As we roll through 2022, getting past what many are calling the post-COVID-19 pandemic era, the cannabis industry and the economy in general, appear to be hitting a reset button as inflation reaches a 40-year high with no sign of a quick retreat, legislative reforms for the industry stall (yet again), interest rates rise and labor and supply chain disruptions clip the appeal of growth investments. The multi-pronged economic stimulus introduced by government in response to COVID in 2020 and early 2021 resulted in added liquidity for many which resulted in a surge in cannabis consumption and production as lockdowns and closures forced citizens to occupy their spare time in relative isolation with homebound recreational activities.
Most jurisdictions deemed cannabis an essential service during the pandemic pause which has expedited certain distribution channels including online ordering, curbside pickup and home delivery in a growing number of locations. Now that the stimulus has dried up, inflation is eroding purchasing power and the era of cheap money is seemingly behind us, marijuana commerce has slowed as evidenced by a tough earnings season for cannabis companies in the first half of 2022. Barring a major move out of Washington, legislatively or judicially, the outlook in the cannabis sector for the rest of 2022 is not nearly as upbeat as it was in the second half of 2020 and through 2021.
The cultivation sector of the plant-touching side of the industry is experiencing a redux of late 2019 with prices for wholesale product plummeting in many markets, both mature and emerging, in response to oversupplied conditions in many state markets. Growers are becoming much savvier and more focused on costs of production, forcing many smaller, older generation facilities to rethink their foothold in the cultivation sector unless they possess unique genetics or are in jurisdictions that continue to limit regulated grows in relation to the respective market. The current limitations on interstate commerce creates incredible inefficiencies as compared to other agriculturally based products which enjoy the privilege of open interstate commerce.
Retail is still stuck in IRC 280E federal income tax hell without imminent relief and the processing side of the industry is witnessing the emergence of true brand wars like never before, notwithstanding the fact that the overall industry is still young and evolving dramatically. Consumers in the more established markets like Colorado and Oregon are becoming much more astute, generally speaking, and are seeking out brands that represent consistency and quality. The municipal battle lines in each state that has approved regulated access are receiving much more focus. For example, Michigan has had state legal access to recreational cannabis since 2018, but it is available in only 300 of the 1,800 municipalities within the state, with Detroit, the state’s largest city, still facing challenges to approve owners and operators of recreational dispensaries within the city limits. Similar municipal restrictions remain prevalent in other states, including California, where Los Angeles continues to only see limited access. Social equity protocols are becoming much more common for new and increased license rights, but with a lack of consistency on what qualifies under emerging state and local social equity criteria.
Justice Clarence Thomas laid down the gauntlet in June 2021 with his statement in the Standing Akimbo II v. United States case that if the federal legislature didn’t sort out the federalism dispute soon the court may need to resolve it judicially (“Standing Akimbo II, 955 F.3d at 1162-63” Standing Akimbo, Inc. v. United States, Miscellaneous 18-mc-00178-PAB, 13 (D. Colo. Sep. 2, 2021). Petitioners argue that because § 280E allows the IRS to investigate violations of federal criminal drug law and does not prohibit the sharing of the incriminating information with law enforcement, § 280E is unconstitutional.). Justice Thomas issued a stern warning to the other branches of the federal government in his June 28 statement as part of the denial of certiorari in this case, stating in part: “Once comprehensive, the Federal Government’s current approach is a half in half out regime that simultaneously tolerates and forbids local use of marijuana. … If the Congress and Executive don’t get their act together then the Supreme Court will likely take up a future case. … A prohibition on interstate use or cultivation of marijuana may no longer be necessary or proper to support the Federal Government’s piecemeal approach.”
In July 2021, we saw the release of the Cannabis Administration and Opportunity Act (CAOA) led by Senators Chuck Schumer (D-NY), Cory Booker (D-NJ) and Ron Wyden (D-OR) with a certain amount of fanfare, but this omnibus legislation appears to be stuck in political limbo as Washington juggles all things political, trying not to give the opposing party any advantage. The upside of the CAOA is that it incorporates most all of the three key pieces of legislation already passed in the House: the SAFE Banking Act, the STATES Rights Act and MORE Act, but the downside is that the CAOA proposes to layer in myriad new regulatory and compliance hurdles that will be a challenge for Washington to coordinate and implement between a number of agencies, including the FDA, ATF and beyond. As noted above, all of this is occurring in an environment that is demanding more attention to a wide range of social equity reforms that are incredibly diverse in definition between both state and municipal agencies.
The larger multi-state operators (MSOs) continue to roll up smaller players given the valuation gap that exists between larger MSOs (with a market cap greater than $750 million) and smaller MSOs (with a market cap of less than $300 million) in public and private markets. The vast majority of these deals involve a large component of stock paid as consideration, which is typically subject to significant lockups and sale restrictions. This aspect makes deal values extremely difficult to analyze from an economic value perspective given the volatility of the currency paid —restricted emerging market equity. At the same time, cannabis stock valuations of publicly traded cannabis companies continue to retreat, and the pace of deal activity has slowed as the arbitrage opportunity of buying a cheap cannabis company with an expensive one has narrowed significantly, rendering deals not as “accretive” to the buyer.
