Radical Candor
Transparency Creates Value
Disclaimer: This is hardly an objective post. We maintain a position in the subject company and our partner, Josh Rosen is the interim CEO, interim CFO and current board member. We are highly involved in driving its strategy and vision. And it’s worth noting, that although we let Josh read this post, we only allowed him to clarify a point or two.
It’s hard to draw new eyeballs into our niche world of cannabis. It seems as though the same news gets circulated to the same people through the same channels. This creates an echo chamber and can oftentimes make it hard to separate signal from noise. Because of this dynamic, companies often only get attention with bombastic statements and hyperbole. What if there were a better way? What if straight talk and candor received the accolades we believed it deserves?
Microcaps in cannabis, in particular, don’t get a lot of coverage. They are extremely illiquid and don’t get nearly the hype of the larger names in the sector (many times deservedly so). It is for that reason we feel the need to highlight what we believe are important points that many may have recently missed. In Part One of this two-part Bite, we will highlight the recent Goodness Growth Conference earnings call and its unprecedented disclosure and straight talk. In an upcoming Part Two, we will go in depth into their newly formed business strategy nicknamed “C.R.E.A.M and Fire.”
Radical Candor
“Surplus Profits”
To our knowledge, the term “Surplus Profits” has never been used on any earnings conference call in cannabis. That's why we were delighted to hear CEO Josh Rosen use the term to describe recent state-level performance in Maryland on the last Goodness Growth Conference Call. Surplus profits is a term we use internally at Bengal and our partner companies when describing the initial euphoria of a limited-license market turning a corner due to regulatory changes. When “Medical” goes to “Adult Use” we often see an overnight step change in the addressable market and customer base. Because the local market infrastructure isn’t yet built up to address this new demand (retail stores, grow facilities, processing, etc take time to build and become operational) you often see a period of time when demand far outpaces supply and business booms for any incumbent operators. Prices are artificially high, stores are packed, and people from neighboring “cannabis dessert” states drive in and purchase products. Sounds great right? At least for bottom lines, product aficionados will tell you the quality is often lacking as well.
But how sustainable is that dynamic? We use the term “surplus profit” because it’s very clear that those numbers will not last and it's intellectually not honest to act like it will. Competition inevitably arrives, supply comes online, more retail stores open, etc. These should all be healthy developments for a market that’s maturing and eventually finding its baseline; plus, consumers deserve choice, with quality and value just as important in cannabis as other consumer products. However, for operators that were reporting blockbuster revenues and profits, these price declines or what we call price normalization, have caused guidance revisions and much consternation.
In our opinion this entire dance can be avoided if more thoughtful messaging is applied. By labeling near term pops in revenue and price as “surplus” you allow investors (and more importantly your own internal financial planning team as we will discuss in Part 2) to realize that the gravy train will not last. Why is that important? It’s true that valuation is more an art than science, particularly in emerging, volatile sectors. But one ironclad truth is that the more predictable a business is the higher its valuation multiple because of the certainty those cash flows represent. If investors are led to believe that revenues and profits are heading one way - only to see revisions are made in the near future - that business will suffer materially from a revaluing of its future cash flows and be rerated with a lower multiple. The problem lies in the fact that by labeling some of your profits as “surplus” now - you take away from the sexiness and excitement that exist when numbers are beaten. It’s very hard for companies not to want to do a victory lap in a very tough environment with terrible sentiment. But we strongly believe by properly labeling revenues as “surplus” you set yourself up better in the long run by not having to disappoint investors when things normalize. We’re not the only ones who feel this way either - the market itself is no longer rewarding upside revenue beats as it once did. Some of this surely has to do with market dynamics, lack of liquidity, etc - but when you zoom out it's clear the market no longer believes in the guidance these companies are providing, and for us, that’s particularly true when we think beyond the next couple of quarters.
For us, we think it’s better to be “long-term greedy” by being more transparent now and ultimately receiving a higher multiple down the line.
State Level Reporting
How does one even define what a “surplus profit” is? This is an extremely difficult question and reminds us of former supreme court Justice Stewart's stance on obscenity: “I know it when I see it.” While an exact number for “Surplus Profit” is impossible to ascertain - it can be pretty clear what it is and more importantly, what it isn’t.
The US is a very dynamic and mobile country. The state-by-state cannabis industry is an interesting test case for price and quality elasticity. For example, if two neighboring states have cannabis programs and one state has 3x the price of the other state - how reasonable is it to expect that the state with 3x the price will continue on with that disparity? That is an oversimplification because clearly other factors of accessibility, product quality, etc come into play…but few of us would argue on the side of one state keeping a 3x step up in price in the long term over its neighbor if all other factors are the same.
One issue with evaluating MSOs is that other than anecdotes (usually the positive ones), we have no idea how they’re doing on a state-by-state basis. Companies typically report consolidated topline numbers and leave it at that. That’s why we were very excited when Goodness Growth openly shared their state level reporting down to same-store sales (and mentioned as much on their conference call). This way you can dive in deeper and see how they’re doing in each state and estimate “surplus profit” however you deem it.
Reporting in this manner can sometimes be scary. It is a level of transparency that few voluntarily want to go through. Some companies will say that they do not reveal this kind of information for “competitive reasons,” but the truth is that such transparency can reveal some inconvenient truths (i.e., one state is providing 10% of overall revenues but 90% of the company’s EBITDA…”Surplus profits” anyone?).
But it can also show investors what to expect and thus not be surprised when disruptions occur. It’s more open and transparent relationships like these that will eventually lead to longer-term capital partners and higher multiples when institutional investors become involved. Opaqueness versus transparency is like procrastination versus hard work - one pays off now but the other pays off much more in the future.
Now we must caveat that this is an imperfect science. Costs from HQ can be difficult to segregate and allocate down to each state. But just because it can’t be done exactly doesn’t mean it shouldn’t be attempted - and plenty of other industries have fashioned solutions to similar problems. We’d rather see a company and management make strides at driving toward the truth than not. These changes are oftentimes difficult and disruptive in the short term but we have no doubt that they will pay massive dividends in the future.
Internal Focus - “C.R.E.A.M and Fire”
So far we have discussed looking at the business through the capital markets and investor lens - which is certainly important but is a distant second to what happens within the business. So what does one have to do with the other? In Part two we will discuss how transparent reporting combined with the internal strategy nicknamed “C.R.E.A.M. and Fire” have made it clear to the team at Goodness Growth what moves the needle for long-term value creation and where their strengths and weaknesses lie. Only after identifying the real gaps (however painful that may be) can you drive forward with the focus and purpose necessary to create enduring value.