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Jerry Derevyanny and Julian Lin break down the current state of the cannabis sector (1:00). How companies are massaging their earnings results (3:30). Proper metrics to use as the market develops (7:45). Green Thumb's growth mode and solid margins (16:05). Institutional capital and what will really make the industry soar (21:15). Thoughts on Verano and Goodness Growth (47:25). New states coming online - worthy of excitement? (57:35) NewLake Capital, cannabis REITs and dividend yields (1:08:40).
Transcript
Rena Sherbill: Jerry Derevyanny and Julian Lin, welcome back to The Cannabis Investing Podcast. It’s great to have you both on at the same time. Always great to talk to you individually. Excited about this conjoining effort, conversation.
I appreciate you both making the time, not just for this podcast, but the insight you share for the sector, which is hard to understand at most times, I think.
So, we're fresh off an earnings season in the cannabis sector. Julian, if you want to get started, how you're thinking about things, looking at things, what names you most paid attention to, surprises, excitements, disappointments, have at it?
Julian Lin: Yes, I think after - ever since perhaps that 2021, 2022 burst of the bubble, a lot of the earnings have become very, a big narrative about price compression, and how that's impacted both top line growth as well as margins. Recent quarters have seen a lot of these companies start to lap easier comparables, not too dissimilar to what a lot of tech companies are saying.
So, a lot of these companies are beginning to see some easing of some price compression, even some gross margin expansion, which just led to some expansion of adjusted EBITDA. So, I mean, the other quarters are get a lot better than maybe what they looked at, what they looked like one-year ago, but of course, the risk of price compression long-term, especially for the operators in these adult use markets with these limited license models, it still remains.
RS: Jerry, want to jump in?
Jerry Derevyanny: Yeah, sure. I think it's interesting because I agree with Julian, but I have a somewhat a little bit of a different take in that. I don't think price compression is really easing.
I think what is going on underneath is that the business mix has changed somewhat with certain, with a lot of operators where it very much depends on the state that you're in. So, for example, if you have outsized exposure to New Jersey, you are going to show better and price compression will look like it's getting better, but really it's just, you're in New Jersey.
As Jersey price compression starts, you're going to revert to the same pattern that you saw before. So, I frankly don't think we learned a ton from Q1s, although that did not stop MSOs from trying to massage their results quite a bit.
RS: We love a good massage in the sector, do we not? Go on Julian, go on.
JL: Just to clarify, yeah, I definitely, sorry if I wasn't clear, I didn't mean to imply there's an easing of price compression. To the contrary, it's more, it's definitely a drain.
So there's, it might appear like there's an easing of price compression, but I think a lot of that is just due to them lapping some easier comparables, but investors need to realize that a lot of these margin gains are probably unsustainable, just because long-term that price compression risk still remains.
And that is a long-term trend for a lot of these adult use limited license markets.
JD: Yeah, completely agree. Same page.
RS: Jerry, how would you articulate what massaging is going on?
JD: Well, I'm glad you asked, Rena. It's funny because I was thinking back to our previous conversations that we had, and I think one of the questions you asked me before was, well, what metrics do you look at, like do you suggest investors look at?
And at the time, I was saying cash flow metrics are really important, and that's what I'd hone in on. Most of all, though, there's no one golden metric for these companies.
I think what we're starting to see now, which is fascinating is that companies seemingly got the religion on cash flow once people lost faith for many reasons in adjusted EBITDA, but what's funny is now that MSOs know that investors or think they know that investors value cash flow, they are playing to that metric in sometimes I think frankly in incredibly disingenuous way. So, let's go into some examples, okay?
If you're telling me you generated cash flow from operations, I know what the accounting says, but generally speaking, most people would assume that you paid your taxes, right. So, to the extent that you are generating cash flow by not paying your taxes or getting refunds from previously filed taxes, okay, that is not the kind of operational cash flow that people really associate with cash flow from operations.
And then when you use that windfall that you got, rightly or wrongly from your taxes to then tout free cash flow, right, that is doubly wrong. Because what you're effectively doing, most likely, is you're not – that wasn't cash flow from operations, you borrowed money from the government. And if you borrow that – that's like cash flows from financing, effectively, you've increased the debt.
So, I think just from my quick glance, I think Trulieve (OTCQX:TCNNF) is probably the most, probably the most egregious from what I've seen. So, you got just under $300 million in revenue in Q1, cash flow from operations is about 139 million, which looks really, really healthy, but then I think there's about 98 million of cash that was generated from uncertain tax positions, meaning that's part of their refund, right.
And then, so you take that and you're about 42 million in tax adjusted cash flow from operations, and then you have about 16 million in CapEx that leaves you with what I would say is, roughly kind of a good free cash flow proxy of 26 million, but they reported just under 124 million of free cashflow, right?
Like Curaleaf (OTCPK:CURLF) is, 338 million in revenue, 46 million in cash flow from operations, but their tax payable went up 41 million, right? So, basically your tax adjusted cash flow from operations isn't much at all, like just under 5 million, 13 million of CapEx.
Suddenly you're at a normalized negative 8 million in free cash flow, which isn't the end of the world. Like there are reasons why you can be free cash flow negative in certain – like in cannabis, we can go into that, but they reported $33 million in free cash flow.
So to me, these are free cash flow, again, we can quibble about the accounting definitions of it, but usually when you hear free cash flow, it's like, oh, that's money the business generated. Well, not really. You're borrowing a bunch of it from the government. That's not like it's incredibly disingenuous.
So now, unfortunately, like as MSOs have started to play to this metric, I think it's become harder for investors to use that metric. And now they have to go in and make adjustments and look at it a little bit more deeply than they might have had to a little while ago.
RS: How would you say that investors can stay ahead of the game, let's call it?
JD: I mean, unfortunately, I don't think there's any shortcuts. I think they have to look at the figures a little bit deeper, a little bit more deeply. And also, I think it bears discussing at least, like, what's the first kind of metric that you should use in thinking about these companies?
And my thinking on this is constantly developing as markets develop and as companies develop and show who they are, but I think there is a good argument for operating income being like an adjusted version of operating income being the right metric to at least start from.
RS: And why is that?
JD: Because I think if you take a step back and think about it, what kind of an adjusted version of operating income will tell you. What it’ll at least start to tell you is, what is the raw economic efficiency of this company?
By which I mean, let's say you just take a look at, all right, how much - you take away the depreciation and amortization and then you have to adjust for it by doing your own maintenance CapEx calculations, but let's just say, I think GTI (OTCQX:GTBIF) reported $100 million in depreciation. That is nowhere close to what their maintenance CapEx is going to be for many, many reasons.
You should adjust out the stock-based comp, but then still take it into account in other calculations, but if you want to just take a look at, take out impairments and stuff like that, you should consider those in other parts of the analysis, but just initially, and you just look at, all right, after your fixed and variable costs, how much earnings did you guys generate, operating income did you guys generate?
