Description

I’ve written previously about the opportunities present in the US Cannabis industry. To quote from my previous write-up:

“Imagine an opportunity to invest in a mythical $100 billion market on its way to $200 billion in which capital is scarce, institutional participation is tiny, and where many publicly traded companies involved are not listed in any major index or traded on any major US exchange.” 

The lack of institutional participation in US Cannabis continues. With little research or due diligence, incredible opportunities are hiding in plain sight. 

Consider Goodness Growth (OTC: GDNSF). In February 2022, Goodness Growth was valued at ≈$400M by the public markets and its would-be acquirer Verano Holdings (VRNOF). Yet despite drastically improved operations and transformative catalysts on the horizon, the business trades at a market cap of $55M today, even after an increase of over 200% over the past 6 months.

Much of the pessimism for the business is due to the aborted acquisition and a balance sheet that has significantly deteriorated. Ballooning interest and lease payments have overshadowed the significant operational improvements with the company reporting a loss of $34M on a TTM basis.

However, we believe three major catalysts- divestiture of their New York assets, adult-use sales in Minnesota, and rescheduling of Cannabis are set to transform Goodness Growth’s business. Even our most conservative estimates show Goodness exiting 2025 with a positive net income. At the same time, capital constraints and regulatory conditions for US Cannabis companies should improve significantly, allowing for a re-rating for the entire sector. Thus, we believe Goodness Growth has a massive upside over the next few years.

About Goodness Growth

Goodness Growth is a vertically integrated US Cannabis Multi-State Operator with operations in the limited license states of Minnesota, Maryland, and New York. It owns cultivation and manufacturing facilities in all three states, along with eight dispensaries in Minnesota, four in Maryland, and two in New York. We expect the New York assets to be divested over the next few months. 

To understand Goodness today, we have to go back to February 2022, when the US Multi-State Operator Verano Holdings (OTC: VRNOF) signed a deal to acquire Goodness Growth for a transaction valued at $413M. Goodness began incurring debt to invest heavily in its operations ahead of anticipated adult-use sales, including a $56M sale-leaseback transaction for a 324,000 sq feet facility in New York. 

However, industry conditions changed drastically over the next 6 months. Already scarce to begin with, investors began to flee the industry as they became pessimistic about the prospects of federal reform. Price compression of cannabis in major markets led to declining margins, reduced growth, and increased scrutiny on the balance sheet just as the cost of capital began to soar. Finally, the New York market began to appear significantly less attractive, as it became clear that the state regulator was hostile to the interests of the largest cannabis companies. 

Operators began to pivot from expansion mode and went from planting flags in as many states as possible to focusing on cash flow and their balance sheet. This is the backdrop behind the stunning news in October 2022 when Verano pulled out of its acquisition.

 Industry observers generally thought this was a good decision for Verano, allowing it to focus on optimizing its existing assets and servicing its significant burden of debt and unpaid taxes. However, they viewed it as an unmitigated disaster for Goodness, which was seen as a major bankruptcy risk. Overnight, $GDNSF collapsed from $1.2 to $0.4.

The turnaround under new management

In February 2023, Goodness appointed Josh Rosen, a partner at Bengal Capital and a major shareholder in the company, as interim CEO. Josh immediately instituted a strategy called C.R.E.A.M (Cash Rules Everything Around Me) and FIRE (a focus on making high-quality products). This has been accompanied by very investor-friendly communication with improved disclosure and replacing the much-maligned Adjusted EBITDA.

The results are there for everyone to see. A win-win partnership with high-quality Cannabis Cultivator Grown Rogue (who I have written about previously) has led to a significant increase in product quality. 

This has been accompanied by divesting their non-core assets in New Mexico and a focus on operational efficiency. The company has been boosted by a start of adult-use sales in Maryland in Q3 2023, where they have outpaced the market (revenue increase of 180% y-o-y versus 116% for the entire market).

Key Risks

The biggest risk for Goodness Growth is the upcoming debt maturity of $56M due by April 30, 2024, versus its cash balance of $13.3M. The company reported that there is an agreement in place to extend the maturity if certain performance metrics (confidential) are attained. We believe that these metrics shall be attained upon the sale of the New York assets (more on these later). We feel confident that the company shall be able to secure an extension as the lender Chicago Atlantic now owns about 36% of the company, especially ahead of the massive opportunity that is adult-Use sales in Minnesota.

Investors are also concerned about its ability to service its massive debt burden of $64M, combined with the $56M sale-leaseback transaction for its New York Facility. Despite an EBITDA of $11.2M for the first 9 months of 2023, a whopping $22M in interest costs meant the company reported a pre-tax loss of over $14M. 

