US MSOs are Likely Undervalued...No, Seriously!
One of the most lucrative, yet difficult verticals to analyze, is currently the US multi-state operators (MSOs). The vertical is a dynamic, fast-evolving part of the cannabis ecosystem, which makes the complexity in analysis equally true for investors ranging from Canadian investors, who are just beginning to focus on the US opportunity, and sophisticated investors who have been investing in cannabis for years.
At Merida, we have a unique perspective on this vertical, which is fortunate since we get a significant amount of questions on the topic. This perspective didn't come easy or through distant observation. I submitted a Connecticut application almost 5 years ago to the day (Connecticut being the first state to pursue a limited license, for-profit model). My team finished first in that process and with Connecticut's program up and running in February 2014, I began learning about the early version of the MSO model as states like Illinois, Minnesota and New York soon moved to make changes to their laws that would allow similar programs to exist. Minnesota moved most quickly, awarding two licensees licenses by late 2014 and Illinois following suit in early 2015. My team scored in the top 2 in Minnesota making our team an early MSO of sorts in late 2014.
At that point, I had spent the better part of two and a half years developing local resources, forming operating teams, raising capital in a far more constrained environment and drafting application materials that would underpin two separate state operations with different sets of rules in what was the cannabis Dark Ages. Add to this an unsuccessful application in Illinois and the resulting amount of information gathered from the regulatory deep dives and local efforts was massive. That was nearly 4 years ago and while there was no guidebook on how to scale operations across multiple states in a federally illegal industry, my partners and I largely focused on what was happening within each facility in order to ensure that patients received their medicine and we generated revenue without crop failures. This was the Model T version of the MSO vertical, with New York and Illinois license processes truly ushering in the beginning of what we now think of as the MSO vertical.
It became clear by mid-2015 that the landscape for these operations were largely changing due to the time and resources needed to even apply for a competitive license in one of the limited license states. For me, what really drove home the reality of this changing license atmosphere was an experience I had in mid-2015 while working on the pre-development stages of Maryland and Pennsylvania licenses. I had the opportunity to present our PA applicant company to the York Economic Development Commission. I had been on the road for six days in Western Maryland and Central PA, missed my wife and young kids terribly and was fried from the travel, long meetings with local officials, potential partners, potential executives, and investors.
Another group was invited to present that same day so that York could climb the learning curve on medical cannabis. The other group presented first and did a great job of laying out their company's story. They had won a license in Illinois and illustrated how they could apply lessons learned in Illinois to their current proposed operation. I knew that their executives had been crisscrossing the state looking for the right community to build and had simultaneously been working hard in Maryland to build the local base of support there. They were digging ditches in a manner that very few were doing in limited license markets in 2015 and I understood the strain and toll that could take.
When I got up to make my presentation, my mind was filled with the experience of the past three years and how most industry participants rarely had anything good to say about their competitors and how everyone was the best and all others were beneath them. This aspect of the cannabis industry had always irked me but the only way to really change that was to not do it. I focused instead on our medical approach, gave the other company its due as a professional operator, and simply wanted to make sure that York understood the positive impact cannabis could have on the local community which had been hard hit by the drug war and opioid epidemic. The response from the leaders of the York community was overwhelmingly positive that day for both groups.
The other group was Green Thumb Industries, or GTI. Pete Kadens, GTI's then-CEO, came up to me after and he could not have been more gracious. Pete and Ben Kovler (and their entire team) have done a great job building GTI into a $2B company since those early days. We ended up speaking for an hour because we were in a small fraternity at that time and the friction of what we were doing was something worth discussing, even if we both kept our strategies vague. As we found out soon enough, two dozen or more other companies were also working away at this path and after the last three years of circling each other like boxers in a prize fight, all of these companies are now colliding into each other, with different paths and stories to their MSO journey with the chase for large market caps as the binding thread.
Its these billions at stake that make the MSO vertical so essential to comprehend. Understanding the state regulatory frameworks that are advantageous to MSOs requires a tremendous amount of contextual analysis while lacking the necessary reference points, particularly important now as valuations for public, or soon-to-be public MSOs, have ballooned past a billion dollars. Many of the companies in queue to go public have valuations in excess of $1 billion even though they are early in their revenue life cycle and still losing money due to rapid capex or opex expansion. Merida’s principals come from this world and understand it well. While valuations for these companies seem extremely high one thing seems clear: the MSOs that succeed over the next two to three years are significantly undervalued at today's prices-you heard that right. Significantly undervalued.
