Cannabis Chart Of The Week: What's The Right Way To Measure MSO Leverage?

The credit quality of cannabis companies has taken center stage in 2023 as the equity capital markets remain shuttered and growth and operating profits remain constrained.

Cannabis companies have rightfully turned to debt financing to plug the gap; however, this has increased leverage for the industry. We have previously argued that Debt/EBITDA over 3x is challenging to sustain in a 280e world. But Debt/ EBITDA is not the only indicator of leverage investors should look at.

Debt/ EBITDA is more complicated than it appears. Should leases be included? Viridian Capital Advisors has always included leases in our debt calculations since before most leases were capitalized onto the balance sheet. They are fixed charges, and since they are often based on mission-critical equipment or facilities, the option to walk away from the lease is often not feasible. They should be considered debt.

The dark green bars indicate Total Debt, including leases to consensus 2024 EBITDA estimates. The red line is drawn at 3x, our general limit on long-term sustainability.

The light green bars add other liabilities to the analysis. The top of the bars indicates total liabilities to EBITDA. Viridian believes it is essential to include total liabilities in the leverage definition to pick up tax and other debt-like liabilities not classified as debt. For example, Jushi JUSHF has $88.5M of tax liabilities on its balance sheet, representing 8.7 quarters of its most recent quarter's tax expense. Goodness Growth GDNSF has $75M of lease liabilities held as "Liabilities Held for Sale," Verano VRNOF  has stated on its conference calls that it uses tax liabilities as a financing mechanism.

Debt/EBITDA and Total Liabilities/EBITDA have critical problems as leverage indicators. One issue relates to the weakness of adjusted EBITDA: it is neither a good measure of profitability (adjusting out such things as equity-based compensation) nor a good measure of cash flow (neglecting interest expense, taxes, working capital changes, and CAPEX). Basing credit quality calculations on this measure is dangerous. Moreover, consensus analyst estimates are systemically optimistic and tend only to get updated at quarter ends.

Viridian believes a market-based leverage indicator is a necessary addition to investors' toolkits. The orange line depicts Total Liabilities/ (Total Liabilities + Market Cap.), the highest weighted of the four leverage ratios in the Viridian Capital Credit model. We believe this ratio to be the best single number indicator of overall credit quality. It directly measures the market's view of the surplus of asset value over liabilities. For example, AYR's AYRWF measure of 93% indicates that the market believes AYR's assets are only worth 7% more than its liabilities. This indicator, in theory, considers everything that goes into equity valuation: regulation, profitability, growth potential, attractiveness as an acquisition candidate, etc. Daily changes in equity prices also inform it.

However, like all statistics, this, too, has weaknesses. Cansortium CNTMF has reasonable Debt/EBITDA and Debt/ Total Liabilities but relatively high market leverage, which could mean that company's stock is significantly undervalued. Similarly, Glass House Brands GLASF has very high Debt/EBITDA and Debt/Liabilities but more reasonable market leverage, potentially indicating market confidence in the company's future that doesn't show up in 2024 EBITDA estimates.

Investors should focus on market leverage and track weekly changes in this ratio as effective early warning signs for their portfolios.

The Viridian Capital Chart of the Week highlights key investment, valuation and M&A trends taken from the Viridian Cannabis Deal Tracker.

The Viridian Cannabis Deal Tracker provides the market intelligence that cannabis companies, investors, and acquirers utilize to make informed decisions regarding capital allocation and M&A strategy. The Deal Tracker is a proprietary information service that monitors capital raise and M&A activity in the legal cannabis, CBD, and psychedelics industries. Each week the Tracker aggregates and analyzes all closed deals and segments each according to key metrics:

• Deals by Industry Sector (To track the flow of capital and M&A Deals by one of 12 Sectors - from Cultivation to Brands to Software)

• Deal Structure (Equity/Debt for Capital Raises, Cash/Stock/Earnout for M&A) Status of the company announcing the transaction (Public vs. Private)

• Principals to the Transaction (Issuer/Investor/Lender/Acquirer) Key deal terms (Pricing and Valuation)

• Key Deal Terms (Deal Size, Valuation, Pricing, Warrants, Cost of Capital)

• Deals by Location of Issuer/Buyer/Seller (To Track the Flow of Capital and M&A Deals by State and Country)

• Credit Ratings (Leverage and Liquidity Ratios)

Since its inception in 2015, the Viridian Cannabis Deal Tracker has tracked and analyzed more than 2,500 capital raises and 1,000 M&A transactions totaling over $50 billion in aggregate value.

The preceding article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.