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Cannabis has Understated Upside and Overstated Risk

Here’s why the sector might be the best option for a high-growth investment strategy:

The top 11 cannabis operators have an expected revenue CAGR of ~30%+ for the next two years, yet trade significantly lower than other industries. This is clearly illustrated in the above chart comparing EV/2023 EBIDTA multiples between public cannabis operators and twelve other sectors. Though not illustrated here, public service providers (as well as private companies) share a similar, correlated growth trajectory, yet none of these companies are experiencing multiple premiums typically garnered for high growth. Beyond low multiples and a high growth rate, upside potential in cannabis is understated when considering:

  • Visible, realistic catalysts (i.e., federal legalization, state-led legalization, normalization)

  • Demand inelasticity – relative to alcohol and tobacco, cannabis is proving to be a consumer staple

This is the first time in 40+ years that U.S. investors are deciding where to put their money in the face of high inflation and a looming recession. They are considering questions such as:

  • Is this business scalable? What is the path to profitability? What does the competitive landscape look like and are there high barriers to entry?

  • In an inflationary environment, will this business retain customers better than other industries? Can they pass higher costs onto customers?

The cannabis sector has compelling answers to these questions but is overlooked due to overstated risk, misunderstood industry fundamentals and catalysts, and lack of institutional participation due to regulations on Wall Street.

What is the size of the market today? What will it be in 2025? (& why is it realistic?)

Legal cannabis sales raked in ~$25B FY2021, up ~40% from 2020. With a 14% CAGR into 2 030, cannabis will reach $36B in 2025, doubling to $64B by 2030. Regardless of federal movement, new state legalization and increased consumption frequency will continue to drive sales growth. Let’s pause and consider if a $64B market is realistic:

  • States have an incentive to legalize cannabis – the sector employs ~500k people and adult-use states brought $3.7b in tax revenue in 2021

  • ~80%+ of Americans support cannabis– a state-level ballot vote has not failed in 2+ years. 37 states and D.C. have already legalized medical and/or adult-use cannabis.

  • While ~44% of Americans have legal access today, the illicit market still rakes in ~$65B

  • With 7/10 of the largest states by population yet to see adult-use sale

  • In Colorado (legal since 2012), 18% of adults consumed cannabis last month (~53% last 6 months), spending $2,683 annually on average.

  • Prevalence is up ~10% since 2012

  • By 2030, 30% of the population is expected to consume cannabis monthly (compare to alcohol at 55%).

  • If we use the U.S. adult population of 2022 (~196m) * 2030 consumption prevalence (30%) * average annual spend per consumer in CO ($2,683) we get a TAM of $157.8B by 2030.

It is clear topline sales will continue to expand and large TAM numbers are realistic. However, sales have been expanding for 3+ years already and multiples remain low. Thus, investors must consider what will bump valuations and drive venture-style returns.

What visible catalysts exist? What is the upside potential?

The obvious factor holding back valuation hikes is federal illegality and cannabis’ schedule-1 status. Full-fledged legalization is not necessary to see valuations jump, but financial services and capital markets access/protection is, and we are getting closer. We believe there is a ~60% chance that legislation protecting financial services companies for working with cannabis businesses will pass this year. There are currently 5+ bills with some level of bipartisan support that would allow this. Financial services access opens the door for:

  • Institutional participation – institutional capital represented 4% of total investment in cannabis in 2021, compared to 44% in Consumer Staples and 69% in Big Tech (see “Institutional Participation by Sector” below).

  • Even Canadian Cannabis has about ~15% institutional ownership and trades at a premium to US names, despite the entire market being smaller than California.

  • Retail investor participation – as of 2021, 55% of Americans engage in retail investing, which significantly impacts some industries (e.g., cryptocurrencies).

In July 2022, The Medical Marijuana and Cannabidiol Research Act also passed the House and is expected to be the first stand-alone cannabis bill enacted into law. Once passed, it will make it easier to research cannabis, paving the way to de-schedule the plant. This would finally shield cannabis businesses from the 280e tax code, allowing them to deduct ordinary business expenses from gross income, leading to substantial margin expansion (see “MSO Taxes With and Without 280E” below).

Between industry CAGR, expected margin expansion, and increased institutional participation – cannabis will inevitably benefit from a massive re-rating, up to 2-3x current multiples over the coming years.

No, the exact timing of catalysts is not certain, but we have visibility we’ve never had before. Within 2-3 years we expect there to be significant regulatory movement. Once that happens, the golden window to invest will be gone. The best companies are being built today – through grit and innovation – before traditional incumbents can enter (and they will, as soon as regulations allow). Economic downturns present a unique time to invest in high growth – it was between 2008-2010 that the likes of Uber, Venmo, and Airbnb were founded. As cannabis investors, we are helping foster what the biggest names in another new industry will be – and we are excited to be in the right place at the right time.

Sources: BDSA Data Consumer Insights 2022; New Frontier Data 2022; Jefferies 2021, 2022; Viridian Capital Partners 2022.

Disclaimer: all statements around valuations are based in opinion and not guaranteed.

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