Well, what that's going to tell you, and then if you look at their asset base, what you should start to hone in on, like, okay, well, you basically, your GTI or whoever you are, you put $3 billion into the ground in these various states and various retail things, you have $3 billion in assets.
What kind of economic return are you generating off of those assets? Before we get to debt, like what is the return on those assets just raw? And then use that as a jumping off point.
Where I think this gets you is, you start to see, who's being much more efficient with their assets, who's potentially over earning and their financials are reflecting a significant amount of over earning, where they're just exposed to some very high price states and that's going to go away and they're going to be left with a much worse business in the end, but I think that where my head is at right now at least as a starting point is that adjusted operating income metric is the best place to start.
RS: Julian, happy for you to weigh in.
JL: Yeah, a lot to unpack there. I think, yeah, definitely agree that it's been frustrating to hear a lot of these management teams tout some free cash flow, operating cashflow, or they say something like, oh, we generated so much free cash flow, but they're really on the opposite end of what, I wouldn't want to say honest, but what typical companies would do.
I mean, typically if a company's benefitting from some one-time stuff that's not really operational, they would subtract that and give you some adjusted free cash flow measure. Whereas in this case, these companies, they're including, as Jerry mentioned, the income tax, they're not paying taxes anymore. They're including that as some operational free cash flow.
But even before Trulieve started this 280E protesting, a lot of these operators were also doing this with inventory. Sort of like last year and maybe even 2022, when they started having excess inventory, this is terrible. So, they had this mark down this inventory, aggressively sell it down.
This is not really good for business, but it might look good in the cash flow front because they're bringing in more cash. And instead of like adjusting and being very clear saying, oh, this is not like a typical cash flow profile of our business, they're kind of still, they were still very happy to indicate, oh, we generate this much free cash flow.
But in reality, if you were to adjust all of these one-time stuff, they aren't really generating meaningful income or cash flow at all.
As far as metrics that I'm looking at nowadays, a big one will just be because of the rescheduling, or the potential rescheduling over the next couple of years, if they could finish it, could be looking at the actual impact of that. So, a lot of these companies, obviously all these companies will start paying less or recording less in 280E taxes.
However, a lot of these companies, even if you were to normalize their tax rates, they're still not generating positive operating - positive income rather, even after you remove the taxes.
So, that's something to keep in mind just because a lot of the investors might be very enthusiastic or very hyped up by the prospects of 280E taxes being removed, but in reality, a lot of these companies might still be unprofitable, perhaps in part due to having just too much debt.
JD: I totally agree with Julian. We noticed that in our Q1 letter, we actually said that pretty much verbatim of how some of the cash flow that is being touted, because these companies very much saw that investors wanted cash flow, they started generating it, was through sell-off of inventory.
There's a great moment in the Jushi (OTCQX:JUSHF) call where I will read to you what the CEO said. This is him touting the company.
We also celebrated our highest revenue week of 2023 during the second to last week of December. I'm incredibly proud to share that we grew our wholesale revenue in 2023 with a 30% improvement over previous year.
Sounds like everything is hunky-dory.
First question coming out of the Q&A. First question just on margin, on the gross margin line, you reported a sequential decline from Q3. Could you provide a little bit more color on that question, blah, blah, blah? And then the CEO, this is like 20 seconds later. Yeah. So, primarily had to do with we were selling through some inventory at discounted prices to move it through.
And that happened in the fourth quarter to generate cash, but he just told you why they had the second highest revenue week of 2023. So, like suddenly what he said before, it takes on a little bit of a different coloring after you look at, after you put it into context.
Yeah, the games that are being played are pretty interesting and I think to Julian's point this 280E stuff, I think gets overblown, because first of all like on an actual cash flow basis like Julian said, nobody's paying these taxes anymore anyway. So, it's not really going to jump the bottom line from where it is today.
I think that the reality of most types of tax changes like this is that sooner or later, most likely sooner, the savings will flow mostly to the customer in the form of price cuts. And I think that just forecasting a wholesale step-up jump in profitability and underlying profitability is just not, it's just way too optimistic to do that.
And I think to Julian's point, one of - they do carry a lot of debt. Most of these companies carry a lot of debt and that actually ends up making a huge difference, right?
So, for example, let's say you take a company and one of the things that it does is, I think reveals, if you start looking at it in this way, like it starts to reveal quality that we, I think we all appreciated, but even becomes more apparent once you start looking at it a little bit more deeply. So, a lot of the comeback, I think from many companies, rightly or wrongly, to – cash flow is the metric. Oh, you didn't have good operating income.
They'll tell you they're investing for growth, right. Hey, yeah, we didn't have great metrics, but we were investing a bunch in our latest state in New Jersey, and we had to ramp up costs and all this stuff and we're going to be generating a lot more money in the future. These are good investments in the future.
Well, what's interesting is that GTI, right. Everybody made a big deal about tightening their margin and all this stuff, tightening their belts. GTI has had very solid margins over the last number of years, been very consistent, has gotten better, was never bad. And they've deployed over a $100 million in CapEx, if I'm not mistaken, in the last 3 years in a row.
So, they've definitely been in growth mode and they managed to do it without generating negative operating income and all this stuff as general rule. And you look at that and go, oh, that's interesting. And it starts to make the other MSOs look worse because you go, okay, well, GTI was able to do it pretty responsibly. Doesn't seem like you guys are able to do it very responsibly.
JL: Yeah, and happy you brought that up because, and this is one point that I've mentioned in some of my other articles when I cover, and this is a totally different sector, pipeline companies like these master limited partnerships. One thing I mentioned there was that you could often just look at the leverage and just look at which companies have the lower leverage.
And ironically, just the fact that they have lower leverage indicates a higher quality management team. So that thinking plays out here as well, as Jerry mentioned in that a lot, like especially GTI, one big reason that they're profitable is because they have less debt. So, they're paying less on interest. And a common investor mistake might be thinking, oh, they have less debt or some companies have more debt.
It just means that maybe they're more aggressive or one is too conservative, but that's only half the picture. The other picture would be like, a lot of these companies, not to pick on Trulieve, but they might take on a lot of debt for acquisitions that just did not pay off. So, a lot of the high leverage you see in the sector could also be an indication that these management teams, they acquired a lot of assets, but did not execute.
They did not get that intended ROI from all of that M&A or all of that investments. So, I guess that is actually a good metric also to look at simply that leverage, because that could be just a very direct indicator of management quality.
JD: I totally agree with Julian. I think that responsible balance sheet management is huge. To me, it comes back to this point, this is the way that I've been thinking about recently is this economic - what is the economic return that they're generating?
