In our recent year end letter we described our current strategy when investing in cannabis as playing small ball. Given that most cannabis companies have now reported their 2022 financial results, do we still think small ball is the right way to approach cannabis? Yes, and below we describe why.
Large MSOs Did Not Impress
Let's drop the assumption that MSOs make money and look at what actually happened in the last year. Of the largest MSOs, GTI stood out from the pack for its operating performance, particularly when you look at the large number of inventory writedowns across most of the other players in 2022, which we view as an indicator of sub-optimal operational decision making and a key part of the cash-flow-generation equation.
Our estimated adjusted operating margin for GTI for 2022 was 30% - significantly ahead of Trulieve, Verano, and Cresco (we estimate that Cresco and Trulieve both had negative “normalized” net income margins in 2022). Curaleaf has yet to report but, given historical performance, we are guessing it will be more in line with Trulieve/Cresco. Tech startups seem to have acclimated investors to thinking that large, ongoing front-end losses are necessary to eventual big wins for growth companies. But even when true in tech, we think the attributes of many successful tech companies with respect to economies of scale and distribution are not found in cannabis, particularly to the degree they are in tech (i.e., scale is not a meaningful competitive advantage for instance).
Price compression (we internally refer to it as price normalization) is coming earlier in many previously uncompetitive markets, so making a large investment into a market and expecting it to pay off with fat margins in future years seems less and less a defensible position. MSOs play off their current performance as making investments in growth - but how profitable is that growth going to ultimately be?
Capital Allocation Is Still A Question Mark
After “How much money does it make?”, the second key question is “Where does that money go?” Cannabis companies are not paying dividends and they are not meaningfully buying back stock (except for fairly transparent attempts to boost the stock price vs. an actual capital allocation mechanism) - so where will the money they make go?
There are two places where that money could go in most large cannabis companies: (1) invest in organic growth (larger/more facilities, new stores, etc.) or (2) acquisitions. The acquisitions history of MSOs is checkered, with some high prices being paid for assets only to be written off a few years later. So, with that kind of capital allocation record, there is a natural doubt that is cast on their organic investments as well - are these also just slated to be written off as market assumptions turn out to be too optimistic in light of what we now know about cannabis market development? We believe a large amount of growth investments made by large MSOs will not be profitable in the medium to long term.
Small Players Are Still Our Focus
So, our portfolio hasn’t meaningfully changed from our year end letter. We still hold our collection of small ball players and are focused on helping them get it right - limiting capital investment to the best situations presented, not deploying too much capital in any one market, and nurturing the ethos of the scrappy operator - the kind of company that rarely needs to cut costs because they don’t get inflated in the first place.
Administrative Note
As you may have noticed, the Bengal Bite has now moved to Substack. This post and our archive can now be found at bengalcapital.substack.com.
Jerry,
Thanks for sharing another write up.
With respect to economies of scale being non existent in Cannabis, I agree with indoor, as that has proven out to be the case. Small grows can be just as efficient as huge grows.
But for a high tech greenhouse *on the coast of* southern california it appears to be a different story. Glasshouse has lowered their cost of production by about half in their first year of expansion, with a goal of $100 per pound (Graham Farrar recently doubled down on this goal, saying he thinks they'll get it below $100).
I know you have pointed out Sunniva as another company that tried and failed with a high tech glasshouse in Cathedral City, CA. And you've also pointed out that Canadian LPs have also tried and failed with large high tech greenhouses.
Cathedral City, CA Santa Barbara, CA
Weather averages Weather averages
MonthHigh / Low(°F) Rain days MonthHigh / Low(°F) Rain days
January70° / 47°2 days January65° / 45°5 days
February73° / 49°2 days February66° / 47°5 days
March80° / 54°1 day March67° / 49°5 days
April86° / 58°0 days April70° / 51°1 day
May94° / 65°0 days May70° / 53°0 days
June103° / 72°0 days June72° / 56°0 days
July108° / 80°0 days July76° / 59°0 days
August107° / 79°0 days August77° / 60°0 days
September101° / 74°0 days September76° / 59°0 days
October90° / 64°0 days October74° / 55°1 day
November78° / 53°0 days November70° / 49°2 days
December69° / 46°1 day December65° / 45°4 days
Sunniva was in the right state, but wrong region. Half the year the highs in their location are between 90 and 108 F, which is entirely too hot. From what I'm finding, they were aiming towards a cost per gram of $1.15 or about $520 per pound. I would imagine keeping things cool enough in the summer was an issue.
I don't need to post the weather for Edmonton (Aurora Sky's location) because everyone knows it gets entirely too cold for cannabis growing. From what I'm finding, they were aiming towards a cost per gram of $.75 or about $340 per pound. I would imagine keeping things warm enough in the winter was an issue.
So scale alone is not a meaningful competitive advantage, I'll agree with you on that.
But scale plus the perfect climate plus high tech greenhouse plus a lot of experience and talent does seem to be a meaningful competitve advantage. Unless Glasshouse is completely fabricating their numbers and Graham Farrar is being totally dishonest in saying they will get to $100/lb.