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There are several ways to build a multi-state operator in the United States: gobble up as many licenses in as many states as possible, piece together a smaller portfolio of profitable businesses, even forgo the THC opportunity altogether and focus exclusively on CBD.

“We've been trying to play Risk, while the market has been playing Monopoly,” is how Kris Krane, president of 4Front Ventures, describes his company’s more discerning approach to M&A.

All these methods were on display at the Eight Capital and Cassels Brock cannabis forum on Tuesday in Toronto, which brought together the leading lights of the U.S. cannabis industry to discuss the “State of the Union” and the opportunities ahead.

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Whatever the business model, the general sentiment was that the U.S. cannabis industry is entering a new phase where the ability to execute on business plans and start turning a profit will matter as much, if not more, than the ability to expand a geographical footprint. That said, there are still plenty of deals to be done. Here are some key takeaways from the conference:

Limits to MSO mega-mergers

After years gobbling up licenses across the country, the largest MSOs are beginning to hit a saturation point where their ability to expand depends more on deepening their presence within states, rather than expanding into new ones. This dynamic has reduced the likelihood of mega-mergers between MSOs like Columbia Care, Cresco Labs, CuraLeaf and Harvest Health, whose CEOs (and one CFO, Neil Davidson of Curaleaf) spoke on a panel.

"When I look at the portfolios of the people on stage, we overlap in almost every market... The land grab concept is still relevant for expansion and pursuit markets, but now is the time that I think people really need to focus on consolidating market share in a profitable way," said Nicholas Vita, CEO of Columbia Care.

Steve white, CEO of Harvest, echoed this: “Somebody asked me earlier today, ‘what about merging with some of these guys?’ And I looked at him and said, ‘well we'd have to sell a bunch of Illinois and Florida’ ... That sort of merger stops making sense at a point when what you're doing is combining two companies and effectively selling one of them off.”

“There are states however, where you can go much deeper,” Mr. White added. “In California, for example, a market the size of Canada...we should all be going as deep as we possibly can.”

Making strategic acquisitions

There may be few MSO mega-mergers in the pipeline, but that doesn't mean that there aren’t deals to be had, particularly for smaller firms putting together regional portfolios.

“When it comes to looking at single-state operators and picking up onesies and two-sies, versus these big mega-mergers, there certainly is an arbitrage opportunity right now, where you can buy single-state operators for less than two times sales, and some of them are really good operators and are actually making money,” said Jason Wild, chairman of TerrAscend.

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The fact that there has been so much large MSO deal activity over the past year actually means more single-state assets are coming to market, according to Jen Drake, COO of Ayer Strategies Inc. (formerly called Cannabis Strategies Acquisition Corp.) which went public last month after piecing together a portfolio of five U.S. assets.

“The result of some of these mega mergers has been, and will be, divestitures, which brings more supply to the market... while at the same time, prices are dropping a little bit,” Ms. Drake said.

MSOs want banking reform. Interstate commerce? Not so much

Having spent fortunes securing a nationwide footprint on a state-by-state basis, the large MSO aren’t eager for reform that opens up interstate cannabis commerce.

“We'd like to see banking reform in whatever way it comes, and capital market reform, that's extremely critical,” said Neil Davidson, CFO of Curaleaf.

“From a descheduling standpoint… the reality is states have set up a framework that captures dollars in their states; so if you see descheduling, I highly doubt you'll see products going between borders,” he added. “I like the regulatory expertise we've built within the organization, and I see it as a huge strategic benefit. From our standpoint, descheduling doesn't really benefit the industry, banking does."

Mr. Vita of Columbia Care suggested that states may even try to limit interstate commerce on the CBD side of things for tax reasons – something that would benefit the large MSOs.

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“Our states are for the most part broke, so they have a financial disincentive to allow for anything but a closed loop system. Most of these states enacted these [industrial hemp] programs as away to fund a donut hole in their own budgets over a long period of time,” Mr. Vita said.

“These politicians are not tone deaf to what's happening out there and the market opportunity, so you look at New York, you look at Florida, you look at Ohio, you look at Massachusetts, there are either programs in place, or will be in place, to limit the ability for people to leverage certainly transborder... CBD products, even those that are industrial hemp-derived,” he said.

CBD players see a mass market approaching

The speakers on the conference’s CBD-focused panel are banking on Mr. Vita being wrong on this last point. Since the passage of the 2018 Farm Bill, which descheduled hemp-derived CBD and mandated that states cannot prevent on the movement of CBD products across their borders, the CBD business model has begun to look more like a traditional CPG business.

“The CBD market is fundamentally different from an M&A perspective relative to what's... happening in the THC market with the MSO roll-up state-by-state game,” said Andrew Pucher, the chief corporate development officer at Tilray, which bought Manitoba Harvest earlier this year to play in the U.S. CBD market.

“This is trending towards what will be an ingredient in the food supply, and what will be a beauty ingredient, and it can be shipped across many state lines... So you actually have the ability to scale a business and build a brand,” he said.

Much in the CBD market depends on how the FDA decides to regulate CBD; it began a public review process last Friday, but may take months or years to issue formal guidance on the drug. Despite the grey area, the CBD panelists predicted that an ‘inflection point” was fast approaching where CBD will go mainstream, driven by demand from retailers.

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"The major retailers, even mid-sized retailers, in pharmacies and in food, drug and mass [merchandise], they're all doing these regional rollouts or test roll-outs, and they're putting it in anywhere from 10 to 25 per cent of their stores. The point is coming where they say, ‘OK, we know it's safe, these products are great, they’re efficacious, the consumer demand is consistent, it's time to now roll it out,’" said Perry Antleman, CEO of Abacus Health Products.

Valuing MSOs

Cannabis companies are notoriously hard to value, given the pace of change and uncertainty around legislation and regulation. Nonetheless, different folk-metrics have emerged, such as funded capacity for Canadian LPs or number of licenses for U.S. MSOs.

Valuing MSOs based on their license count is increasingly irrelevant, according to several speakers at the event. Here’s how Brian Schinderle, executive VP Finance of Grassroots Cannabis, put it:

“It was very important probably a year ago to show flags on a map … We don’t think that really matters right now. I think the market has gotten to a point where they really differentiate on who’s got important states, states that are really strategic. Even more to the point, who is going to be on a path where they can really deliver free cash flow?

“Valuation isn’t going to be a multiple of revenue or a multiple of flags on a map, it’s going to be a multiple of free cash flow. We’re quickly evolving to a point, probably by early 2020, where those kinds of metrics will really matter, and it will be the execution, and who can get stores open, who can be profitable, who can correctly allocate capital, control their costs, and really have a path to delivering free cash flows," he said.

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