So for example, GTI is able to put, it's like $2.5 billion in assets off the balance sheet and they're able to generate $200 plus million or whatever it is in operating income out of that, right. Some portion of that is going to go to pay debt, right, because that $2.5 billion, some of that is equity, some of that is debt. And so debt is going to have its price.
It's not just that GTI's cost of capital is a little bit lower because it's less leveraged. Their liabilities are just a lot lower. So, when you look at like that 2.5 billion in assets, there's maybe just under $600 million worth of debt on that. So, it's a fairly small portion of the overall capital that went into the company.
If you look at a company like Curaleaf or Trulieve, suddenly a lot more of those assets, like there's just a lot more debt as a portion of those assets or just a lot more debt generally, plus if you combine it with the fact that they're just not as economically efficient out of their assets, they're just not making as much money, like Julian said, they're not getting the ROI.
Well, that starts to squeeze you from both ends and that doesn't look very good. And it doesn't look very good for the future.
And I think one of the things that cannabis investors generally are missing is that there is this inherent expectation that if we were to uplist to NASDAQ tomorrow, that multiples would go up and therefore prices would go up for these cannabis companies.
I'll be the first to admit, of course there's probably going to be a week of speculation, there's going to be a lot of volatility. But if you go back to fundamental first principles, what I think people are missing is that there is a reality where even if the multiple increases later, the actual forecasted cash flows, true free cash flows for these companies, will go down and you're not going to end up with a great result.
Because the market will know that in the future, Curaleaf is going to make less money than it makes now. And then they'll put a multiple on that. And even if the multiple is higher than it is now, you're still working with less cash in the future. And so, the pricing for that company, for the equity is just not going to be all that great.
If (MSOS) goes down 50% and then gets 100% bump from the speculation, you're going to end up at the same place. And so, I think a lot of people are frankly going to end up getting burned on trying to trade through this type of stuff.
JL: This is another great point to bring up. And this is a very common troubling thing I hear a lot in the cannabis sector. It's not too dissimilar to what you see with like (AMC) and GameStop (GME), ironically, but this idea that, oh, there's this notion, oh, there's no institutional capital in the sector.
And once they uplist and once custody is allowed, all of a sudden institutional capital will make all of these stocks soar.
I confess at one point I was, I am guilty of believing in this kind of message, but at this point this is, it's very naive because I think Jerry mentioned this in a previous Twitter spaces we had, but there's an important note here in that not all of the MSOs are created equally, right? So, you've got a lot of MSOs that are focused on limited license states, which means that they have high profit margins right now.
But the problem with this in terms of, when you think about valuation, is that the long-term trend of margin has to be lower when you're in a limited license state and you're selling cannabis for 10x the price of California prices. And when you have price compression, that does not really lend itself to a high rich valuation.
Typically, stocks that have a high valuation have pricing power, they have secular growth, they're starting to see operating leverage. They have this ability to grow revenues, not just grow revenues at a mid-single-digit rate, but also earnings at a higher rate than that.
But the problem here is with these companies that are as Jerry mentioned, over earning because they're in these limited license states, you get the opposite where they might struggle to get – they might be lucky to get mid-single-digit revenue growth, but their margins stay the same or go lower. So you got reverse operating leverage.
That business model typically earns a very low valuation. In fact, one can make the argument that the current, so the current, a lot of these stocks are trading at maybe 8x, 10x EBITDA, in the case of Curaleaf, like 15x adjusted EBITDA. You can make the case that they deserve a more cyclical valuation, but it could go even further.
Like typically, when you think of a cyclical stock like oil, they get this low multiple because the prices could go lower, but at the same time, the multiple is not that low because prices could go higher. But when you have these limited license operators, you only get one end of the dynamic. You only get the bad end. You don't get this possibility of prices going higher really.
So, you could make an argument that their multiples should be lower than a cyclical valuation as what you'll see in an energy sector.
And then just one more note to that is, I mentioned not all MSOs are created equally. I should note that there is institutional capital in the sector that is being quite vocal. You've got Jerry making quotes, but also Aaron Edelheit of Mindset Capital. Some institutional capital has positioned very clearly.
It's very clear that they've been positioning in more of these unlimited license operators. The operators where they have the opposite dynamic, where they're not facing the same price compression risk long-term, it's the opposite, right?
And that's the thinking of where institutional capital probably will be flowing to. They think more long-term than this really naive, oh, yes, institutional capital comes in, so, everything goes up. That's really not how institutional capital is going to view the sector.
JD: Yeah, I totally agree. I think, again, there will be some trading around this. Of course, there's going to be some volatility, and certainly there could be some arb algo funds that come in, but when people talk, when people offhandedly say institutional capital is not in the space, what they mean are people that are not algo trading.
They mean people that are taking a bet on the long-term development of this industry that there are institutions that want to buy-in and they desperately want Curaleaf stock and they can't get it. You know what I mean? And then something will unlock that they can get it.
I'm sure there are at the margin like a couple institutions that will do this. The issue that the other side that people forget is that there are plenty of willing sellers, most likely. Like from what we've seen, if you've looked at MSOS and how it's traded and everything, yeah, sure, you've seen bumps, but then very rapidly, there are sellers that start to come out of the woodwork on this stuff.
So people assume that like this increased demand will not be met with increased supply very quickly as liquidity comes to the sector. That's also not warranted.
I think the long-term, the interesting thing about the long-term pricing dynamic is I totally agree with Julian. Generally, the crazy thing to say is that, if you look at some of the more fundamental underlying cross currents of like what is actually going on in some of these companies' businesses on a day-to-day, state-to-state basis, it is not what gets a high multiple because to get a high multiple, people need to generally think that you're going to be making more money in the future than you're making today.
If the reason that you are making a lot of money solely is because or mostly is because you're selling weed where it's $6,000 a pound, and that as long as that continues, you're going to make money. That's not something that gets a high multiple as a general rule, okay.
What is interesting is that there are some companies where all of this stuff of the talk of margins and why is this stuff, like, what are we actually trying to figure out? Well, you're trying to figure out return on capital, is really what you're trying to figure out and then return on incremental capital.
And so, sometimes if, and I think again, the only guy that really talks about this from what I've seen of the major players is Ben Kovler where he will talk about return on capital and talk about dollar margin versus percentage margin. So, if you have a solid business with good operating leverage and everything, your percentage margins can go down as prices compress, but your dollars generated, which is the real metric that you're judging the equity on, can actually go up.
But if by the time prices become compressed to a certain point, like your cost structure doesn't work, that's a business that's fundamentally impaired, which I think unfortunately some of these large MSOs are.
But if by the time prices normalize, you're in a position where you're still making money and you're able to absorb more volume, that is the definition of a business that should get a higher multiple because the return on capital can be shown to be like very sustainably very high, especially if you have redeployment opportunities, which I think Ben Kovler has actually told you that there are limited redeployment opportunities because he's buying back his own stock and debt, right. But yeah, sorry. Just piggybacking on what Julian said, if that makes sense.
