefined themselves right, like Apple was just a niche computer company that couldn’t compete with Dell before the iPod came out, if you go back 20 years, right. Like I remember when Apple traded for less than cash.
But I think the slight difference now is cannabis can be more – it will come down to the regulations, but it could be viewed as more of a consumer product and who knows, maybe one of the outcomes is, if the U.S. like legalized every thing nationwide overnight tomorrow you would probably see some of the larger alcohol, tobacco, CPG companies swoop in and maybe buy some of the larger ones then use that as a platform to expand beyond that, but I don’t necessarily think that’s going to happen. But sort of how does the industry evolve? Ultimately it’s sort of a new consumer product and I think studying how past, other industries have evolved will make you a better investor in terms of being informed on this sector.
RS: Right. Do you see it playing out in terms of, inevitably, you know alcohol is going come in, retail is going to come in, pharma is going to come in, do you see one of the existing cannabis players as able to kind of take on a bigger player like that or do you see kind of consolidation among existing cannabis players as that being more likely?
MR: I am not sure, I think it comes back to right now I think it will be more whoever can generate cash and not at least for the equity holders and not have the bond holders take it over. You know, the company could do great in the hands of the bond holders and we will see how MedMen fares, now basically controlled by Gotham Green. Who knows but that doesn’t necessarily mean that going out and buying the $0.20 stock today doesn’t necessarily mean you are going to be a part of that growth. That all being said, you know, I think the jury is still out and I think it depends on how the regulations evolve, because it is still really early, I mean still the U.S. at least is federally illegal.
You have a lot of banks that won’t even go near the sector because they worry about the money laundering, but if we pass the Safe Banking Act or somehow would normalize at least the banking and then what happens, what happens if it gets de-scheduled, so it’s still legal, but not you know Schedule One or what happens if additional states legalize and I guess this comes down to how it happens.
Honestly, different laws will I think affect the different outcomes, right. If it is not legal, but not illegal, like if they just say okay it’s not federally illegal and states you do whatever you want that’s a different model that will favor different business models then, oh, it’s federally legal nationwide and we also struck all these treaties where you know now it’s globally legal and you know now it’s just like coffee, you can grow it South America and ship it anywhere.
I don’t think that’s is going to happen, but you see what I’m saying like, we don’t know what the laws are going to be and I think different regulations will favor different types of business models, right. The world will look very different if it’s coffee then you are going to have – it will look more like Starbucks then if it is a patch work of different state regulations maybe looks more like alcohol and maybe looks more like even pharma where it’s legal, but you have to go to a doctor or you have to jump through these other whatever legal hoops it depends right.
RS: Yeah, so interesting. I mean like with COVID it went from illegal, but now essential item that looks probably more likely to be a state-by-state, I mean I don’t know of course, but it seems like it was on track to maybe being de-scheduled and now it seems like with COVID happening and the delay there. I don’t know if you have an opinion on this, but it seems to me like it’s more likely to now be more states going legal, but at the same time it could be that states also push it off, I mean like we’re seeing in New York. So, I guess kind of, who knows? Do you have an opinion on that, likely the changing with, kind of, it becoming an essential amenity with COVID?
MR: I mean I think the fact that so many states labeled it in some form an essential service. I think the last count I had was maybe 28 of the 33 and they have changes daily and there is nuance to all of it, but I think you combine that, that’s first a good lobbying argument at the federal level. Then, second you just layer in, you know there is just less politics and I guess more just economic math if you ramping up. If you are hitting tax revenue and ramping up government expenses and then also, you know you’ve upended a lot of service economies that even if they come back it’s still, even if the restaurants can open again, there is going to be a lot that don’t reopen I think. You sort of upend all that and you sort of need generally domestic jobs and this is a product that you can like legislate to be – I mean at this point it is literally intrastate, right, like you can’t ship across state lines at this point even.
You are going to start to see, well how do we generate revenue? Okay, let’s maybe we try legalization and I think that all pushes in the legalization direction, the caveat being if there was something like okay next Wednesday we’re going to debate this provision that probably gets pushed off I’m guessing a little bit. But next year, when they can’t make our 2021 budget or 2022 budget – it generates a fair bit of tax revenue and that’s how most of the places are legalized which are on more of the tax side.
RS: Yeah, I mean wild times that we’re living in and I think you know just a month ago or two months ago we were having very different conversations about what this year was going to look like. You know welcome to life I guess. It’s interesting. I mean, I would think like when you started also the conversations where you know when you started in the cannabis industry conversations were very different than they are now. I mean people were excited about Canada, now people are not, you know. Things change quickly.
MR: Yes, they definitely do. I think if you can have the stomach for sort of near-term volatility, I do believe in sort of that longer term thesis that you know this is a proven consumer good that’s going to disrupt a lot of existing industries and gain share from a proven market and I guess the other thing we didn’t get into was the analysis we just did where, I basically went back and analyzed what other consumer companies had done in the tech bust, you now 1999 to 2003 tech bust and 9/11 and in the great financial crisis, sort of what did those consumer businesses bottom out on valuation? And it ranged depending on the business model, but placed on average it was, they bottomed at 7.5 times EBITDA and about 2.4 times sales.
So, if you can – the key caveat is, remember that’s probably after you’ve reduced your estimates. You know like the company comes out and says, sorry we’re not going to make 100 million this year, we’re going to make 75 million this year, once you sort of get down to that base level number, you can underwrite an investment at 7.5 times EBITDA at least history shows that that was on average where the consumer companies bottomed out. And there’s a lot of companies, especially in the U.S. operators that they are trading below 7.5 times EBITDA. I would want to go back and really cut those estimates, but even if you double it, cut the estimates in half that four times on 2021 goes to 8 times you’re starting to get sort of where other consumer companies have bottomed out is sort of my general point.
And then you get exposure to that longer-term thesis. Again, assuming you know it’s not the bond holders who owned everything. That four times EBITDA isn’t, you know it’s levered at 3.9 times EBITDA and you’re that little sliver on the equity side, in which case you should just buy the bonds if you can.
RS: Many important caveats to implore.
MR: It’s not like they are trading at 20 times revenue anymore. You know, you can make reasonable arguments like okay that seems to make, the valuations are trying to look like normal companies.
RS: Right, right.
MR: Normal companies that don’t have multi-decade, long-term macro growth thesis behind it.
RS: Exactly. Well Mike, I think we’ve covered a lot of good ground here. I think you’ve also brought up a lot of really interesting points. I like the comparison with the tech world and seen where they’ve bottomed out. Anything else you want to leave listeners with?
MR: I think just you know at the end of day investing is finding the good management teams and good balance sheets to allocate your own capital. So try to really understand you know what’s the business model and what’s the investment case that that management team is doing before you invest in a specific company and that goes on the public and the private side you know. Here’s a dollar, what are you going to do with it, that’s – we’re going to grow it essentially, just really understand what those are and do your own homework.
RS: Sometimes you got to get back to the basics.
MR: Yes.
RS: Well Mike thanks so much for taking the time and sharing your knowledge and expertise and insight with us. Really appreciate it.
MR: Thanks a lot.
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