We realize that synthesizing the MSO opportunity necessitates far more information than just looking at capacity or state licenses held, or footprint. Without context, footprint or licenses means very little to ultimate value. I'd rather have three dispensaries in limited license Maryland than Los Angeles. Why? Maryland only allows ~100 dispensaries by law or about 1 for every 60,000 people. That is unlikely to change for a long time. California will likely end up with more than 1,000 dispensaries in 2018 and 2,000 by the end of 2019. That would put it at about 1/4 of the ratio of Maryland. Pennsylvania and Illinois have even better ratios. A quick look at the highest valued MSOs as of now shows that they have licenses in NY, Illinois et al. That is the power of limited licensing in the current federally illegal environment.
The benefits to MSOs who have established their presence is pretty straight forward because of how hard it is to operate these diverse organizations. MedMen is a great example. Whatever flaws MedMen has, they are in a small group of multi-state operators (MSOs) that have been able to acquire limited licenses in several states, which has helped their public efforts to raise significant capital. How many other early California dispensary owners have been able to go public with operations like Medmen in CA as their sole asset? One-Harborside and at a fraction of Medmen's valuation.
For that reason, MSOs (including Medmen) deserve credit for taking the path less traveled because what they are trying to do is very difficult. That difficulty comes from a multitude of directions we will lay out below, and there is a certain mindset and expertise you need to plow through the MSO development. Companies that are doing it now are much farther ahead of companies just waking up to the opportunity than people realize.
The fact that we may highlight Medmen or any company's flaws (particularly on governance/capital strategy), must be tempered by what we unequivocally know to be true: MSOs all deserve a ton of credit and respect for simply grinding forward through an unknown landscape. We admire their work, grit and efforts, and respect them all for what they have achieved and are trying to achieve. Period. Full stop.
We aren't recommending anyone buy any specific company’s stock at this time even if we think we have a good idea of who will succeed over time. It is worth pointing out that MSOs that are efficiently run will shine when the time comes when apples-to-apples comparisons of MSOs will be possible. At that point, numbers will be compared confidently without biological value adjustments, one-time charges and other reporting quirks that make it difficult to get a true operating picture.
In that context, the biggest risks to MSO success right now are non-accretive dilution from overspending and over-extension of operations causing significant operational failures. Also crucial is staying focused and disciplined on core opportunities (as opposed to “spraying and praying” as an acquisition strategy). The lessons of Greek general Pyrrhus spring to mind; that battles being fought now (or in this case, ambitions pursued) should be avoided if they come with casualties which leave you unable to continue the war.
MSOs in general all face this: the cost of “winning” now versus “winning” long term, of overpaying for assets, trying to win de novo licenses, merging with a competitor, or overspending to win the marketing cycle. Winning one small battle is never worth losing a war and rarely is one decision responsible for either. The constant application of sober, long term thinking will ultimately prove successful primarily because the MSO game is far harder than investors realize and only a small class of people/companies (maybe 100-150) have tried it and really understand its incredible complexity.
So let’s spill some ink laying out the challenges and why GTI, Cresco, Acreage, Curaleaf, Vireo, 4Front, GrassRoots, Columbia Care, Ianthus, Harvest, Liberty Health and a select few others are likely to grow into dominant national players.
The reward for MSOs is now clear. MSOs have an easier path to go public and an easier path to raise capital. Which allows them to hire top talent. Which gives them a greater ability to aggregate crucial information to make smarter decisions. Which can help them experiment with new technologies, or research and develop specific approaches that a single state operator can only dream of except in small isolated cases. They obtain currency to acquire licenses where they did not win or apply. They can acquire or merge to create additional shareholder value and most importantly, they can position themselves strategically in the $100B+ U.S market that is the golden gem of the global market. You can thank federal illegality for that but ultimately, even Canadian companies will be looking for U.S assets and in truth, only a few will have enough cash or value to even think of acquiring a top 20 MSO in 2020. Merger? Possibly. Outright acquisition? Unlikely.
But not all MSOs are identical. We tend to view the MSOs based in limited-license states as far more likely to see larger valuations over time. Will a few companies that have operations across California, Oregon, Nevada or Washington succeed? Absolutely. That said, if you are looking at the highest probability of a top market capitalization, the focus needs to be on MSOs who have multiple limited-license operations in states like Illinois, Ohio, Pennsylvania, Maryland, New York and Florida. The reasons are many but here are the top reasons why limited-license MSOs are likely to grow in value from here but also why they are hard to value. And as the title states, why the best ones are likely highly undervalued.