JL: Yes, and then just a comment on that last point about Ben Kovler and Green Thumb. Yeah, they're clearly, they've proven themselves to be the top operator in the sector. This is without any doubt.
But if I had one quibble, it would actually be something that I don't see written very much in the sector. It's that I'm not in total agreement with their share repurchase program just for a couple of reasons.
I realized that the quick take would be like, oh, okay, you're buying back stock. This is good because you lower your shares outstanding. This is reducing the float. That would be like the really first level take. But whenever we think about capital, you have to ask what is the best use of capital?
So, perhaps they're not able to deploy the capital, as Jerry mentioned, but at the same time, I don't – for starters, I don't even know if that's true. Just given Florida, Florida might be potentially coming online or legalizing at some point, perhaps Green Thumb could be more aggressive in building up their Florida footprint, which, from the looks of it, is still very profitable, even as a medical state.
But more importantly, if we're talking about, so there's two things I look at. One is Green Thumb doesn't trade at the cheapest valuations in the sector, even among public stocks. So, you have to wonder, is it really best for them to be buying stock at 10x or 9x EBITDA when you could just also lazily look at any other company.
But at the same time, more importantly, like if you're trying to prepare yourself for some “institutional capital” coming I hate this term, but let's say we're really trying to prepare ourselves for this.
Another thing institutional capital likes is lack of leverage. And sure, yes, Green Thumb has the best financial metrics among peers. They're profitable, they have less debt, but this is a very, very low bar that we're comparing to. If you just compare it to a normal company, Green Thumb still has too much leverage.
I think that capital, if they have excess capital, just buying back debt, reducing leverage, even though that will not impact the bottom line as much as buying back stock, I think it will impact the multiple to a far greater degree.
JD: Oh, Finally, we've found a disagreement between Julian and I, half an hour into the podcast. So, I'll take the other side of this. First of all, I'll note that GTI did buy back debt. They bought back about, I think, a little less than half of, probably about a third of what they did for stock. They bought back just under $26 million in debt. I actually think that the leverage level is pretty responsible for GTI.
The other thing that I think is really important to look at in discussing this is, you can get an idea of what the current cost of debt capital is for these companies by looking at, well, what does their debt trade at? And I think GTI, understandably so, understands that it's a premium company and that it gets relative to cannabis, a premium cost of capital.
So, they're the only like, their all-in cost of capital right now is actually pretty close, I think to what the debt was issued at, which is 7%. So there, I think they can rightly forecast that if they had to refinance all this stuff, there's probably going to be demand for it in the market. And then they're probably going to get pricing relatively close to what they got before.
And so, I think it totally makes sense for them to look at, okay, we might get a little bit of a higher multiple. Really what they're doing is, yes, they don't trade at the cheapest multiple, but if you look at it and go, okay, I think my business is going to do in 2026 x amount of free cash flow and they have pretty good line of sight, I think on some of this stuff.
And I think it totally makes sense to go, listen, I'm buying my own stock at a multiple of like under 10x future free cash flows, true free cash flows or under 8, under 7, whatever it is. I think that is a very defensible decision.
And I think that tells you, they've also redeployed back into their business, because like I said, the CapEx, there's a bunch of CapEx spend that's happened that I don't think is fully reflected in their financial results, particularly Minnesota, is coming online and they probably spend a pretty penny there. I think they ramped up some New Jersey stuff.
I think it's very reasonable to go, those investments will bear fruit as their previous investments have borne fruit. And so, it's a good decision to buy back. Overall like I can understand buying back the stock versus buying back the debt. I think that Julian's criticism though, I generally agree with for pretty much every other major cannabis company. Trulieve basically arbitrage their tax refunds to pay off their debt. And I see a lot of that happening in the industry.
JL: Yeah, I guess if we could just stick on this topic. I think if we compare with the peers for Green Thumb to have the flexibility to even think of share buying back stock, Yeah, it looks great.
But again, I still think it's a very low bar. I mean, just remember what you had mentioned earlier would be like the operators who are operating in adult use limited license markets, over the long-term, the margins might be pressured, right?
And Green Thumb, they are the most profitable operator even compared to like operators operating in unlimited license states, but at the same time, they face that risk, very, very clearly because they're primarily in those limited license markets.
But yeah, so they are currently profitable, but at the same time, their net margin still stands at, a mid-single-digit percentage of revenues.
So, it doesn't take a whole lot for the current, like currently everyone's happy, they're able to buy back stock, but just a tiny downturn here, like if margins were to, if gross margins or whatever were to decline 5%, 10%, which is not too inconceivable, if that were to happen and they were not able to offset that on the OpEx, and which might be possible just given that they already are so lean, you could quickly see their cash flows wipe out.
And obviously, if this were to happen, all the other operators are probably in a much worse situation. But if we're just focusing on Green Thumb itself, just a tiny swing here in the margins, suddenly they're no longer profitable on a GAAP or non-GAAP basis.
To me, I guess it's possible that I'm just more bearish on the operator model, right, but I think just because long-term they're facing, they're going to face these margin headwinds, it would make sense, even if it's not the most accretive right now to the bottom line, could be trying to switch from having a net debt to switch to having net cash.
It's just, I mean, obviously this is a bad example, but even like you see in the EV markets or some other markets where all these companies, they have a lot of net cash just to prepare for, like a bad storm. I think these cannabis operators, they're just totally on the opposite end where a lot of these operators have deep, deep leverage when in reality, even if they had a net cash position, it's still not clear if that would be enough for like the next 5 years.
JD: Yeah, I guess I'm usually pretty pessimistic on margin stuff, but I might not be as pessimistic as you in this sense. I think that GTI has a good amount of levers in there. Like their gross margins don't look crazy. And I think the thing that, again, this whole idea of like margin percentage and margin, if you look at what happens with cannabis markets generally, right, so, let's take a look at the one that comes to mind is Michigan, right?
What happens when a market matures, which is what's happening at various rates, kind of underlying business. So, a lot of GTI’s money comes out of Illinois, most likely, right? Their kind of home state where they have a very good business, I'm guessing. And what, as that market is maturing, which is, it's going slow, it's fairly limited license. So, you get that pricing oligopoly for longer.
But if you look at Michigan, the general pattern is, so Michigan in January, 2022 sold about 153 million in dollars in terms in that whole market, but that was decomposed that into 6.7 million units at an average cost of just under $23 a unit, right. If you look at in December 2023, so two years later, the overall market's at 273 million or so, but that's over 21 million units at an average price of just under $13 a unit.
I don't know the exact numbers, but if I look at it and work with some assumptions, right, and the key assumption is that you don't like, let's say I built a facility in Michigan or Illinois like GTI did, and that facility costs me a $100 million and that has certain running costs or whatever. There is a universe where if my costs are good and in-line, my percentage margins go down between January 2022 and December 2023, but the actual amount of money I'm making goes up.
