Description

Summary: Cannabis stocks [MSOS:NYSE] are trading near both 52-week and all-time lows following years of regulatory shortfalls, limited institutional participation, nagging price compression, and a perceived deceleration in the industry’s growth.  We believe federal rescheduling of cannabis from a Schedule I to Schedule III drug will set the wheels in motion for critical steps that will remove onerous tax structures, improve operating leverage and efficiencies, and reduce cost of capital.  We believe “the train has left the station” from a regulatory perspective on the back of a historic HHS and DEA recommendations both progressing swiftly, and potential for rescheduling to be completed in mid-2025. The main risk is regulatory changes are difficult to time/trade.

Challenges Leading to Cannabis Stocks Being Stuck in ‘Cannabis Jail’

The Cannabis sector has faced numerous non-permanent challenges over the past couple of years, down 86% from highs and down 30% over the last 6 months. 

Several contributing factors include:

• Regulatory Disappointments: Ongoing regulatory changes, including the SAFER Banking Act introduced in the Senate in December 2022 has not yet passed the House of Commons. Additionally, the reclassification of cannabis from Schedule I to Schedule III has faced uncertainty due to presidential candidacy and resulting delays in the legislative process
• Limited Institutional Participation: Many cannabis companies remain on the Canadian Securities Exchange (CSE), hindering their ability to uplist to senior exchanges, which has limited the involvement of institutional investors.
• Significant Pricing Compression: Increased competition in key markets has led to pricing pressures, shrinking profit margins and complicating growth due to discounting practices and troubling state-specific supply-demand dynamics.
• Stagnant Perceived Industry Growth: Large players are seeing mid single digit growth, with catalysts like Ohio’s adult-use legalization falling short of expectations, leading to flat-or-negative revenue trends in Q3 2024.
• Challenging Macroeconomic Factors: The current economic environment has negatively impacted consumer spending patterns, with inflation resulting in reduced basket sizes, even as customer traffic remains steady.  While cannabis is considered to be a staple, it is not immune.

The Path Forward: while rocky will lead to a brighter future

While these challenges are significant, cannabis stocks are trading at substantial discounts to their potential intrinsic value, and we believe that the industry is on the verge of a turnaround. We see rescheduling as the first domino in a potential chain of positive developments:

• Elimination of 280E Tax: The removal of this tax could result in $50 to $150 million in incremental annual cash flow for large Multi-State Operators (“MSOs”). This financial relief would strengthen balance sheets and support debt repayment and capital expenditure plans.
• Federal Legality: Though it may seem like a technicality, it will lay the path for the critical industry-wide changes
• Political Developments: Following rescheduling, we may see the reintroduction of initiatives such as:
  • SAFER Act, enabling cannabis companies to access banking services and credit cards so that they don’t have to operate like its 1950’s with cash
  • The new Garland Memo, which could facilitate uplisting, improve capital structures and lower the cost of capital
• Improved Capital Structures: With the SAFER Act and rescheduling, companies could access cheaper debt, improve equity deal terms, and restructure capital more favorably
• Institutional Inflows: A favorable Garland Memo alongside rescheduling could attract institutional investors, enhancing liquidity and market dynamics.

As these factors align, we expect cannabis stocks to re-rate. The potential rescheduling of cannabis from Schedule I to Schedule III under the Controlled Substances Act represents a transformative opportunity, particularly for the MSOS ETF, which is well-positioned to leverage these developments.

Step One: Rescheduling

Rescheduling has undergone a fast-tracked, multi-step process, and we believe we are near the finish line, with potential finalization by mid-2025 or sooner. The final step is an Administrative Law Judge (ALJ) hearing in December 2024 and a final ruling (note: there are various steps between ALJ and final ruling but they are largely procedural). The main risk for rescheduling lies in Trump's decision to embrace or reject the policy, but we believe this has been mitigated by his recent comments on Truth Social, which indicate support for adult legalization in Florida and rescheduling.

It is important to highlight that the rescheduling process has advanced significantly more quickly than anticipated. The Department of Health and Human Services (HHS) completed its scientific study in a record timeframe of 10 months, while the Drug Enforcement Administration (DEA) took 9 months to propose a ruling. Typically, these legislative processes span several years.

There is clear support for cannabis. The comprehensive 250-page memorandum from HHS highlights extensive scientific research, the successful legalization in Canada, the absence of significant fatalities or other issues, and the medicinal benefits for war veterans further emphasize that this is an issue with substantial public support.

Cannabis stocks are trading near 52-week lows, despite significant cash flows being generated by large. Additionally, key markets like Florida are moving toward adult-use cannabis in November 2024. This could help jumpstart growth in one of the country’s largest cannabis markets.

