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With the progression of individual state regulated markets, entrepreneurs, investors and other industry participants have remained intoxicated by the prospects for federal cannabis reform. These interests have been further inspired by the U.S. Federal Government’s heretofore reluctance to interfere with legal cannabis businesses.
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Nearly 10 years since Colorado implemented the nation’s first recreational use market, the U.S. Cannabis sector is potentially on the cusp of regulatory change. The Drug Enforcement Agency (DEA) could opine on the Department of Health and Human Services (HHS) recommendation to reclassify Cannabis from Schedule I to Schedule III by year end. If re-scheduled to III, 280E taxes (the most significant cash drain) no longer applies which will likely trigger an industry “reset” with new sources of capital, improved cash flow profiles and ultimately higher valuations.
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Third quarter results marked improvement over Q2 for the Tier 1 MSOs, underscoring the notion that “the strong get stronger,” while Tier 2 performance brings into question their ability to remain independently viable going forward. Revenue growth was driven by new store openings and the implementation of Maryland’s recreational use market on July 1. Pricing pressure however, remains a concern. Effective cost controls resulted in better margins and operating cash flows. Also, several companies have better managed street expectations as actual results fared better or were in line with analyst estimates.
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Volatility in quarterly operating metrics, including Gross and EBITDA margins, is still to be expected for all MSOs as the industry continues to evolve. Legalization may have been somewhat predictable in some of the liberal-minded western states, however, the growth expectations we previously assumed would catapult the industry nationwide have failed to discount the nuances of regional politics and the ability of opposition forces to bog down the clarity of regulatory reforms. The notion that a few states would lead with “best practices” for others to follow simply did not materialize.
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The ability to scale and generate sufficient levels of operating cash flow to satisfy current tax obligations as a result of the 280E burden is arguably a differentiating factor among operators. The current darlings include: Tier 1: Green Thumb Industries, Trulieve and Verano; Tier 2 is represented solely by Marimed.