So, because I am able to take advantage of that leverage that I have in the business, and because my SG&A costs are not going to ramp with volume in that sense, I already have the infrastructure in place, my costs are under control.
And so, like for example, let's just take a business, a good company, let's say, and let's take Michigan pricing and tell me if this hypothetical doesn't make sense, but let's say in year one, they sold 7 units at an average price of $23 a unit, $161 in sales, their COGS per unit was about 7.
So some reasonable assumptions, you're at $49 in COGS, blah, blah, blah. By the time you get down to it, and your overhead percentage is 35% of sales, by the time you get down to it, you made about $56 in profits. So, 35% profit margin on your overall sales.
Now, let's say pricing has changed to two years later, pricing's way lower per unit. So, now you're selling 22 units at an average price of 13 bucks. Your COGS for a good business, your actual COGS, will maybe even go down a little bit on a per unit basis because you are getting benefits of scale, right?
So, I think it's reasonable to think like, okay, like it's going to go down a little bit, maybe a dollar or two, but you're still going to be making a lot less gross margin per unit. The next thing that has to happen in a good business, which you're starting to see with GTI in particular, is that SG&A, your overhead as a percentage of your revenue, does not scale with your revenue, right?
Because you don't need to add people in overhead with each dollar of revenue. That's exactly what you want to see. So, in year two, let's say it's only, now the business is a lot bigger. You're selling $289 a year, whatever it is, because you're doing more units at lower prices, but ultimately, let's say it's only 30% of your revenue is now overhead.
Well, these are not like heroic assumptions here, but in year two, even though prices have compressed and your margins are totally different and you're now making $61 in profit, right?
And so, between year one and year two, like year one was 35% profit margin, year two is 21% profit margin, but if your capital invested is the same, so if you didn't add to your facility and your actual capital investment in this business is $100 million, well, your returns to capital went up in year two, right?
That's the number that I think that's where multiples get assigned. And that's where I think institutional capital and where that's what the market is trying to get to. And so, even with some of this compression stuff that's going on, a great business will shine even with compression because the volume will offset and the dollars will actually go up, right? Does that make sense?
JL: Yeah. I mean, I think I could appreciate like if you still earn more dollars, more profit dollars in spite of lower margins, that's still going to be a net benefit. Yes, absolutely, but I guess where I still will disagree is, I think that dynamic you're mentioning might play out more in, I think Grown Rogue (OTCPK:GRUSF) is one of Bengal Cap's holdings, right?
It might play more out in something like Grown Rogue or Glass House (OTC:GLASF). But I think, like as you mentioned, the SG&A is not scaling upwards at Green Thumb.
There's the operating leverage, but I think that is not really indicative of a good business in terms of like, if you just look at a business without the management team, it's not like it's a different boat. I think Green Thumb, it's still, it's the same business as a Trulieve, Curaleaf and so forth, but it's just the management team executes better, much, much better.
I think perhaps that the other management teams, they are not able to generate the operating leverage on the OpEx end, just like Green Thumb is, but these are still all limited license markets.
I guess, unless I see evidence of Green Thumb like somehow taking market share in limited license states and aggressively growing their gross profit dollars, it's just hard for me to see how this dynamic will benefit them more than something like even a Curaleaf or Trulieve, just – at the end of the day, they're still just the same limited license operators.
JD: Yeah, I think, so, one of the things I think is important is like, I'm hugely skeptical of limited licenses and blah, blah, blah. I think limited retail licenses tend to have a little bit more lasting staying power.
And because - I hate using the term first mover advantage, but people that are early in certain markets, they tend to grab the best retail spots. And so that, and a good retail location is a sustainable competitive advantage. And so, there is a universe where a lot of this depends on your assessment of management quality and trust in management.
But to Julian's point, the fact that these numbers are different indicates that these companies are different, sometimes. So, the fact that SG&A per store, I think you can start to get, reading the tea leaves, you can start to get a picture of which companies are just more efficient, which companies need more resources to do less, frankly.
So, with GTI, what's been very interesting is that on my rough numbers, they've had a significant decrease in SG&A per store, right? Where they're now down south of 2 million. And before they had a, it was much higher than that. And I think fairly some of that is because they grew stores open over the last year.
But if you start to look at their normalized go forward number versus other companies, you start to see a difference. And that difference indicates like that's the difference between a good retailer and a bad retailer. And so, just like in any public other sector, you would see a good retailer gets a better multiple than a bad retailer because they're just, they're able to be much more efficient with their space and assets.
So, for me, I think out of all the big companies that can take advantage of this dynamic where, as pricing goes down, volume goes up, and dollar profits could go up if you're set up the right way, I think it's GTI.
To your point, Julian, yeah, Grown Rogue, big holding for us. Huge fan of that company. That is exactly how we think about Grown Rogue in a lot of ways where, as pricing comes down, we're, yeah, we'll take advantage of the high price when it's there, but we're not threatened by pricing coming down.
Generally tend to be the most bearish in the room on any given MSO, but Julian has me beat on GTI. So, it looks like I'm the bull on this one.
JL: Well, I think though, perhaps you might disagree on maybe the growth potential of GTI, but I think I could agree that even if I think they have very similar business models as a Trulieve or Curaleaf, I think, as you mentioned, the fact that they are able to operate, and a much leaner scale that that should be shown in the valuations.
So, I think, just if you include the management team in the business, which is at the end of the day what is going to be shown in the income statement, yeah, I think Green Thumb, it does deserve a big premium, a notable premium to Trulieve, Curaleaf, Verano (OTCQX:VRNOF), just because they are able to operate bottom line at a much higher margin than the others.
It might be through cost discipline and so forth. But perhaps that also comes out to just generally when people look at maybe EV to EBITDA, this kind of valuations, it matters most in a takeover, but unless a company is not being taken over, really what goes to shareholders matters most and Green Thumb is still the only company that is really generating any capital for shareholders.
RS: Can we, maybe we'll choose a different lane for a minute. Jerry, I'm curious to get your thoughts while we're on this deep and insightful topic of proper metrics and what companies are reporting and how they're reporting.
One of the things you were saying last time you were on the podcast was you were calling for companies to be more transparent in what data they do release. And one of those data points was state by state sales. Verano did release that data. We just had an interview with Verano last week, to some people's consternation on Twitter especially.
Any thoughts on them releasing that or what your thoughts were on Verano? I know you have maybe if not special insight, special interest in Verano, curious to get your thoughts there and that data point specifically?
JD: Yeah, so I'll be honest. So Verano, because of, so to what you're referring to, my partner Josh Rosen is the CEO of Goodness Growth (OTCQX:GDNSF). We hold a position in Goodness Growth on the Fund, and Goodness Growth is suing, is in a lawsuit with Verano right now over the merger that did not happen between them, right. So that naturally leads to me not looking at Verano as deeply just because we couldn't take a position in it anyway. So, what's the point?
