Distressed Opportunities in Cannabis: Time to Take A Serious Look

The COVID-19 pandemic has affected cannabis stocks and the cannabis industry in both positive and negative ways. One of the difficulties with this pandemic is that it is incredibly unpredictable. One week it looks like the spread is slowing, and the next week we see a significant outbreak. The reality is that COVID-19’s effect on our economy and society significantly impacts cannabis, with the impact likely to worsen in the coming weeks and months.

This health crisis and the coming economic downturn will profoundly impact the cannabis landscape. Cannabis stocks have been in a bear market for nearly a year, with many public cannabis company stocks down almost 80% from their highs in 2019. This has made access to capital a significant challenge for both private and public companies. Now that the U.S. economy seems headed into a recession, cash strapped cannabis companies will find it even more challenging to raise essential capital to operate and expand.

Cannabis Operators Facing a Diversity of Challenges

Each region faces unique challenges based on customer demographics, regional supply chains, and local regulations. We’ve seen supply chain disruptions across multiple cannabis verticals, including soil and cultivation supplies, vaporizer components, packaging, Personal Protective Equipment (PPE), and necessary office supplies. Some companies have faced supply shortages that have stalled revenue as their cash reserves dwindle, leaving them extremely vulnerable. The pandemic has caused labor interruptions as companies work diligently to keep their employees and facilities safe. Riots and looting have directly impacted businesses in California and Illinois, amongst other states. Purchasing trends have shifted dramatically, leaving suppliers with either an oversupply or shortage of products. We’ve also seen single state operators that had reached profitability and were ready to expand pre-pandemic, pivot to defense, and miss opportunities to access lucrative new markets currently opening up for licensure across the country. It’s clear that numerous factors lead to volatility in the space, and for many business owners, times are desperate. Our partner firm 3C Consulting, LLC (3C), is actively working with companies to navigate these challenging times and is standing by and ready to assist any of your current cannabis portfolio companies. 

Already this year, we’ve seen cannabis M&A deals fail, thus forcing target companies to sell off assets to raise capital, lay off significant staff, and restructure operations to focus on core aspects of the business. The high times of 2018 and 2019, when many companies accessed cheap capital and over-inflated valuations to consolidate assets across the world, are long gone. Despite news articles touting how lucrative the cannabis industry is, the reality is that very few cannabis companies have yet to achieve profitability.

Cannabis is still a new industry where revenue is reinvested into growing the business. Plus, there are an array of obstacles not seen in other sectors, including sky-high tax burdens due to IRC 280E, which prohibits cannabis businesses from claiming most standard business deductions. The state-bound nature of the industry forces cannabis companies to replicate their operations in every new state vs. taking advantage of economies of scale. All this is further exacerbated by a lack of access to commercial debt and institutional capital. 

Cannabis businesses have few options to turn to for required capital infusions. Many companies will be forced to shut down, with no U.S. bankruptcy protections available. Creditors will be challenged to collect their debts. Adding to the problem, the illegal status of cannabis at the federal level restricts cannabis businesses from accessing federal bailout/stimulus packages. 

According to a recent Financial Post article, cannabis stocks have lost over 25% of their value in 2020 on top of a 50% decline in 2019. The COVID-19 pandemic has been a key driver in pushing company valuations lower in 2020. Even after cannabis businesses in several markets were deemed essential during the lockdown, sales have been sporadic. We’ve seen retail sales in states like Nevada decline massively, shadowing the loss of tourism. Pre-pandemic Planet 13, the owner of the world’s largest cannabis dispensary in Las Vegas, made 85% of its sales from tourists. They have since had to pivot quickly to serve residents through their delivery services. The full gravity of the situation will be revealed when the company’s Q2 earnings are reported. In the meantime, Planet 13’s stock (PLNHF) has rallied 315% since the broader market bottomed in March. While Washington sales have remained relatively steady in 2020, year-over-year sales have increased during the pandemic. Over the last few months, some operators have closed, while others have adapted quickly and successfully increased their market share. 

An Industry in Need of Capital

Whether companies are struggling to keep their doors open or are currently expanding their operations to meet the changing demand, many are in desperate need of capital. These circumstances have laid the groundwork for unprecedented access to quality cannabis investment opportunities at exceptionally low valuations. However, the only way to take full advantage of these opportunities is via the right knowledge and in-depth scrutiny. 

Adding to the above, institutional investors have remained on the sidelines for the most part. This has created a dearth of capital, estimated at over $4 trillion, currently not deployed in the cannabis industry. Investors that move into the space before that capital is deployed will have substantial arbitrage opportunities. The above being said, investors need to proceed with caution. 

The cannabis industry is heavily compliance-driven; therefore, even simple mistakes can lead to costly fines or the loss of your license to operate. Additionally, federal illegality has kept the industry highly fragmented. This means that there can be great arbitrage opportunities; however, there also will be significant losses. While some of the currently distressed businesses are long-term gold mines, many are time bombs that were not suitable investments in the first place. You need to know how to avoid bad deals and create bonafide cannabis businesses. 

Practically, suppose investors have not operated a cultivation facility, built an extraction company, or run a dispensary. They should proceed with extreme caution since they may not know the fundamental issues that could handicap their cannabis investment. In just a few different cases, our team, along with 3C, helped save investors from losing over $100 million by finding problems with cannabis operations in which they invested. These would have been total losses and now have been turned around and are headed towards profitability.

The cannabis industry is remarkably resilient. We have seen the market follow geopolitics both positively and negatively in the past few years. With trillions of dollars of wealth creation ahead and valuations at their lowest, the cannabis industry remains one of the top growth industries for the sophisticated investor.

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