Though revenue and profit estimates for the cannabis industry have declined, the upcoming second-quarter earnings season brings the risk of further estimate cuts.
California-based KushCo Holdings might be a forewarning for the industry given that it already reported its financials for the quarter that ended in May and supplies many larger cannabis companies.
KushCo’s results and guidance were 47% lower than consensus estimates, which had already been cut by 17% before the report.
The question for many investors before they invest is: Have the estimates for the industry been adequately reduced?
Fundamentals for industry growth remain strong; capital remains tight
The overall macro investment thesis of legal cannabis actually improved during the COVID-19 crisis as the industry showed resiliency and underlying demand held up.
Fundamentally, legal cannabis sales continue to grow at a double-digit rate in most of the United States and Canada (ignoring one-time pressure from reduced tourism in Colorado and Nevada), and more states continue to advance legalization efforts.
Fundraising in the cannabis sector remains tight both for public and private companies as the pandemic exacerbated the capital drought that began in the second half of 2019.
Companies that have been able to raise capital at all have typically done so on expensive – and creative – terms.
Many investors are starting to evaluate the better businesses at more attractive valuations, but they also are waiting for the estimate cuts to stop.
Companies that are profitable (or that can show a credible path to profitability) with transparent investor communication, good corporate governance and balance sheets should enjoy a lower cost of capital once that point is reached.
How much will estimates be cut with second-quarter earnings?
Consensus revenue estimates for 15 publicly traded U.S.-focused and 12 public Canada-centric cannabis companies have already started to decline, dropping about 16%-17% for 2020 and 14%-21% for 2021 since the valuation low on March 30.
Growth rates for 2020 have declined from 132% to 93% in the United States, while the 2021 growth rate has increased as some estimates get back-end-loaded with the 2020 reductions.
Growth rates are a major influencer on a company’s multiple, and they remain very strong for the cannabis industry.
|% Change in Estimates||Sales Estimates 3/30/2020||Sales Estimates 7/10/2020|
|US-Focused Public MJ Operators||-16%||-14%||$3,750||$5,912||$3,138||$5,095|
|Year-Over-Year Growth %||132%||58%||93%||62%|
|Canada-Focused Public MJ Operators||-17%||-21%||$2,166||$3,291||$1,807||$2,595|
|Year-Over-Year Growth %||65%||52%||41%||44%|
Stocks have rallied, but valuations still reasonable
Public cannabis stocks have rallied from their March 2020 lows, with the average marijuana stock up about 75%, compared with 42% for the S&P 500.
Valuations have also expanded off the lows, with the U.S. companies trading at about 3.5X 2020 revenue and the Canadian businesses maintaining their premium valuation at about 5.0X 2020 revenue.
Those multiples are up from lows of 1.6X and 3.5X sales for the U.S. and Canada, respectively.
For comparison, public consumer and technology stocks bottomed at 2.4X reduced sales and 7.5X reduced EBITDA estimates in the 2000 tech bubble burst and the 2009 global financial crisis – details that I outlined during Marijuana Business Daily‘s April 7 Investor Intelligence webinar.
As with any investment, stronger business models command higher multiples and more volatile ones command lower multiples.
Investors that deploy capital at these trough multiples on reduced estimates maximize their return opportunity from multiple expansion and minimize their downside risk.
Though the average for public cannabis stocks remains above these levels today, many solid cannabis companies still command lower multiples.
One key differentiator will be profitability; those companies that can show positive EBITDA will have a funding advantage.
U.S. cannabis stocks trade at an average of 8.0X EBITDA on 2021 EBITDA at an average 24% margin.
The risk today is that the EBITDA estimates underlying such multiples must be cut further in the near term during second-quarter earnings season.
But many companies in both cannabis and consumer industries have proved that a 24% EBITDA margin is reasonable and sustainable, regardless of when it occurs.
What does this mean for private companies?
Though they don’t trade every day, private businesses are still impacted by the moves, valuations and sentiment of public companies, since the public market is usually the exit for private investors.
Investors will be more willing to invest in private companies if they are more confident those investments can exit to the public via an IPO or a sale to a public company.
And investors can always purchase cannabis exposure with liquidity and transparency in the public markets.
There are also many cannabis-focused special purpose acquisition corporations (SPACs) with more than $2.2 billion in market caps looking to acquire private companies, which would make them public.
Private companies that can provide investors with conservative revenue and profit targets with a solid rationale amid the pandemic as well as transparent communication with investors will be able to raise capital at lower cost.
Basically, act like any other good public company.