1 - The Risks of Competitive Licensing
As Penelope Ann Miller said in Carlito’s Way, “If you want to get IN, you need to get in.” In the MSO world, that means obtaining licenses in constrained limited-license states and small pockets in Arizona and California. Operators in other adult use states lack competitively won licenses and it's much harder to shift into that mode now that there is an established base of MSOs with the muscle memory and resources to compete in every new state. While there are plenty of Colorado, Oregon or Washington operators, many have not had to go through this type of licensing and are a different breed of operator. You want examples of the type of effort required to win licenses?
A well-established Colorado dispensary operator applied with Northwell (formerly LI Jewish Hospital), a top hospital system in NY, and finished in 20th out of 43 applicants. With the best-connected hospital system in the state! Tilray finished 32nd out of 43 in NY. Yes, that Tilray.
For most MSOs, scaling means winning these de novo licenses. Vireo owns one of two Minnesota licenses. Curaleaf, Columbia Care, Vireo, MedMen, Acreage and Ianthus all have a license of the ten in NY. Grassroots and 4Front are in PA/Illinois/Ohio, GTI in Ohio, Illinois/PA/MD, Cresco in PA/Illinois/Ohio, Liberty Health in Florida and Ohio, Harvest in PA/MD, and virtually every MSO worth knowing has won high stakes licenses that carry massive terminal value.
When you survey the landscape of states, the limited-license medical states are likely to provide much more stable ecosystems for operators as they grow, but winning licenses in these states is fraught with risk. And when they go adult-use, these MSOs have a significant scaling advantage and embedded customer base to build off of. Massachusetts is a great example of that. This tactical advantage cannot be easily valued right now but it's only overvalued in a few companies in our opinion.
The risks of the MSO licensing approach are not insignificant. The expenditure on developing an application can run from $2-5 million of pure risk capital and if you lose, that money is vapor. This is exactly what happened to my application in Maryland, five days before launching Merida in late August 2016. While we were fortunate that our two years of work and $2.2 million did not go to waste as we eventually merged our developed assets into a winning applicant, the initial disappointment of that loss was the type of professional rebuke that is never truly forgotten. How did we react? We stayed true to our plan to launch Merida and focus the same sweat and toil we used to build a massive local effort on ancillary opportunities that did not need licenses rather than continue fighting the licensing wars.
All of the MSOs who now fight for these license are incredibly sophisticated in their approach, which takes time, money, executive bandwidth and local partnerships/local talent (which must be developed with time, money and executive bandwidth). They also have a consistent methodology for managing reputation, quality control, and razor-sharp resource allocation, After all that they need to spend $25 million or more to build out a facility, develop a patient base, and lose money while programs get up and running, all while reacting to constantly changing laws. Sounds fun, right?
2 - Travel and Local Development is a Grinding Grind
As I highlighted before with my interaction with GTI in 2015, developing an MSO requires a ton of travel and local development. The MSO path requires an immense effort at the corporate and local level and an internal professionalism that was not often found in 2013-14 or more broadly because the industry requires companies to ignore federal law, which can lead to a lack of formality or career paths that teach corporate development. That alone is one reason why there are 20 or maybe 30 companies that will be able to pull it off.
How many hundreds or thousands of local meetings or presentations have Columbia Care, Liberty Health, Ianthus, Grass Roots, Vireo, et. al. done since they started. I've done hundreds myself and I moved to an ancillary-focused investment thesis when I started Merida more than two years ago. By now, it is too numerous to count but many have valuations to justify that hard work.
While I don’t know every single executive from the companies above, I am fairly sure they are constantly traveling, meeting local partners, reviewing facilities, putting out fires etc. Over time, that muscle memory and experience become hard to compete with unless you have done it yourself. This may be unscientific but the most common text I get from an executive in the space I’m trying to call is: “I will call you when I get through security.” Enough said.
3 - Losing is Baffling, Painful and Expensive
I can’t say for certain if every company on the list has ever failed to win a license, but I know many have. Vireo and GTI had long fights in court to get their Maryland licenses after the Maryland process was exposed as somewhat irregular. Curaleaf and iAnthus finished out of the top 5 in NY before five more licenses were added (and a lawsuit to stop those five failed). Several of the MSOs lost in the first stage of Pennsylvania licensing as well.
The point isn’t to highlight losses but rather to point out that it takes a tremendous amount of corporate will to plow forward through the disappointment of losing. The calls with investors, the sickening feeling of wondering what you could have done differently, the frustration with arbitrary standards of scoring applications in various states, etc.
Losing can also feel like a repudiation of a company or its methods that is hard to reconcile. For larger MSOs, it can have profound consequences on stock price, investor sentiment and divert resources from existing operations. The opportunity cost is simply massive. As many of our portfolio companies would attest, we put a maximum effort in helping them build their companies and putting up to two years in a company-building effort that could be a zero is something I don’t miss now that I lead Merida.