But what is interesting to me about it, and I listened to a little bit of the interview, I don't know what the consternation is from it. I mean, they gave relatively high level answers to stuff.
I think that they aren't as egregious as others, but they did report 21 million in free cash flow. And I think 9.6 million of that was a tax thing. So, their true free cash flow is about half that. But they're nowhere close like worst on the list of fudging those figures.
What I think is interesting is that people, and again, just disclosing the position, Goodness has filed their motion recently in the lawsuit in Canada, which is I think similar to what we would call a summary judgment motion to decide issues before a trial is necessary, or at least limit those issues. I think people should, especially investors that are serious about it, should take a look at those numbers, at that motion.
And I think there was a little bit of sticker shock because Goodness announced that they're requesting, I think, over 860 million in damages from Verano. And I think a lot of reaction has been a little bit of sticker shock and a little bit of people just being incredulous.
What I'll say about that is I think people should go to the motion and see how they lay out their arguments for that number. And they should see that this was a number pulled out of the air. This is a very principled number.
And I think the mental heuristic error that people are making is that people assume they have like this, it seems like the buzz on Twitter assumes that there should be a symmetry between the amount of damage that someone caused and the amount that someone benefited from having caused that damage. So like, if I take a hammer to someone's car, I can do a lot of damage without receiving a lot of benefit to myself.
And so, I think when someone wrongfully terminates merger and I think Goodness has some decent claims there, I don't think the market realizes that the harm that Verano caused can be very disproportionate to the perceived benefit to Verano.
And that's not a reason to limit damages for Goodness. It just means that Verano could be on the hook for a pretty decent size check to Goodness at the end of the day. And I think that some of the takes that I've seen on the lawsuit have assigned it as a risk to Goodness, which to me is just incredibly unreasonable.
Like, I'm not saying this is about the company thing for Verano, but what I am saying is that people should acknowledge that - people don't seem to be taking it very seriously. And I think that they should be taking it more seriously.
RS: What's your sightline on timing and what's your thought on, I mean, I imagine you feel like it's going to go in Goodness Growth's favor, do you feel like those numbers are going to be met in terms of meting out the judgment and what's the timing there?
JD: I don't have a good view on that, honestly. Yeah, I don't want to speak to like Canadian, especially with Canadian law, which I'm not familiar with all that much. I don't know how long these things take to decide and the whole process around that. So, I don't want to give expectations that I can't base in fact.
RS: Do you want to speak for a second, why else you're bullish on Goodness Growth?
JD: Yeah, for sure. I think, listen, there's a reason why Josh is my partner. I have a very, very high opinion of him. I think that this is his second stint as CEO of a cannabis company. I think that he is one of the people, he's unique in the cannabis industry from the people I've met in a lot of ways, but one of the ways is that I think he is relentlessly honest about performance, about his mistakes, about all that, and he has taken everything he's learned and he's now applying it to Goodness on his second go-around.
And I think he has a very good idea strategically of where the cannabis market is going and what the best way is to pivot Goodness to take advantage of that. And what he's trying to instill, and Goodness was not a bad company before by any means. So, it is not besmirching what came before, but I think he's really tried to ramp up efforts in Goodness.
Well, it's like these cute things like the weed hustle office that they established. And he's really, I think, shifted it so that the North Star of that company really is, okay, are we doing a good job by our customers? And let's make sure that we're doing that and our economics are in-line. And so, I'm really excited to see as the cloud, I think, begins to lift over that company in terms of what's going to happen with New York, and they've announced some developments on that front.
And as that comes to its conclusion, as they have a good relationship with Chicago Atlantic (REFI). And, I think they've been very honest and transparent about the status of those negotiations and how they're going and as much as they can share with the market, even if there is no resolution yet.
And I think Minnesota presents a terrific opportunity for them to really give customers, with the partnership with Grown Rogue and all the hard work that they've been doing, a really good value and be ready to serve a market that's going to be standing with product ready to serve a market well from day one of adult use, I think that's just an incredible opportunity.
And I, for one, am bullish on the long-term prospects of it. I mean, again, it's a position in the Fund. And yeah, I think they’re going to be set up to do some great things.
RS: I appreciate that. By the way, I think some of the consternation and this is just my speculation on the matter, but it seems to me that when there's litigation involved and especially when prices are jumping all over the place, I think people like a public flogging of executives when they're on the receiving end of some litigation. That's my guess - that there was no flogging questions.
Julian, you certainly don't have to, but anything to say on this topic or those companies?
JL: Just looking at the evaluations, perhaps Goodness might be pricing in a little bit of some settlement on that litigation, but Verano trading around 10x EBITDA, it doesn't look like Verano is really pricing in anything there.
I guess one question to Jerry, if I could, what were your modeling points for Minnesota for Goodness Growth? I think I saw a report where someone estimated Minnesota could be generating $1.5 billion of revenue by 2029. What are you expecting in terms of market share and margin there?
JD: Yeah, so I will admit like, I have not done an in-depth modeling exercise in a while on Goodness. And part of the reason is my theory on modeling for cannabis is usually to get comfortable with a realistic downside and then just let the upside play out however it may.
I think $1.5 billion out of Minnesota in a couple of years of adult use does not strike me as crazy in that it strikes me as being roughly in-line with, it might be, that might be a little bit high because my barometer for this stuff is, I usually go to per capita spending from a mature market like Washington and just roughly ballpark what an adult use mature market is going to look like from that number.
And roughly 300 per resident is where you get to, and there's obviously little corrections here and there that you can make, but I think that gets you to maybe 1.2 billion-ish for Minnesota, just rule of thumb.
I think that they're going to be, from the way that I understand the litigation now and what it's looking like is, they're going to be able to serve that market. And yes, there's going to be some competition but they're going to be one of the major wholesalers and decent sized retailer in a very early market that there aren't a ton of other licenses there.
And so I think that it's a good setup for what we would call over earning for a couple of years, but that over earning, I mean, there are, I think not crazy scenarios where a decent year you can more than pay off any debt that they have on the company with like a decent, not even a really good, but like a decent year of Minnesota adult use.
RS: Speaking of Minnesota, I'm interested to hear your thoughts. Another point that we were talking about in the Verano conversation was their excitement around Ohio and Florida and Pennsylvania and the opportunities there if they do go online for adult use.
What are your thoughts about those three states? A lot of love being shown to Ohio and what people think might play out there. What are your thoughts there? Julian, if you want to go first.
JL: Well, it's definitely the next market. I think investors might be even sleeping on Minnesota somehow, even though it seems like it's going to be starting, it might be one of the more recent markets to be coming online. But perhaps investors might have some shock over New York and just how long it's been taken there, but that might not be so fair to be applied here.