This is where the sale of the New York Assets will be crucial. While we do not expect any meaningful proceeds from the sale, the transaction will allow the company to save over $10M in interest payments each year. It should also result in meaningful improvements in Gross and EBITDA margins, given that the New York market is by far the weakest of the three and almost certainly is not profitable for the company.

The company indicates that the sale of the assets is impending and should be concluded very shortly.

Minnesota Adult Use Sales

In 2023, Minnesota legalized recreational Cannabis, with sales slated to begin in Q1 of 2025. The usual thumb rule for recreational sales is to expect the market to grow by between 2 to 2.5x once sales begin. However, we believe that the numbers should be far higher for the Minnesota market.

With just around 50,000 patients in a population of 5.7M, Minnesota’s Medical Cannabis program is one of the weakest in the country. The per capita cannabis expenditure in the state is less than $16. Looking at existing mature adult-use markets, the average per capita expenditure on Cannabis comes out to around $250. However, to be conservative, even if we assume that the per capita sales will be around $100, over 20% lower than the corresponding figure for New Jersey, we’re still looking at a market that is over 6 times larger than the current size.

What makes this even more exciting that Goodness is one of only two vertical operators in the state, and thus is poised to disproportionately benefit from recreational sales. Goodness currently holds around 60% share in the existing medical market, and it’s eight dispensaries all have great reviews that are, on average, better than those of their competitor Leafline (owned by leading MSO GTI). 

Goodness exited Q3 with $14.6M revenue from Minnesota. We believe that this number should easily exceed over $50M per quarter upon legalization. Applying the company’s current 28.5% EBITDA margin to this increase (in reality, this should be dramatically higher), we believe incremental EBITDA should be greater than $10M per quarter. Even better, given the additional catalyst below, much of this figure should translate directly to operating cash flow.

Rescheduling

One of the biggest issues facing the industry is the classification of Cannabis as a Schedule 1 substance. It is classified in the same class as heroin and MDMA and as more dangerous than Cocaine, Methamphetamine and Fentanyl.

All companies that are dealing with Schedule 1 substances have to deal with an onerous tax provision called 280E. 280E disallows Cannabis companies from deducting ordinary business expenses while filing taxes. Effectively, this means that US Cannabis companies pay tax on their gross profit, and can have tax rates as high as 70%. 280E means that despite reporting a pre-tax loss of $14M, Goodness has incurred additional income taxes of $7.3M, leading to a total loss of $20M. 

However, a few months before the mid-term elections, President Biden asked the HHS and the US attorney general to initiate the administrative process to review Cannabis’s schedule under federal law. His statement indicates his opposition to Cannabis’s current classification.  While this is a process that usually takes several year, the HHS sent a recommendation to the DEA asking that Cannabis be rescheduled to be changed to Schedule 3 in less than a yer since Biden’s announcement. Crucially, Schedule 3 or below means 280E will no longer apply to Cannabis companies. 

It is important to note that the DEA is legally bound to accept the HHS’s scientific recommendation. In a fiercely contested election year, it is highly unlikely that political appointees will disagree with the president on an issue that will sway the voters on the margins. 

We expect to see a rescheduling announcement before the elections. This will save over $10M per year for Goodness Growth. It also sends a giant bat signal to the world and the financial industry that it is now safe to enter the Cannabis waters. While true institutional participation might need additional regulatory action in the form of the SAFE Banking bill, we do expect to see a rerating of the industry after rescheduling. 

On top of this, cannabis’s classification as a Schedule I substance means that no US cannabis company is allowed to deduct expenses while filing their taxes, a provision known as 280E. Despite reporting a loss for the year so far, Goodness Growth has paid over $10M in Income Taxes.

Verano Lawsuit

After the termination of the acquisition by Verano, Goodness Growth filed a lawsuit seeking damages for breach of contract. The company’s management views the Verano litigation as a key asset of the company. While we do not account for this in our investment thesis, we do agree with their assessment. We believe that Goodness should receive a meaningful amount shortly as a result of their litigation, which should further improve their balance sheet. 

Summary

Goodness Growth represents the kind of opportunity that can only exist in a market utterly devoid of institutional investors such as Cannabis. Available at a market cap of $55M, in our estimation, Goodness’s Minnesota operations alone are worth multiples of that number. 

The divestiture of the New York Assets and Rescheduling will ease concerns about the balance sheet while greatly improving cash flow. Even a conservative estimate indicates that Minnesota’s revenue is likely to triple upon the start of adult-use sales in 2025, much of which will flow straight to the bottom line. 

With over a $20M reduction in interest costs and taxes, along with at least $40M in incremental EBITDA, Goodness should exit 2025 as a company unrecognizable from its 2022 avatar. The initial acquisition price of $435M could well seem like a bargain!

Catalyst

Extension of upcoming debt maturity

Divestiture of New York Assets

Start of Adult-Use Sales in Minnesota

Rescheduling of Cannabis from Schedule 1 to 3