Life Expectancy Declining At Some MSO Companies

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On May 26, 2022, Seeking Alpha published an article by me titled “Cash Crises Loom At Cannabis MSO Companies.” This article brings that article up-to-date by including Q2 2022 financial results. More importantly, this article includes secured debt with specific maturities to help determine corporate life expectancy. The existence of maturing secured debt when a company is unable to pay off that debt creates a life-or-death crisis for equity holders and less-secured creditors.

MSOs are likely to minimize the seriousness of lump sum debt payments particularly when they have an option to renew maturing loans. They are unlikely, however, to mention that creditors generally have the right to call a loan prior to maturity and the right to not renew a loan in the event of material adverse developments. For the aforementioned reasons, this analysis ignores renewal options and assumes debts must be paid on stated maturity dates.

iAnthus: The Canary

On February 13, 2019, Seeking Alpha published an article by me titled “Don’t Be Lured By The iAnthus/MPX Merger.” That article detailed the financial weakness of iAnthus (OTCPK:ITHUF) and in that article, I made the following prophetic statement: This touted first-of-its-kind merger of two cannabis companies looks like two helmsmen throwing life buoys to each other from separate boats. iAnthus’ pro forma financials ought to carry a skull and cross bones symbol. The fact that iAnthus has a market capitalization of $418.3 million testifies to investors being lured by promoters, lawyers, and investment bankers into the cannabis sector under the guise of making tons of money. iAnthus dream of being a national brand depends entirely on investors continuing to supply it with limitless amounts of money and that is certain to end once people awaken to its cash burn. iAnthus is just another example of MSO alchemy.”

Less than 14 months later, on April 6, 2020, iAnthus issued a press release announcing it did not make the 13% interest payments totaling $4.4 million due March 31, 2020 on $159.2 million of secured debentures. This was an event of default and iAnthus was not able to renegotiate with the creditors.

Most MSO companies, including iAnthus, were incorporated in Canada; therefore, Canada laws apply. The inability to pay debts is specifically identified as an act of bankruptcy under Canada Law R.S.C., 1985, c.B, 42(1)(F).

The secured debenture holders submitted a reorganization plan under the Canadian Bankruptcy and Insolvency Act that essentially wiped out the equity holders. After the reorganization, shareholders were left owning only 2.75% of iAnthus.

MSO Cash Flows

This article identifies MSO cash flows by analyzing Q2 2022 data contained in company financial reports filed with SEDAR and/or the SEC by 12 of the largest MSOs. These cannabis companies were selected because they are either the largest publicly traded ones with available data or they have signed an agreement, like Goodness Growth (OTCQX:GDNSF) and Columbia Care (OTCQX:CCHWF), to be acquired by one of the larger MSO companies.

Line one (1) of Exhibit 1 shows the June 30, 2022 cash and cash equivalents position of each MSO. Line two (2) shows the cash provided from operations. Line three (3) shows current income taxes paid relative to the amount incurred in Q2. Line four (4) shows tax-adjusted cash provided from operations, which factors in the nonpayment and overpayment of income taxes incurred in Q2.

MSO Cash Burns

SEDAR

Line five (5) shows the amount of cash spent on property and equipment purchased during Q2, which is frequently referred to as CAPEX. Line six (6) shows free cash flow “FCF,” which is obtained by deducting CAPEX from tax-adjusted cash provided from operations.

Exhibit 1 shows 3 of the 12 MSOs, Ayr Wellness (OTCQX:AYRWF), 4Front (OTCQX:FFNTF), and Jushi (OTCQX:JUSHF), failed to pay all income taxes they incurred during Q2 2022. While those taxes were deducted along with other taxes to arrive at net income after taxes, they need to be deducted from reported cash provided from operations in cash flow statements to get an accurate picture of true operating cash flow. After all, a cash flow statement begins with the net income after taxes reported in the income statement and assumes all taxes incurred are paid.

A comparison of lines 2 and 4 in Exhibit 1 shows significant differences between cash provided from operations before and after adjusting for actual income tax payments. Verano (OTCQX:VRNOF) was the only MSO shown to report positive cash provided from operations. It also paid more in income taxes than it incurred in Q2 and had the highest reported tax-adjusted cash provided from operations.