JD: I don't have a ton of thoughts. I don't try to forecast these things too much. Again, my underlying point on this stuff is, and I think where this gets really important, is you have a realistic chance that in these early adult use markets, that prices will go up as more people flood in the market, supply doesn't adapt as much as demand.
And so, like in Maryland, you had prices go up from medical to early adult use. And that carries with it the chance of making some very good profits for a certain amount of time, right.
At some point, with some speed, these places will normalize just like anywhere else. And then what makes it difficult for investors, and in terms, like we talked about metrics, is then you have to look at, okay, what does this management team have a history of doing with the money, like the extra money that gets made, right?
So, for example, not to pick on Trulieve too much, but Trulieve they made a ton of money in Florida in 2019, 2020, they generated a ton of money. Where did that money go? Arguably, leaving aside the hardest thing, arguably some of that went to Massachusetts and then other states where they didn't - Massachusetts in particular, that was a strikeout for them. And they've ended up leaving the state while having burned most likely a decent amount of cash there and leaving assets there and stuff like that. It's not the worst thing, but that needs to be taken into account, right? Because if you go, hey, I'm really excited about Ohio, what that translates to is, I'm going to be making a ton of money for a while. We can debate about how long from Ohio because I have assets there in place and all this stuff.
Okay, well, when that money comes into the company, what are you going to do with it? To Julian's point, are you then going to redeploy it into the next state or are you going to de-lever? Are you going to, and what is your history for having deployed the previous money that you made in other markets? Like all the money you made in Illinois or Massachusetts or whatever it was, where did that go? Like how did shareholders benefit from that? And with some of these companies that are set up to “do well” in Ohio, you wonder A, for how long that's going to be; B, what are they going to do with the money? And are shareholders really going to see any of that money or is it going to go to paying off debt? And then ultimately, you'll be left with a slightly de-levered company that's still not doing all that great.
The fact that The Cannabist (OTCQX:CBSTF) is in Ohio is nice, but it doesn't change the fundamental long-term value of cannabis, all that much for me. I think people forget that these things go away and sooner or later, there's only 50 states, like you're going to run out of next states to go into.
And at some point, you're going to have to demonstrate that your business models work under stress. And some of these companies have not done that.
JL: Just to add to that, I think historically multi-state operators have enjoyed some premiums to some of those operators with less diversification, but just a reminder, just two years ago, New Jersey was hyped to be one of the biggest catalysts for the sector, but what we instead saw was that, especially for some of those larger multi-state operators, New Jersey ended up not moving the needle, or it ended up just hiding some maybe weakness in other states.
I think if one is looking at maybe Minnesota, looking at Florida, it might be better to position, or it might make more sense rather to position in some operators that have outsized exposure.
So, for example, Goodness Growth operates in only – once they get rid of New York - they're basically just in what Minnesota and Maryland or in Florida, another name, haven't really brought up was Cansortium is basically just Florida, right. So, you get these operators that it will definitely move the needle if an adult use conversion happens. And at least there is real potential reward. Whereas if you're going to buy something like, not to pick on Curaleaf, right, they're just so big Florida coming online is really, they will notice it, but it's not going to give you that potential reward for the potential risk.
JD: I was going to piggyback, because Cansortium (OTCQB:CNTMF), so that then, there's the first layer of issues you look at with cannabis companies, then to make it even more complicated, you go, okay, yeah, there are these good operators, what's going to be the bad, Cansortium is certainly going to benefit a lot. It seems like they've really righted the ship a lot over there.
I heard the interview with Robert Beasley. I liked a lot of what he had to say. I like how he views the business, but then the next step that you have to look at is, okay, we come back to the debt, right? When you're in the big leagues of like New York Stock Exchange and all this stuff, and you have major debt, a lot of companies, a lot of what they do is they manage their maturities so it's very gradual. You don't have that in cannabis as a general rule.
So, you have companies like Cansortium, Goodness is also one of these companies where I think transparency is important but you need to renegotiate things. You're going to need to do something about the debt. It is a question mark for equity in terms of how much value is going to be given away to the debt or how that's going to be decided, right.
And so, in addition to having the operations question marks, some of these companies have significant balance sheet question marks, because you look at, okay, well, how do you price in that there's most likely going to be a fairly dilutive event or some other kind of bad thing that's going to happen that might take a chunk out of the value of the company.
So, the best example I can think of is, Jushi, where Julian, correct me if I'm wrong, I don't know if you know this, but I think Sundial holds some or all of the Jushi senior debt, right, which is due, I believe, this year or coming up soon.
And I think I said this on live, but Sundial hasn't been shy about showing what happens when companies can't pay them off, right? They have effectively foreclosed. And so, you for sure have a lender, you should count on having an aggressive posture. So, how does that reflect in the price of Jushi? Like that's also something you need to consider.
JL: Yeah, I think investors across the board and I have in the past just underestimate debt. Debt in my opinion is single-handedly one of the most important parts of any downside scenario.
Reducing debt really helps a bullish scenario, but having a lot of debt, which is certainly the case of basically every operator in cannabis, it really amplifies it that it's almost like, if a company has a ton of debt, that stock almost becomes like a call option, just in terms of risk.
And that just cannot be ignored because if things go wrong or if, for example, 280E does not get removed so quickly, just that debt really drags down and amplifies that bear scenarios.
RS: All right. I appreciate all the time that you're giving us. I really appreciate the insight. I feel like we're getting into masterclass of cannabis investing territory with this conversation. So, I want you both back on at the same time.
I feel like I'd like to give you the last word and just share with listeners, anybody interested in finding out more about Julian Lin, specifically around cannabis analysis. He runs Cannabis Growth Investor on Seeking Alpha. Jerry Derevyanny runs Bengal Capital. Look out for their insights. They're worth looking out for.
Julian, what are your final words? What are your thoughts for investors? If you want to go broad, if you want to go specific, happy for you to do it.
JL: Yeah, I definitely will say just try to avoid some of that AMC, GameStop thinking and thinking just this very shallow analysis thinking, oh, institutional capital will come in and it will lift all boats.
I think maybe reading a bit more material from what maybe Jerry publishes or maybe what, as I mentioned before, Aaron Edelheit of Mindset Capital published, just that will tend to indicate some more sophisticated analysis in terms of how to be analyzing these MSOs.
Because they're not all equal, and not all of them are going to have the same business 10, 15 years later, even if they look very similar today.
JD: Yeah, I'll jump in and say, if people want to find out more about Bengal or what our thoughts on the cannabis market are, Bengal Capital.Substack.com or Bengal Capital. We put out our views in our newsletter. We show you where we're talking our book. So, people should know where we're coming from and what we hold.
