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We have laid out our reasons for optimism that better times are likely ahead for investors after enduring two years of losses in the cannabis sector. We continue to believe better distribution and a broader set of products permitted for sale will help improve the Canadian market, and we expect accelerated medical and adult-use legalization as well as the scaling of existing operations bode well for the American market. Look for big revenue growth and profitability from the leading MSOs as the year progresses. With that said, one negative trend from last year that we don’t expect to change is the supply of stock.
Stock coming into the float can arise from a number of sources. Early investors and founders can cash out a portion or all of their stakes, and this is something that we expect will continue to be an overhang. Another avenue for supply of stock is that underwater public market investors will likely sell into rallies as they recover some of their paper losses. The most important source of supply, though, is likely to be from the companies themselves raising capital to cover operational losses or fund expansion.
This month, we have already seen substantial equity sales activity, with HEXO Corp repeating its Boxing Day debacle and selling more stock just weeks later on the same terms as that December 26th offering. This week, we saw Aphria, which teased investors during its recent conference call with talks of future dividends, issue C$100 million of stock at a discount to the market with warrants as well. We also saw a successful raise for cannabis REIT Innovative Industrial Properties, which sold $217 million of stock in an upsized deal that was followed by the stock actually rallying. This followed large raises over the past couple of months through its at-the-money offering (ATM) as well.
One of the positive developments for MSOs has been the expanded access to non-equity capital, with debt and sale/leasebacks becoming an alternative. Of course, not all companies are able to access these alternatives, and we have seen MedMen, for example, sell stock via a private placement, recently. The largest U.S. operators, which have leaner operations than Canadian peers, perhaps due to not having the luxury of abundant capital historically, likely won’t be able to achieve growth goals relying solely upon debt issuance and sale/leasebacks, so we are expecting to see more equity issuance from these leaders as the year plays out. In fact, with capital as a strategic advantage, we look for those that can raise capital effectively to do so to expand their competitive positioning relative to those who aren’t able to do so.
Investors need to temper their optimism somewhat by incorporating an expectation of increased supply of stock. Some of the challenge is merely technical, but some of it is more troubling, especially when the raises aren’t for growth capital or balance sheet repair. Take HEXO Corp, for example, which has been selling stock right at tangible book value, perhaps a signal that it expects its large operating losses to persist. Most of the LPs, including the largest ones, have relied upon debt over the past few years, and investors are watching this closely. Companies are being proactive in addressing upcoming maturities, and we think this augurs for more equity raises in that sector of the market. In the U.S., we think that the largest MSOs have some flexibility given their access to debt and sale/leasebacks, but many operators aren’t generating positive operating cash flow and will struggle to raise capital except through equity sales.
We think a key to investing successfully in the cannabis sector this year will be staying out of the way of capital raises and then perhaps rotating into the name after sale of stock, especially if it is for growth capital.
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Alan & Joel