Is FOMO Driving a Greater Fool Trade?
It’s been an eventful month on the regulatory side and the accelerating evolution of the cannabis industry continues to amaze. Within that evolution, over the next three months, approximately 10 to 15 U.S.-based cultivation or dispensary operators will either go public or complete “pre go-public financing.” We are constantly asked for our perspective on these opportunities and while we try to be responsive, our thoughts are more general in nature. We feel it's important that our ecosystem has some sense of the risks and opportunities this vertical presents to help you better review and analyze these unfolding transactions. There are certain fundamental ideas that underpin Merida Capital Partners' thesis of cannabis as an investment:
As cannabis becomes less restricted legally, more people will consume cannabis medically and recreationally and usage will likely grow at a healthy clip per year until the middle of next decade.
Cannabis will be both a medical product and an adult-use consumer product in virtually every large state (except for Texas, perhaps) in the next several years.
Federally, cannabis descheduling will occur in a reasonable period of time.
As more states liberalize their laws, government regulation will become the most important exigent factor for the vast majority of operators.
As more professional operators enter into the space, or scale existing operations, the supply chain will become more sophisticated, leading to the growth of leading supply chain providers that will outstrip the growth of cultivators deep into the future.
We could go on and on about the industry CAGR and shifts in attitudes towards alcohol, recreational cannabis and the medical replacement of opioids as a maintenance medicine but for the purposes of framing our thoughts on a fast-evolving trend which is the focus of this commentary, these simple fundamental ideas suffice.
Some of the companies going public are great companies that will succeed over time. Some are riding a wave and will not perform nearly as well. Of equal importance to the future success of the offering is how they price their public securities, how the public offering is structured, and what their actual financial results are since you cannot blindly rely on public investors to push these stocks up as they go public. The markets are starting to become better at assessing risk/rewards of the U.S. cultivation vertical and eventually, it will differentiate between strong and mediocre, or even poor operators. The link below relating to an article detailing some of the financial engineers starting to participate in these offerings is another cause for concern for smaller investors.
The definition of a “greater fool” trade is one where the merit of a company is immaterial to the purchase; you are simply buying a security because you think it will go up, thereby creating a window for when you can sell for a profit to a “greater fool.”
Given the risks of our industry this is a bad way to play the cultivators going public. We believe fear of missing out (FOMO) on the cannabis opportunity is driving some interest in these companies and we see significant risks in buying into some of the high market capitalizations indicated without these companies having current revenue or profits to justify such high valuation levels. This does not apply to any opportunity specifically but most of these companies are still early in their growth cycle.
Looking at the existing public inventory of cultivators is one of the best ways to determine if a company is pricing its offering correctly. As of today, there are several public companies in Canada and the U.S. that largely rely on U.S. cultivation for the thrust of their opportunity. Terra Tech (TRTC), MPX Bioceuticals (MPXEF), iAnthus (ITHUF), and Liberty Health Sciences (LHSIF) -- whom we helped with their successful application for an Ohio dispensary license -- are all trading publicly and have been so for some time.
The market has had ample time to digest these opportunities and their stock prices would seem to be a sophisticated and nuanced “democratic vote” on their valuation. As a comparison, all of these companies would appear to be trading at much lower valuations/metrics than the soon to be public crop of companies based on our review of the opportunities we have reviewed.
The Canadian market has far more public cultivation companies and, with federal legality, access to large, overnight bought deals. We recently analyzed the 22 bought deals (i.e. registered PIPEs that are priced at closing) from January 2, 2018 to May 24, 2018 and the results are surprising if not outright shocking.
With over 1.2 billion CAD raised across these offerings, only five of the 22 were in the money at the time of this analysis, and two of the five were in the money due to acquisition. Clearly the risk tolerance of the Canadian market and ability for cultivation companies to raise gobs of money with somewhat elastic pricing sensitivity has driven the U.S.-based companies to the capital markets there. What is equally interesting is the tolerance of investors who continue to buy public Canadian securities in companies who are likely to continue tapping the market for capital, knowing that many of such deals are not only dilutive, but are quite likely to drop after that dilutive raise. An article linked to below in the Financial Post could explain why this is happening. Whatever the reason, this is an important fact to consider as you look at this new crop of U.S.-based companies who are sure to aggressively tap the markets for capital after going public.
We note that if you are evaluating these opportunities in U.S. cultivation, regardless of where they trade, you may be buying into the thesis that these companies can use their balance sheets to acquire assets at metrics that offer high yield operating opportunities. There are a few reasons to be skeptical of this. In mature markets where there is no competitive constraint, our research says that successful operators will not be eager to sell for anything less than EBITDA driven metrics that would make a public acquirer hesitant to move forward. In higher barrier medical markets, operators who are barely built out, or just starting to hit their operational sweet spot, will want much richer metrics given their current lack of earnings. In either case, each opportunity must be scrutinized carefully for relative risk/reward skew based on where they are operating and what those state markets look like.
Consider that licenses in Florida that required, or require, large capital buildouts of $20MM or more have sold for $45-$55MM. It takes a long time to make $65-$75MM in sunk costs back and should Florida add licenses while companies are still climbing the curve to profitability, it could take years for Florida cultivation operations to be profitable. On the flip side, Colorado, California and Oregon are mature markets where big revenues don't necessarily translate to big profits anymore so lower metrics are not a guarantee of high yield for an acquirer.
With at least 10 newer public companies and 4-5 existing ones vying for every asset, it's unlikely that it will become cheaper to acquire assets, so you could essentially be buying into multi-state cultivators at premium valuations who will then need to dilute their equities to acquire the assets they need to justify the valuation; that is not a virtuous circle of value creation. Some of these companies will go public at reasonable valuations, and some will execute on a smart plan, but simply buying into them because you believe someone else will buy the stock from you at higher levels is a trade that requires constant vigilance, a strong risk tolerance and a highly attuned sense of trading inflection points.
Our advice: be patient, be thoughtful, and do your due diligence to avoid “chasing” value. Specifically, look for companies that are priced modestly to leave a fair amount of value for new, post-public buyers to buy into after the offering. Some of these companies are sure to be big winners but if you are thinking about investing in these trades, be aware that if you are instinctively assuming that you can flip these stocks for a quick profit, the “greater fool” in this trade might be looking at you in the mirror.