Now that the MSO opportunity is becoming defined (and lucrative as heck), it’s going to be interesting to see who wins and who loses in New Jersey since virtually every MSO I have spoken to has submitted an application; note that only six can win there. That is high-stakes work and losing companies will not react well.
I know that pain, my partners know that pain, and for a public company, New Jersey is going to leave some companies worse than it found them. When large, well-capitalized companies lose, it could get ugly in the immediate aftermath. To reiterate: The MSOs are valuable specifically because they are attuned to these risks in a way that a Washington company applying the first time won’t be. And Canadian companies? They had a chance to work with Health Canada iteratively on their applications; there were delays but no risk of “losing” if they took care of their business.
4 - Information is Power
When you are operating in four states and spending $20-$30 million in opex, you are going to be consuming a lot of information. The muscle memory we often refer to is really just a cute way of describing a company’s information gathering, and how it reacts to the collective data it has. Merida often vets 50 or more companies per month and uses the information we gather to put all of our opportunities into context, learning from each interaction so we can draw sensible conclusions. The MSOs who will ultimately succeed do likewise. They research, they develop, and they consume data the way Merida does.
There is no understating the value that every single vendor or company looking for capital or to sell a product approaches MSOs. Though it can be overwhelming, you can learn a tremendous amount from the velocity of information that comes your way. We often compare and contrast ideas with MSOs and we find that they are far more plugged into the information flow than other industry participants. The top seven or eight Canadian LPs also have the luxury of this informational firehose.
To illustrate this in a holistic manner, MSOs have a ton of internal information, a great deal of regulatory knowledge and compliance-related information, and platforms across many states from which to learn from. That base of knowledge is already a huge advantage over a single state operator. Add to that the deal flow, research, and other information to be gathered with bigger staff and multiple points of contact within a widespread organization and after a few years, it is virtually assured that MSOs will have a vastly superior information/data feedback loop than smaller organizations, and the best ones will use that advantage to drive asymmetric value far in excess of their less nimble peers.
What is that worth over two to three years? We assume that information advantages could translate to billions of dollars in smarter and less expensive acquisitions all the way to efficiencies in operations across five or six standalone facilities.
As those efficiencies magnify and accumulate, you will have large, well-versed and well-funded companies looking to acquire assets, create new products, or compete at levels that only other MSOs can play. In a $100 billion-plus industry, the information advantages and lessons from competing for licenses, combined with experience operating in stricter markets is just the type of training that can help turn millions of dollars of revenue into billions of dollars of market cap.
5 - Strict Markets Are Educational Laboratories
If you are competing for market share across several states, at a minimum, a company would need to comply with the highest standards required for its licensing. MSOs have massive advantages on this front. When California passed its adult-use law, they gave operators nearly 18 months to bring their operations up to a higher standard. Even with that time horizon, many California-based companies failed to properly prepare for the changes in laws. When we won in Minnesota in 2015, the law required that cultivation and dispensaries be operational in six months under incredible regulatory scrutiny. Many California companies weren’t even doing required laboratory testing after almost a year after the BCC gave them notice of new requirements. Rules drive behavior and MSOs are under constant rule pressure.
It's simply a different animal in limited-license states. Most limited-licensing states require strict guidelines about operational timelines, lab testing, quality control, nutrient/pesticide usage and security. They also require far better record-keeping. In many ways, MSOs become better organizations because of the external stress of the regulatory regimes they are operating under. Due diligence efforts on an MSO who is public reveal audited financials and even private ones often have impeccable record keeping. That is still somewhat rare in cannabis industry.
Like the biggest LPs in Canada, MSOs in the U.S. have been forged into strong operations through their exposure to tight regulations and the advantages from having greater capital channels, greater access to information and access to resources of a wide variety. As we are now seeing in Canada, you will be able to assess MSOs on an apples-to-apples basis and determine which are most valuable or offer the best opportunity as they scale over the next few years.
Stock prices will go up and down as investors react to news or events that might be out of a company's control. As the U.S. market progresses towards loosening, we aren’t recommending investments in any specific company even though we have thoughts on which MSOs will have the greatest success, and which will be mediocre or possibly fail. The point generally is that MSOs are likely undervalued when considering all of the accumulating advantages. We believe that this will lead to tremendous value over the next two to three years for those MSOs who judiciously utilize those advantages.
Long term, the MSOs will be just fine. Don't focus on the short-term stock price as it likely doesn't reflect the long-term value these companies will achieve over time.