In case you missed it... Cannabis as a Consumer Staple, Part II | The Bengal Bite 🐯
Last week we looked at cannabis as an emergent consumer staple - something that a significant portion of the population regularly purchases regardless of economic conditions. But cannabis is currently an outlier among consumer staples for two reasons, both of which are potentially significant to investors: growth of state-legal cannabis outpaces even the fastest-growing consumer staples, and the stocks of cannabis companies are much more volatile and are valued differently, than other consumer staples companies.
Most staples tend to have stable, regular demand but also not have very high growth rates - usually, growth rates are not too far off of GDP growth (as people get richer, they might eat more expensive food but are unlikely to suddenly start having three dinners) or population growth (for fairly obvious reasons). But, state-legal cannabis sales are growing much faster currently, and estimated to grow at 19% per year for the next five years straight.
As a multiple of forward earnings, consumer staples companies tend to trade roughly on par with the S&P 500, but at a much higher relative multiple when you factor in the estimated forward growth rate of earnings (the PEG Ratio below, an imperfect measure we are not endorsing but just using as quick shorthand for this article) - investors pay up for the certainty of earnings vs. growth of earnings. Plus, with the stable underlying demand, they tend to be less volatile than other sectors.
Source: Yardeni Research, www.yardeni.com
Alcoholic beverage companies are one of the hottest subsectors of consumer staples because its projected growth is higher than most others. But it still isn’t in the same league as cannabis: some optimistic estimates put total alcohol revenues growing 7% to 2022, with a 14% bump in EBITDA, implying a 2022 EBITDA multiple of 16x while major U.S. cannabis companies trade for under 13x.
Source: Stoic Advisory 4/16/21 update, NYU Stern industry multiples compilation, and Bengal research
And cannabis stocks are much more volatile. Below is a graph showing the relative price moves of MSOS (blue line, a decent proxy for U.S. MSO cannabis stocks), and XLP (orange line, a popular consumer staples ETF), and XLY (turquoise line, a popular consumer discretionary ETF). Despite the surging underlying demand, cannabis stocks are significantly more volatile than staples, and even put consumer discretionary stocks to shame.
So, cannabis companies sell a staple that’s growing faster than any other, and they trade at a discount to companies that sell slower-growing staples while having more volatility.
Make no mistake: there are many reasons that cannabis would trade differently from other consumer staples or be valued differently. But when you see the magnitude of negative difference in valuation/volatility matched with the magnitude of positive difference in underlying growth, we think it’s a good idea to take a step back and take a broader look.
This Week's Bite:
Come on, give me some of your pots! In business, location can be everything, and for a small Oregon town, Ontario, being next door to Boise, Idaho has its advantages. Other than being known as the place where the tater-tot was invented, Ontario is also just an hour’s drive from the largest city in Idaho, a state where even hemp-derived CBD is still illegal. That has meant a huge boon for the city’s 9 dispensaries (for 11,000 residents) as hundreds of millions of dollars flow into tax coffers thanks to the cross-border traffic. (Politico)
Congress holds vote in honor of 4/20: Never one to pass up a symbolic moment, the House Democrats have voted to pass the SAFE banking act this past Monday. While we’ve discussed in the past why we believe this won’t be a game-changer, it will likely have some significant positive effects on the industry and it is encouraging to see the steps taken by Congress, especially as advocates wait for the anticipated Senate legalization bill from Senator Schumer. (Bloomberg)
‘Green Rush’ fails to materialize for some: Canada, being one of the first major countries to fully legalize cannabis, was supposed to experience an economic boom as Canadians and people around the world clamored to buy Canadian cannabis. However, chronic issues of oversupply, monopoly buyers, and lack of domestic demand have led to many companies having to curtail ambitions. Many of these issues were forecast but widely ignored in the speculative land grab and capital raising frenzy.
U.S. MSO’s rapid inflection towards generating profits as large state adult-use markets come online strongly suggests that the U.S. will not follow the example of its northern neighbor. (The New York Times | New Cannabis Ventures)He did do that: ‘Steve Urkel’ actor, Jaleel White, has partnered with 710 Labs in order to launch his own Purple Urkel cannabis line. After hunting for the original cultivar strains, Mr. White was very excited for the collaboration, “To smoke the end result from such a quality pod has been surreal. I feel a little bit like Willy Wonka, the flavor came out so similar to grape candy.” (Forbes)
IRS targets cannabis companies: Infamous bank robber Willie Sutton, upon being asked by a reporter why he robbed banks, replied: “Because that’s where the money is.”* Just so with IRS audit examiners, who were able to net over $2,700 in back taxes assessed per hour spent auditing certain cannabis businesses vs. just under $700 per hour spent elsewhere.
IRS tax code section 280E, which bars cannabis businesses from taking deductions other than the cost of goods sold for tax purposes, increases the tax burden on cannabis businesses.
Readers should keep in mind that prior results don’t equal future results - the audits described in these articles took place years ago at a different stage of the industry. Understanding of, and compliance with, 280E is likely much higher than when these audits took place - not to mention that the industry, in general, has become far more professionalized in terms of accounting. (Marijuana Business Daily - Part 1, Part 2)
*No, this phrase was not said by John Dillinger, even though it’s often misattributed to him. If readers have the urge to fact-check us, we will admit that this quotation may not be properly attributed to Willie Sutton, who denied ever saying it but also happened to be well known for lying about anything and everything about his life.