The first half of 2022 was dominated by macro-related news about inflation, rising interest rates, high gas prices, supply chain issues, and a bear market for public equities. As a result, sourcing equity capital became even more challenging for cannabis operators, leaving debt capital as one of the only viable sources for capital today. In fact, approximately 80 percent of all capital financed in 2022 has been via the debt route. Making matters worse are continued delays in significant regulatory reforms (particularly with the SAFE Banking Act), which have added uncertainty and frustration among operators and investors alike.
Despite these cumulative macro and regulatory headwinds, many operators are continuing to execute and report accelerating levels of revenue, profitability, and cash flow. The industry as a whole is expected to see top-line revenues trend toward $30 billion by the end of 2022.
With the industry expected to continue facing a number of macro, regulatory, and industry-wide challenges throughout the remainder of the year and beyond, here are four key trends to keep an eye on, along with strategies that can help companies navigate the rough waters ahead.
Lending standards tighten
Cannabis lenders are taking a scrutinous approach to underwriting, and their definition of a sustainable, viable business is very different from what it was just a year ago. Gone are the days of focusing on revenue growth projections and the “land grab” with the number of dispensaries and brands a company holds. Now, lenders want to know whether a business is already profitable or if the management team has laid out a clear and credible path to profitability and scaling the business.
Diving down deeper, there will be decreasing levels of focus on financial metrics like earnings before interest, taxes, depreciation, and amortization (EBITDA) and more focus on sustainable levels of net operating income and free cash flow. As such, lenders will pay more attention to the underlying business and the executive management team’s ability to scale, rationalize expenses, and drive profitability across vertically integrated businesses.
Institutional money remains elusive
The public cannabis market in the United States remains highly inefficient and limiting because plant-touching businesses are allowed to trade only on the over-the-counter markets (in the U.S.) and the Canadian Securities Exchange (in Canada). Exacerbating this challenge is the lack of firms that allow for property custodial services for publicly traded cannabis stocks. As a result, the majority of institutional investors, ranging from mutual funds to large hedge funds, are relegated to the sidelines and not investing in the sector today.
These structural issues, combined with the frustration about a lack of any meaningful regulatory reform, have been the main culprits in driving virtually every multistate operator (MSO) stock down more than 60 percent on a year-over-year basis—despite the underlying fundamentals on an operational and financial basis for many MSOs having improved meaningfully over the past year.
Unfortunately, the latter fact has fallen on deaf ears in the institutional investor community. The downdraft in public-equity valuations for public MSOs surely has a domino effect on private companies and single-state operators, whose equity valuations are becoming more stretched and whose consolidation and acquisition opportunities have been postponed.
Going forward, one of the potential positives of the proposed SAFE Banking Act will be the emergence of more financial institutions that not only will provide much-needed custodial services to the sector but also potentially open the door for some of the MSOs to upgrade to a major U.S. exchange like the New York Stock Exchange or Nasdaq.
Debt capital is available but not easy to access
The level of scrutiny from lenders is at an all-time high, given that many have been burned by mismanaged companies imploding and being unable to pay back their loans. As with lending to any other sector, the issue boils down to three important factors: collateral, debt service, and debt covenants.
The key here is lending to solid businesses that can scale effectively and profitability, as the underlying collateral packages are only as good as the company’s ability to service the debt payments. As a result, while the underlying collateral packages provide foundational support, there is intense scrutiny on the business and the related management team’s ability to execute against their strategic, operational, and financial goals and objectives.
Operating a vertically integrated cannabis company is no easy task, as it encompasses a wide range of skill sets ranging from agriculture to specialized manufacturing and retail/branding sales. As a result, the ultimate scorecard for a company’s financial health is its income and cash-flow statements, not a fancy pitch deck.
Inflation is a growing concern
While rising interest rates don’t directly affect lending to the industry—due to current federal status, cost of capital in the industry is typically around 300 to 500 basis points higher than the prime rate—the overall impact of inflation will be felt on the consumer-demand and cost-input sides. When consumers have less discretionary income, they naturally will rethink prices and reevaluate the quantity and quality of the products they buy. In short, many consumers will “trade down” to lower-priced products or even return to illicit markets where price points are typically materially lower.
But as proved by the past few years during the pandemic, when the sector was deemed an “essential business” by all legalized states, cannabis demand remains resilient. On the cost side, supply-chain pressures have been affected negatively by inflation, which has been reflected in many supply-constrained direct costs and construction-related costs. As a result of these added macro pressures, many companies have been forced to take an even closer look at their business and proactively make tough decisions to be more efficient on both the pricing and cost side of the ledger. The ultimate goal, of course, is to accelerate profitability and/or shorten the path to becoming profitable.
As we look at the rest of 2022, it is helpful to remember we’re still in the early innings of a multi-year growth pathway for cannabis as it slowly evolves into a major consumer-packaged-goods category. Many early entrants—companies run by founders with big dreams and hopes for federal legalization—rapidly are being replaced by successful corporate leaders from relevant or adjacent CPG industries and other industries prioritizing sustained and growing profitability over nebulous big-picture factors such as number of owned licenses or wishful thinking about regulatory reform. The strongest businesses simply will focus on company-specific factors that are within their control to build lasting shareholder value, which will be noticed and rewarded by large and mostly untapped institutional investors someday soon.
Paul Penney is a certified public accountant and the chief investment officer at Safe Harbor Financial, where he is responsible for running the company’s senior secured lending efforts. He is actively involved in institutional investor communications and mergers-and-acquisitions-related efforts.