Public cannabis investors, who tend to place more emphasis on the short term than the long term in their buying decisions, have seemingly thrown in the proverbial towel on cannabis equities sending cannabis stocks plunging over the last year.
Many have invested in the cannabis sector on the expectation that eventually the federal government in the U.S. will deschedule marijuana from the Controlled Substances Act of 1970 and, in turn, remove the IRC 280E tax burden and eventually lift the restrictions on interstate commerce (It is anticipated that any federal legislation to deschedule marijuana from the CSA would also add a federal excise tax similar to the Alcohol and Tobacco excise taxes. The MORE Act passed by the US House of Representatives would add such a tax starting at 10% and gradually increasing to 25%). While we believe this all will happen at some point in the future, the likelihood of this happening in the next one to two years is dubious, at least from a legislative front. The September 2021 Glass House Brands acquisition of a 5.5-million-square-foot, high-tech greenhouse in Ventura County California for the production of high-grade marijuana flower is just one prime example of the industry moving toward eventual interstate commerce.
Many Democratic leaders want a wider range of reform that addresses the descheduling of marijuana from the Controlled Substances Act, expungement of cannabis related prior offenses and emphasis on social equity components for new licenses, while Republicans may be more amenable to incremental reform.
With a perfect storm of issues looming over the cannabis industry (lack of reform, rising rates and inflation) and a disappointing earnings season for cannabis stocks in the first quarter of 2022 following a banner year for cannabis sales in 2021 boosted by COVID-19 stimulus, the value of many publicly traded cannabis stocks is in freefall which, in turn, influences private company valuations. However, emerging markets like cannabis tend to be hyper volatile as investors’ emotions swing from wild optimism to despair rapidly as market conditions change. Growing fears of a domestic and worldwide recession and lasting inflationary pressures are not helping.
We are seeing the early stages of a period where the underlying fundamental economic environment is changing. The free money and low interest rates are over, which will see a rotation out of overpriced growth stocks and into underappreciated value stocks. The era of “free money” is not a recent phenomenon. This has been a defining factor affecting asset valuations going as far back as the financial crisis of 2008 (Lehman Brothers, AIG, et al). The collapse of the markets then led to a spectacular deflation of asset value that we should not forget. Recently the Federal Reserve Bank has been extremely aggressive in maneuvers to “re-flate” depressed assets by providing massive amounts of liquidity into the system (aka “free money”) by artificially suppressing interest rates and purchasing bonds in concert with the trillions of added liquidity in governmental stimulus surrounding the COVID pandemic. The Fed has maintained a highly accommodative stance (low interest rates and an expanding balance sheet) since 2008. The “free money” era has fueled an extended period of highly speculative trading in the stock market, with artificially low borrowing rates and a lack of competitive returns on fixed income instruments.
Despite slowing and declining sales for cannabis companies in Q1 of 2022, the growth story for MSOs or single state operators located in key emerging cannabis markets that are near, or have just recently rolled out, adult-use/recreational access is still intact, in our view. However, more regionally focused MSOs or single state operators positioned in more mature cannabis markets may have a tougher road ahead to sustain the growth witnessed to date in the industry. With hyper growth becoming a bigger challenge, investor sentiment will likely remain depressed in the near-term until the industry has a catalyst for optimism which could come in the form of legislative reform (passage of the SAFE Banking Act in the Senate outside of the larger CAOA), reacceleration in growth in emerging cannabis markets, some sort of judicial decision of significance, or an improvement in overall stock market fundamentals.
With so much uncertainty in the air, and the industry maturing, the valuation of cannabis companies has moderated over the last year with parties more focused on traditional valuation techniques and approaches such as multiples of EBITDA or some other version of cash flow, and we are seeing multiples and growth expectations compress. That said, the industry remains attractive as an alternative to fixed income options and more traditional industries for astute investors and lenders able to find the best value propositions at the right price.
Ryan Cram, CVA is a senior financial analyst and Ron Seigneur, CPA/ABV, CVA, ASA is a founding partner of Seigneur Gustafson LLP (SG), located in Lakewood, Colorado. SG is nationally recognized for its expertise in the marijuana and hemp/CBD sectors with respect to business and intellectual property appraisal, economic damages and lost profits assessments and related consulting and tax planning and compliance. Seigneur is co-author of The Cannabis Industry Accounting and Appraisal Guide, published by LuLu in May 2018 and the Financial Expert Guide for Family Law Judges and Attorneys, published by LuLu in June 2020.
Seigneur and Cram are authors of the 30-page November 2019 BVR Briefing Cannabis and Hemp Valuations: A Market Analysis; and the 29-page Emerging Issues in Cannabis white paper, published internally by SG in March 2020. Surf to: www.CannaValuation.com and www.cpavalue.com for more info.