The time may have finally arrived for Canadians who have been waiting patiently for an opportunity to invest in the nascent legal cannabis market in the United States.
The approval of five additional state cannabis ballot measures during the election in November, combined with strengthening balance sheets among the largest U.S. cannabis companies and increasingly bipartisan political support for legalization, has created an ideal entry point, experts say.
In fact, despite ongoing federal prohibition and onerous tax policies, U.S. cannabis companies make for better investments than those in Canada, says Vivien Azer, managing director and senior cannabis research analyst at Cowen Inc. in New York.
“We are more constructive on the opportunity in the U.S. relative to the adult-use market in Canada,” she says.
That’s in no small part because the U.S. market – even when accounting for the various states in which cannabis remains illegal – is substantially larger than Canada’s, but that’s also because “there is also a quite notable difference among the [licensed cannabis] operators,” she says. “You look at the top half-dozen or so in the U.S., every one of them is profitable with increasingly healthy margins.”
Beyond the fundamentals, Graeme Kreindler, health care analyst at Eight Capital Corp. in Toronto, expects further momentum to be driven by the incoming administration of president-elect Joe Biden and vice-president-elect Kamala Harris.
“This is going to be the most pro-cannabis president that the United States has ever had, so a lot of people look at the tone from the top in terms of what is going to happen in the industry,” Mr. Kreindler says. “This has so far been a state-by-state story, where you’re looking for that groundswell of grassroots support. It’s really been more of a bottom-up story, but the top-down perspective is why you’re getting a lot more attention paid to [cannabis] and more enthusiasm for it now.”
In terms of exactly where in the U.S. cannabis market Canadians should invest, many experts recommend companies with assets in multiple states, often referred to by the acronym “MSOs” – or multi-state operators. Some examples include Green Thumb Industries Inc. (GTII-CN), Trulieve Cannabis Corp. (TRUL-CN) and Cresco Labs Inc. (CL-CN), all of which trade on the Canadian Securities Exchange.
“In a nascent industry, the ability to control that entire supply chain, to manage that entire process end-to-end is, in many circumstances, allowed many of these companies to have best-in-class cost structures and deliver best-in-class products most reliably to their end consumers,” Mr. Kreindler says.
Jesse Pytlak, an equity research analyst at Cormark Securities Inc. in Toronto who covers the U.S. cannabis sector, also says that “the scaled multi-state operators offer exposure to greater legislative and regulatory catalysts, have cost of capital advantages and better trading liquidity.”
However, because of conflicting state and federal cannabis laws, MSOs are generally required to replicate their entire footprint in every state in which they operate. That has often required those companies to create identical versions of cultivation, processing, distribution and sales assets in complete isolation from one another, creating substantial cost challenges.
“A lot of the multi-state operators get in trouble because they are doing big land grabs and trying to figure out where [legalization] is going next,” says Codie Sanchez, managing director of cannabis-focused private equity firm Entourage Effect Capital LLC in San Diego. “That didn’t work out so well in the past.”
Ms. Sanchez recommends that investors focus more on companies with focused operations in a single state. Some examples include Gage Cannabis Co. in Michigan and Caliva Inc. in California, both of which are expected to go public in 2021.
Recent state-level successes – South Dakota, Arizona, New Jersey and Montana all approved adult-use ballot measures in November – “demonstrate that legalization is no longer a partisan issue,” Cormark’s Mr. Pytlak says.
The latest Gallup poll on the issue, published on Nov. 9, showed 68 per cent of Americans support cannabis legalization, including roughly 50 per cent of self-identified Republicans. By comparison, Gallup found just 12 per cent of Americans supported legalization when it first began asking that question in 1969.
Regardless of whether investors choose to invest in multi-state or single-state operators, they should be aware of the risks stemming from every U.S. cannabis company being subject to Section 280E of the U.S. tax code.
The regulation dates back to a 1981 court case, in which a convicted cocaine dealer was able to successfully deduct regular business expenses from his earnings. Congress passed Section 280E in 1982 to close that loophole. However, because the language applies to any business connected with “controlled substances,” the entire U.S. cannabis industry is banned from claiming basic business expenses such as rent, utilities and office supplies against their tax bills.
“Because of the burdensome 280E tax treatment that cannabis companies are subject to in the U.S., cash flow, as it pertains to debt-servicing ability, is important to monitor,” Mr. Pytlak says.
Cowen’s Ms. Azer says the “very onerous” section 280E provisions create “a challenge with cash flow in the cannabis sector.” Yet she has noticed “several of the companies that I cover reporting positive net income in the third quarter despite 280E.”
That reinforces the argument that now is an ideal time for Canadian cannabis investors to start putting some of their money south of the border, Mr. Pytlak says.
“This is an US$18-billion industry with the potential to become a US$100-billion industry,” he says.