Curaleaf (OTCPK:CURLF) and Green Thumb (OTCQX:GTBIF) were the only other MSOs able to report positive tax-adjusted cash provided from operations. They were able to do so because both paid much more in income taxes than they incurred during Q2.

Nine of the 12 MSOs that reported negative cash provided from operations also had negative tax-adjusted cash provided from operations. Ayr Wellness had the largest negative tax-adjusted cash provided by operations of -$53 million.

Cash Burn Rates

Free cash flow (FCF) is a favored Wall Street metric and discounted free cash flow is the basis for generally accepted fundamental stock valuation. The quest for companies and sectors with free cash flow has accelerated during the recent market downturn and is likely to continue due to Federal Reserve actions to combat inflation. In this article, FCF is defined as tax-adjusted cash flow provided from operations minus CAPEX.

Two monthly cash burn rates are calculated for each of the MSOs in Exhibit 1. One is the quotient of cash and equivalents (line 1) divided by average free cash flow per month based on Q2 2022 and is presented as line 10. The second monthly cash burn rate, line 9, is calculated on the assumption that current income tax liabilities are entirely paid off, thereby, reducing the amount of cash and equivalents in the numerator, before dividing by the average free cash flow per month.

Data in Exhibit 1 show that if these 12 MSOs continue to rely on nonpayment of taxes owed, their cash will last between 3 months at Jushi and 127 months at Green Thumb. If, however, each MSO pays off its entire past due income tax bill, which is shown on their balance sheets as current income tax payable, Verano and 4Front would have very serious problems. In fact, if Verano and 4Front paid all their past due taxes on June 30, 2022, they would have overdrafts of $68.6M and $23.6M, respectively. They would, in fact, have to write “hot checks” to the IRS!

The MSO in the best shape to pay off its tax bill at the end of Q1 was Green Thumb. If it paid its tax bill, it would still have enough cash to last 121 months.

Benefit of Not Paying IRS

Among the MSOs analyzed, VRNOF had the greatest amount of income tax owed ($161.4M) on June 30, 2022. Curaleaf ranked second with $125.3M in past due taxes. Cresco Labs (OTCQX:CRLBF) owed $59M and ranked 3rd.

Corporations do not pay penalties for nonpayment of taxes; instead, they are charged interest at a rate of 1/2 of 1% per month. MSOs that do not pay their taxes are, therefore, able to borrow money from the IRS at an annual percentage rate of 6%, which is well below what they would otherwise have to pay to borrow money from other sources. Given the interest rate differential, income tax owed by MSOs should not necessarily be viewed as a serious financial weakness unless the amount owed dwarfs cash and other current assets. Current income taxes incurred, however, need to be factored in when determining how much truly free cash flow is generated by an MSO.

It would be interesting to see how the IRS fares in the event an MSO that is past due its income taxes enter into bankruptcy in Canada, which is generally where they are incorporated. I have a feeling that the U.S. government might end up with an equity interest in a business that is federally illegal! It happened before when the U.S. Government ended up owning a famous brothel in Nevada due to a bank failure.

Merger Implications

Verano and Goodness Growth have signed an agreement to merge as have Cresco Labs and Columbia Care. CEOs involved in these mergers have stated they expect these mergers to close in Q4 2022. The likelihood of these mergers being transformative and suddenly creating a positive free cash flow is remote.

If Q2 results persist and no external funding is employed, after Verano acquires Goodness Growth, it would have $110M in cash, income tax payable of $161M, and negative free cash flow of $4M/month. Verano’s cash would be gone in 29 months even if it did not pay off its taxes.

If the Cresco’s acquisition of Columbia Care closed on June 30, 2022, Cresco would only have enough cash to last 7 months provided it did not pay off its taxes and 4 months if it did. A combined Cresco/Columbia Care entity shows $171M in cash, negative free cash flow of $79M, and a current tax liability of $59M.

Unlike mergers in other industries where there are considerable cost savings, mergers in the cannabis sector have not yielded meaningful savings. The illegality of interstate shipping of cannabis and state laws requiring intrastate cultivation and processing takes away the possibility of many economies of scale through centralization. Truth be told, the driving force for cannabis company mergers has been the desire to grow revenue by adding states and it has been fostered by investment bankers interested in M&A fees and CEO egos. Economies of scale in the cannabis MSO model appear to be nonexistent.

