Are we still playing cannabis small ball?

In a word, yes

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.

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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.