Timeline and Progress of Rescheduling

• October 2022: President Biden announced that he had directed the Department of Health and Human Services (HHS) and the Office of the Attorney General (AG) to expedite the review of marijuana’s classification under federal law. He also pardoned thousands of Americans who had been federally convicted of simple possession of the drug. Some speculated that this was a strategic move from Biden to attract young voters. Following the news, MSOs rose from $9 to a high of $12.11 in December 2022, only to decline to a low of $5.48 in subsequent months.
• August 2023: In an unprecedented 10-month timeframe, HHS issued their recommendation to the U.S. Drug Enforcement Administration (DEA) to reclassify cannabis from Schedule I to Schedule III under the Controlled Substances Act. This is a process that usually can take 2 to 3 years, but was “fast-tracked” under Biden’s directive.
• DEA Review and Biden Administration Actions:
  • December 22, 2023: Biden issued further pardons to marijuana offenders and reduced sentences for non-violent drug offenders
  • March 15, 2024: In a closed-door White House roundtable on criminal justice reform focused on cannabis policy, Vice President Harris urged the DEA to act “as quickly as possible” on cannabis rescheduling. She called the current classification “absurd and patently unfair” and stated, “I just need to say it, we need to legalize marijuana.”
  • April 25, 2024: the White House hosted another roundtable in what it deemed “Second Chance Month,” where Vice President Kamala Harris discussed further cannabis pardons with Kim Kardashian
  • May 21, 2024: The Department of Justice (DOJ) proposed transferring marijuana from Schedule I to Schedule III of the Controlled Substances Act, aligning with HHS’s stance on marijuana having accepted medical uses. The DOJ’s action came just 8 months from DEA review, marking yet another record achievement in the process. Investors now await a final rule.
  • August 27, 2024: The DEA announced the ALJ hearing on cannabis rescheduling would be held in December 2024. Originally, a final rule was expected before the election, but this ALJ hearing, set after the election date, seems to eliminate all hope for that outcome.

Election Impact: What Are the Odds?

With the ALJ hearing scheduled for December, rescheduling has naturally become an election issue. However, we believe that Schedule III has reached a stage where it is highly likely regardless of the election outcome.

Scenario 1: Kamala Harris as President

This is the best case for rescheduling. Kamala has been a strong proponent of cannabis reform, including both rescheduling and cannabis legalization. Considering the democrats initiated this process, it’s logical to expect her to see it through to completion.

Scenario 2: Trump as President

Trump’s behavior in recent weeks suggest his presidency poses less of a risk to rescheduling than previously feared. For years, cannabis lobbyists and industry groups have been engaging with Trump’s campaign team. And, per Marijuana Moment, Trump met with industry leaders on September 3. Since then he made three significant comments on cannabis, including a post on Truth Social urging support for Florida legalization and research into rescheduling. These statements should significantly ease investors’ concerns that Trump may scrap Schedule III altogether. The process is in its final stages, and now that Trump has voiced his support, we believe a reversal in posture is unlikely.

Impacts on Rescheduling:

Upon rescheduling ‘plant-touching’ companies will incur income taxes on operating profit rather than gross profits. The savings from this change would be both significant and timely. According to Zuanich Associates, in calendar year 2023 (CY23), these Multi-State Operators (MSOs) paid $575 million in income taxes. If the 21% tax had been calculated on gross profits, the declared taxes would have totaled $842 million. However, in CY23, MSOs paid approximately 68% of that amount ($550 million). This ratio has consistently declined, from 91% in CY21 to 90% in CY22, and then to 68% in CY23.

These potential tax savings could be significant, paving the way for further reform which would attract wider institutional interest.  We believe rescheduling could trigger a domino effect potentially including:

• A push for SAFER Banking Reform
• New and updated Cole Memo (which would allow for the underlying MSOS companies to potentially re/uplist to NYSE/Nasdaq)
• Interstate Commerce: Enhanced operational efficiencies could arise from interstate commerce, allowing MSOs to consolidate operations and achieve economies of scale.

Valuation

The MSOs are currently trading at an attractive valuation of 7.2x 2025 EBITDA, significantly below historical highs of 14x, indicating that the market may be overreacting to uncertainties surrounding rescheduling.

Risks and Concerns

Although the rescheduling process has been described as “fast-tracked,” several questions and pronounced concerns have weighed on cannabis stocks:

• Lack of DEA Involvement: The proposed rule for rescheduling was signed by Attorney General Merrick Garland, not DEA head Anne Milgram, which raises concerns about the DEA’s support for rescheduling.
• Biden’s Withdrawal: Biden’s withdrawal from the election campaign may remove the urgency for cannabis reform to be “fast-tracked”.
• Democrat Commitment: Kamala Harris and other Democrats did not discuss cannabis at the Democratic National Convention and in debates, which raises questions about their commitment to finalizing rescheduling.
• Trump’s Candidacy: Investors worry Trump will stifle rescheduling. This has become a greater concern following the appointment of JD Vance, who has previously opposed the cannabis reform movement.
• ALJ Hearing Delay: Initially expected to come before the election, the ALJ hearing was set for December 2024, exacerbating fatigue over the procedural process. We believe the ALJ hearing is crucial for tightening the rescheduling process, as Democrats likely want to avoid court challenges that could overturn the decision, especially following examples like the recent student loan case.
• Financial Problems: Many cannabis operators face looming debt maturities in late 2025 and 2026. Without significant industry changes, these companies may be forced into bankruptcy, or seek refinancing or additional capital at unfavorable conditions.

Conclusion

Investing in the MSOS ETF offers a unique opportunity to benefit from the imminent rescheduling of cannabis. The strong fundamentals of the underlying MSOs, combined with potential tax savings, industry growth, and pricing stabilization, makes cannabis stocks attractive.  We believe rescheduling marks the beginning of a broader positive shift in the regulatory landscape with several favorable developments to follow. With valuations at trough levels, we see the current risk-reward as highly favorable. 

Catalyst

- Final rule for Rescheduling

- Florida turning to Adult use cannabis state in November 2024 

- Potential for New Gardland Cole Memo

- Potential for SAFER Banking 

- Kamala Presidency supports cannabis legalization