Secured Debt

The preceding cash burn analysis ignores the fact that MSOs are loaded with debt other than that owed the IRS. Accordingly, the financials of the 12 MSOs in this article were combed to identify maturing debt obligations, since a failure to pay off a debt when due or called is an act of bankruptcy.

Leases have been omitted as debt in this analysis, because they do not involve large lump sum payments. Lease payments are not totally ignored since they are included in cash flow statements.

Exhibit 2 shows the amount of debt these 12 MSOs have maturing yearly from the June 30, 2022 through 2027. Debt coming due is always a concern when a company has negative cash flow and limited external sources of funds. Investors ought to be particularly conscious of huge debt maturities, because that is what caused so much grief for iAnthus shareholders.

MSO Maturing Debt

SEDAR

It is apparent from the data in Exhibit 2 that these 12 MSOs have not carefully structured the maturity of their debt. The fact that ALL $400M of Verano debt and ALL $46M of Goodness Growth debt mature in 2023 is worth mentioning since they are about to merge. A proforma of their Q2 2022 results shows the combined entity would generate ~$3.8M in NEGATIVE FREE CASH FLOW PER MONTH; therefore, the chances of them being able to pay the ~$46M due April 30, 2023, the ~$290M due May 30, 2023, and the ~$110M due August 28, 2023 out of internally generated funds is ZERO! The holders of Verano and Goodness debt are perfectly positioned to do what iAnthus debt holders did to iAnthus shareholders.

If some of these 12 MSOs continue to perform the way they did in Q2 2022 and are unable to either extend or replace maturing debts, then their shareholders are doomed. All 12 had negative free cash flows and five have disproportionately large debts coming due in the next 30 months relative to their cash positions and negative free cash flows.

MSOs With Highest Default Risk

The five MSOs which seem to be at the greatest risk of default during the next 30 months are Ayr Wellness, 4Front, Jushi, TerrAscend (OTCQX:TRSSF), and Verano. All five have huge debts coming due, negative free cash flows, and insufficient cash as shown in the following exhibit.

Exhibit 3 shows all five MSOs have considerably less cash than debt coming due. Furthermore, it shows that negative cash flows are consuming existing cash very fast, particularly at Ayr Wellness, 4Front, and Jushi.

MSOs At Highest Risk

SEDAR

Holders of Ayr Wellness secured notes are already evidencing some concern. On September 15, 2022, a C$58,000 block of Ayr 12.5% secured notes due December 20, 2024 traded on the CSE at a dollar price of C$90, which equates to a yield-to-maturity “YTM” of 18.31%! The next day, AYRWF stock traded at an all-time low of $3.50 on the OTC.

Conclusion

Cash is essential to the existence of corporations and can be generated either internally and/or externally. It is as important to cannabis MSOs as water is to human survival.

MSO executives and investors believe that banks are anxious to lend money to MSO companies. As Chairman of the American Bankers Association (ABA) Commercial Lending Schools, I helped train thousands of bank lending officers and doubt they will lend to MSOs; because, as shown in this article, MSOs have not demonstrated an ability to generate free cash flow, which is necessary to repay loans. Loans to money-losing companies with negative cash flows are likely to be classified as substandard, doubtful, or loss by bank regulatory authorities and jeopardize a loan officer’s career. Company executives need to face this reality and focus on creating positive free cash flow as fast as possible because the clock is ticking.

This article reveals that major MSOs will run out of cash in the near future if they continue to experience cash flows like they did in Q2 2022. Accordingly, companies that do not have existing shelf registrations with room to raise funds via debt and equity issuance need to immediately file such shelf registrations. If a company gets an opportunity to raise cash, it needs to take advantage of the situation.

Negative free cash flows and high cash burn rates are painful and can be fatal when debt comes due and external equity sources of funds vanish. Investors wanting to avoid getting wiped out by MSO creditors need to pay close attention to MSO free cash flows and the ability of MSOs to pay off debt as it comes due.

We will soon see how MSOs deal with their cash flow problem. They cannot wait until they run out of cash, because then it will be too late.



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