Are Multi-State Cannabis Operators (MSOs) A Good Investment With Marijuana Rescheduling On The Horizon?

Republished By Plato

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A recent survey indicates a growing optimism among institutional investors towards U.S. cannabis multistate operators (MSOs). The key driver behind this heightened sentiment is the potential rescheduling of marijuana by the federal government, a development that could encourage significant investment from major financial players.

According to Frederico Gomes, a cannabis equity analyst at ATB Capital Markets in Calgary, Alberta, and the primary author of the report, the surveyed institutional investors, primarily composed of hedge funds, are currently more bullish than they were six months ago, largely due to the anticipated rescheduling of marijuana. However, despite this positive outlook, Gomes noted that the increased capital has not yet materialized from an institutional investor perspective.

The survey, conducted between October 23 and October 27, involved 23 institutional investors. Approximately 61% of respondents expressed the belief that U.S. cannabis MSOs would outperform the S&P 500 in the coming year. Furthermore, the report revealed that 75% of the investors foresee an 18-month timeline for the U.S. government to shift marijuana from Schedule 1 to Schedule 3.

Despite this optimism, a significant portion of the surveyed investors reported either no change or reduced exposure to MSOs over the past six months. This trend suggests that investors remain cautious due to past regulatory setbacks and are waiting for concrete rescheduling recommendations from the U.S. Drug Enforcement Administration.

The survey also gauged expectations regarding the likelihood of the U.S. Congress passing the SAFER Banking Act, which would enable financial institutions to serve state-legal marijuana businesses without fear of federal repercussions. The respondents expressed a 50-50 viewpoint on this matter, indicating substantial uncertainty. Gomes highlighted the challenges of predicting the outcome, citing past failures of cannabis banking reform legislation and political uncertainties associated with the new Republican speaker of the U.S. House of Representatives, Mike Johnson. Overall, the sentiment among institutional investors appears positive, but the market remains cautious and uncertain about the regulatory landscape.

Investment Preferences and Capital Allocation

ATB inquired with institutional investors about the factors that would enhance their willingness to increase investments in MSOs and requested them to rank these factors based on importance.

The top-ranking factor, chosen by nearly 61% of respondents as their primary consideration, was the rescheduling of marijuana from Schedule 1 to Schedule 3.

In contrast, the prospect of additional MSO equity uplistings to the Toronto Stock Exchange was deemed "the least important factor" influencing their investment willingness.

The survey also sought opinions on how investors would prefer MSOs to allocate their capital. According to Gomes, the clear preference was for MSOs to focus on deleveraging and reducing debt, with investment in organic growth ranking as the second-most-desired behavior from the investors' perspective.

Investors, it seems, are not keen on seeing mergers and acquisitions (M&A) in the sector; as Gomes noted, "Investors are not really looking for (mergers and acquisitions) in the sector." Despite numerous acquisitions, the investors believe this has not resulted in significant value creation.

Share repurchases emerged as the least-favoured method for MSOs to allocate capital according to the respondents' preferences.

Cautious Outlook on the Canadian Cannabis Market

Despite the growing optimism among respondents regarding U.S. multistate operators, a more cautious outlook was observed concerning Canadian licensed producers and cannabis retailers, with 60% anticipating these companies to underperform the S&P 500 in the coming year.

The ATB report highlighted a divergence in the factors influencing sentiment between the U.S. and Canada. While regulatory considerations primarily drove sentiment in the U.S., the prevailing sentiment in Canada was influenced by fundamentals. Poor operating results and shareholder dilution were cited as key reasons for the negative view held by investors, as outlined in the report.

Gomes noted that some respondents chose to skip questions related to investment in the Canadian cannabis industry, emphasizing the challenges marijuana companies in Canada face in accessing capital.

Despite all respondents expressing active interest in U.S. marijuana MSOs, the ATB report revealed that only 52% displayed interest in Canadian producers and retailers. The report suggested that the prevailing negative sentiment in the Canadian-regulated cannabis industry might present a potential buying opportunity for contrarian investors.

The report stated, "Canadian cannabis bulls are close to extinction, which could mark a bottom in the sector." Gomes explained that investors, having faced disappointments in Canada, are likely waiting for signs of improvement, particularly in terms of companies achieving profitability.

The report highlighted that a turnaround in fundamentals, particularly companies attaining sustainable profitability and positive free cash flow, was identified as the most crucial factor. Additionally, reducing Canadian excise taxes, impacting margins and profitability, was ranked as the second most important factor that could potentially sway investor sentiment positively in Canada.

Dynamics, Regulations, and Profitability in the Cannabis Landscape

As we peer into the future of the cannabis industry, it becomes evident that navigating this evolving landscape requires a nuanced understanding of dynamic factors. Whether scrutinizing regulatory shifts or adapting to market dynamics, cannabis companies in the U.S. and Canada face a complex journey ahead. As regulations continue to evolve, shaping the legal framework for cannabis, companies must adeptly respond to ensure compliance and seize emerging opportunities.

Crucially, the path forward is not solely dictated by regulatory changes. Investors and industry participants are keenly observing the industry's march toward profitability. The focus on attaining sustainable profitability and positive free cash flow emerges as a pivotal consideration. This signifies a maturation process for the cannabis sector, where financial stability and responsible business practices become increasingly crucial. Companies strategically navigating these dynamics stand poised to survive and thrive in an industry marked by rapid evolution and shifting investor sentiments.

Bottom Line

Institutional investors exhibit a growing optimism towards U.S. cannabis multistate operators, fueled by the potential federal rescheduling of marijuana. While the survey reveals increased bullishness, particularly among hedge funds, the actual capital influx remains pending. Investor preferences underscore the importance of MSOs focusing on financial health, with a clear aversion to mergers and acquisitions. Despite the positive outlook in the U.S., a cautious sentiment prevails in the Canadian cannabis market, providing a potential contrarian buying opportunity. The industry's future hinges on factors beyond regulatory changes, emphasizing the necessity for companies to achieve sustainable profitability and positive free cash flow.