I think just as a base case for most investors, kind of casual investors looking at the space, I think the way to think about it largely is, why should I own, like if you want just exposure and big company set yourself up for taking advantage of the trade and everything and managing your risk, to me, it's like, why buy anything other than GTI unless you're going to go some of the - really spend time trying to find some of the higher quality small cap names like Grown Rogue.
To me, like any potential cannabis investment should be weighed against GTI. And I totally agree with Julian that there is this, as trading has become even more gamified than it was before, that people are playing with fire because, I don't think they fully appreciate why Ayr (OTCQX:AYRWF) and Ascend (OTCQX:AAWH) and some of these very levered companies are much more volatile than the other ones and how EV/EBITDA ignores the fact that, well, guys like, you get discounts to EV/EBITDA when there's a lot of debt.
I think that's how, if I were just an investor, like casually looking at the space, I would just frankly buy GTI and go away for 5 years, 10 years. And that might be in terms of like a headache ratio and like amount of pain, it might be the best thing to do.
Although I did have a question for Julian, if you have time.
JL: Absolutely.
JD: What's your view, I mean, you were, we've debated some of the REITs and some of the debt providers, publicly traded debt providers in this space. Do you have like a current view on what their dividend yields look like and how you're looking at those opportunities?
JL: Yeah, I think the main one we were talking about before was NewLake Capital (OTCQX:NLCP). Definitely now it's trading at around an 8% dividend yield. I would say from a valuation perspective, it's still interesting, right?
Especially when you have the traditional REITs trading more around the 5.5% range, but it's definitely going to be way less compelling than what we were talking before.
I think we were talking before it was at a 12% yield. And one of the interesting points back then was like, it was so cheap that what is it like, they could have wrote down their assets, but was it like 50% and shareholders will still be good on the money.
Those kinds of dynamics are not quite the same now. So, the interesting thing with these REITs, these net lease REITS, especially NewLake Capital is, as their valuations expand, the risks facing them change, right? It's not quite there yet, but when (IIPR) was trading at like a 1%, 2% yield, a big risk was ironically just legalization and this idea that more capital could flow into the sector, just because that will stop their growth.
But when a stock, even if it's trading at 8% yield, slowing growth probably is not really that much of an issue, just because that yield is already high enough, but what I could say about NewLake Capital is it's definitely a team to look at.
Just look at how they executed the last many quarters. You don't typically see, even outside the cannabis sector with REITs, you don't typically see these management teams do what they did in that their stock was low, and what NewLake Capital did was instead of just buying more investments at the same valuation as their stock, they were buying back stock at a 12%, 10%, 11% yield. They initially were resistant, but at some point they started doing that and then they got more and more into it. And that's just incredible.
So, you get to assume that they focus on being very lean. They're generating this 80% actual cashflow margins that are not like adjusted by inventory or whatever. And then they were just deploying all excess capital into share repurchases instead of trying to grow the business.
And that's exactly what you want to see a company do when their stock is really cheap. But yeah, I mean, just the short answer to your question would be, obviously the opinion is going to change as the valuation goes higher.
JD: That's interesting. Yeah, no, no, it totally makes sense. I did notice that the valuations had ticked up, so the yields are down. I guess my question would be, not disagreeing at all, but isn't that telling you something?
If NewLake Capital is going, hey, right now, like if you look at their portfolio yields, I'm pretty sure they're somewhere in the 13%, 14% right? In terms of what their leases that they've given out are yielding, just raw without expenses, right?
If they're telling you that, hey, instead of making more leases, which are going to yield 13%, 14%, whatever percent it is raw, we're just going to buy back our stock at that 12% implied yield, that's telling you something on potentially how much – what they see the market and how the returns are looking.
I guess one of the ways that I also think about it, you're talking about as legalization comes, most likely they will see - it'll be interesting to see if they do take price hits and what will shift because the other thing that happens is they get leverage that gets available to them at most likely cheaper prices than they have it now.
And so, you would start to potentially see them become as levered as other REITs, comparable REITs are, because a lot of real estate investment trusts are, there's a very big layer of debt and then a smaller layer of equity. And these - cannabis is unique in that they're almost all, I think equity.
IIPR in particular has debt as a very small part of that capital that went into that company. And so, your return on equity might still be very, very good as they add leverage, but anyway, I just wanted your view on it because I think you're very well educated. I was wondering what you thought.
JL: Yeah, I think you're right. Of course, if there was going to be some repricing, as you mentioned, as legalization happens, it's important to note that the leases still don't expire until, I think there's still another 10, 11 years left.
And typically in these net lease situations, these leases are ironclad unless the company goes bankrupt. And even then the new operator, they still have to assume the lease.
But yeah, as you've mentioned, even if they have to reprice, when these leases expire, that will be offset by leverage. And I think we might have even understated how much leverage these companies usually take.
For example, Realty Income (O) is considered to be one of the least levered companies in the sector, and they're at like 5x or 5.5x debt-to-EBITDA, whereas NewLake has just no leverage at all. So, they have a lot of ways to go there, but I think they still look attractive, relative to just a traditional net-lease REIT, but yeah, my conviction is definitely a lot lower than when it was at a 12% yield.
JD: I think for me, the biggest, not the biggest, but one of the big risks with IIPR is that, or the REITs generally I should say, is that redeployment risk, right? As this money is coming back, eventually like all, your leases will come due and the market needs to take a view on, okay, well, what is the yield going to be on the leases that follow.
And all of that is going to be reflected in your net present value at some point. And so, I worry about if the market takes the view that your redeployment yields are going to be much lower, how does that reflect and then leverage. I don’t think - there's a lot of moving pieces. I don't know if you can go into it. Do you look at any of the other debt providers like a AFC Gamma (AFCG), Silver Spike (SSIC), do you take views on those?
JL: So I tend to not look at something like AFC Gamma just because they they're externally managed and that tends to really change the game for the investor. But yeah, so you do bring a good point. And this is very important, like this redeployment.
In this case, it's not really redeployment of assets, that's more like when the lease expires and if everything's legalized, just the asset all of a sudden, the rent might be cut by half or something, right? And that could be a big sticker shock for investors. So, as I mentioned before, when the stock is much cheaper, these risks are not so important.
For example, like when the NewLake was yielding 12%, and you're thinking, oh, maybe in 12 years, if cannabis is legalized and they have to cut rent by half, that might be bad, but at the same time you’re like, okay, even if we assume they cut rent in half right now, they're still going to be cheaper than a conventional net lease REIT like Realty Income, in which case you're like, okay, that apocalyptic scenario is not so bad at all, right?
But when the yield all of a sudden has dropped to 8%, still attractive, but that same idea that, okay, if they cut it in half, it's not quite the same, right? Suddenly they will actually be more expensive than one of those traditional REITs.
So, this kind of risk emerges just as the valuation gets higher and higher. So, it's definitely something to keep in mind of in case someone was ignoring it before, it's not something you can keep ignoring forever.
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