Every Crisis Brings Opportunity

Speaking at New Frontier Data’s virtual conference a few weeks ago, some of the comments made by investors convinced me to share some thoughts and experiences from my work on the ground in Europe as CEO of a medical cannabis company.

The cannabis industry in the US and Canada is currently undergoing its 27th month of a bear market which coinciding with the shakeout caused by CV19 makes this one of the greatest entry periods in history.  Unfortunately, it seems like very few investors will take this step. This shakeout will be especially bad in the US where many companies will not qualify for emergency loans due to the fact that the industry is still federally illegal. This is not going to be the case in Europe where medical cannabis is 100% legal and available in pharmacies. In addition, none of the European companies became as overvalued as they did in North America. High-THC cannabis cultivation is allowed only in a handful of European countries but companies that are licensed to cultivate and produce can use the banking system normally and, unlike in the US, there is no risk of operating in a “grey area”.

Moving to Europe 3 years ago, besides the contrast in regulation, I couldn’t help but notice some other differences from the situation in North American as well. For example, one of the most recent trends in North America is for investors to look for companies that are already EBITDA positive. This is smart and makes a lot of sense for maturing markets and companies that have already been around for five or ten years. However, the European medical cannabis market is only in the second inning and companies need to go through a formal government licensing procedure to be allowed to enter the market. Thus, I believe that the goal in Europe at the moment should be finding the strong teams with a clear path to revenues and hopefully in the not-too-distant future EBITDA positive.

Many investors in the US are now “waiting for the bottom” as some wait for bankruptcies. Bankruptcies in the cannabis space will be dragged down by litigation and investors will have difficulty finding a clean purchase. As we used to say on the emerging markets bond desk “bottom pickers get stinky fingers”. I just read a letter from Paul Singer at Elliot Management who is renowned for successful investing in distressed and other strategies for almost 50 years and his comment was “Our job, and style, is not to pick tops and bottoms with precision (actually, not to pick them at all), but to have a portfolio that can make some money in normal times and keep it when the music stops for any reason”. The key is to ignore all the ‘panic’ news on TV and look for viable strategies in this unique industry that is still growing at a rate of 25% to 50% annually. 

One of the main factors working against the overall industry is the “herd” mentality that is more prevalent among cannabis investors than in other markets. One such issue where the herding mentality is very noticeable is that it is risky to invest in US companies that “touch” the plant which makes no sense whatsoever since if the Feds decide to prosecute state legal cannabis, then all peripheral companies are also going down because the legal industry as a whole will disappear. Another such fallacy is that cultivation is being commoditized and that it is a race to the bottom. Even large, well-respected US cannabis investors make such claims on conference panels even though I know for a fact that some of them have personally invested in cultivation companies. It might be that they are doing their best to discourage competition. Anyway, the main reason for this second fallacy is the fact that many people still confuse high-THC medical cannabis with CBD-dominant industrial hemp. It is true that the latter can be commoditized whereby large farmers can utilize economies of scale and prevent smaller players from entering the market. However, this cannot be far from the truth when it comes to top shelf medical or adult-use high-THC cannabis, especially the cultivation thereof in an EU GMP certified facility, where each of the numerous strains requires a differentiated strain-specific approach from the grower, not only in the cultivation stage but also during drying and processing. Anyone who has visited such a facility can easily understand why top-quality producers have held their prices high even through the ups and downs of the market as a whole. 

I notice that many retail investors and even larger ones love to dip in the cannabis space and use their knowledge and experience from prior investments in other industries to extrapolate how things will play out. M/Billionaires with decades of experience in developed markets are using their success stories to dictate to cannabis managers exactly what to do and how to succeed even though they don’t really understand the intricacies of the market and most have probably even never touched the product (or at least not since “back in their days”). It’s difficult to extrapolate from other industries to predict the future of the cannabis industry. Moreover, it seems like everyone is wasting their time looking for “The Google'' of Cannabis while there obviously isn’t one and there probably never will be. The cannabis market is so diverse in its product range and so global in its span that investors are just overcomplicating the industry and looking for a needle in the haystack. This is becoming more obvious with every single day as we see the giant LPs that were supposed to be the new Googles in the industry backing out of deals that were made just for press releases whose sole purpose was to please the investors. It seems to me that the days of large cannabis companies ``taking over the world” by setting up grows and factories all over the globe are over. The story used to be “We will grow in 20 countries, rec, medical, edibles, vapes, organic, non-organic, lower-line, top shelf, indoor, hybrid greenhouse etc.” These days are behind us. Equally so, every time I hear someone saying that “brands” will dominate the market, I begin thinking of all of the “brands” that will soon disappear off the shelves. Remember 4 years ago when without a rapper attached to your deck you didn’t have a brand? Where are most of them now? What matters in the long term is not the brand but the product, the market demand for it and the team behind it. For this reason I believe that the brand that you bet on is the team that has shown the most organic growth. I am not talking about the team with the largest cap raise or the shiniest presentation, but the team who has shown that they have a great product that is selling and they are able to roll their cash-flow back into the business and produce growth. Look for a team that covers the entire scope of the project. So often, I meet with supposed “teams” and it’s just a bunch of guys who basically appear to be 5 or 6 CEOs, none of which seems to have the intention of doing any leg-work. This industry needs managers who can execute. I don’t mean the experienced “bosses” who sit back and tell people what to do and wait around to take credit for the success. I mean the ones who put their heads down and grind it out day after day through ups and downs, confusion, misinformation, rejection, closed bank accounts (times 10), cash-flow delays and sometimes even dealing with half-criminals. The managers you pick need to possess focus and discipline.

Things have changed much since cannabis was firing up about 5-6 years ago. Back then, you had your lawyers, doctors, general contractors with a few bucks flying to Colorado and the West Coast, seeing some facility or a product in a store, getting baked out of their minds, and then sending small checks of $100k to $500k. Most of them never got equity on paper but everything was moving so fast that they had to rush in. Now their calls aren’t returned by the “managers” they backed. That is because the term Due Diligence has only entered the cannabis industry’s vocabulary recently. We finally have some investment funds starting to do actual due diligence, but it’s still rare to find analysts who fully understand the global industry and ask the right questions. Though in saying that, I would nevertheless strongly recommend retail investors and family offices who want to dip a toe in the industry, to invest in dedicated cannabis funds (ones that touch the plant for the record, otherwise just buy an ETF) and put the effort into picking those fund managers. For a retail investor to invest directly into companies, it’s expensive for legal costs, it’s time consuming and very difficult to complete a full due diligence and then even more difficult to understand and track ongoing operations. Another take away from the boom/bust is that many investors relied on the securities exchanges to police public companies and indict unethical managers who got away with theft, inside dealings and false press releases. The cannabis public markets have really proven to be the wild west.  

It is unfortunate that the cannabis industry is still a lightly covered industry by research brokers. Most of the ones covering it would pretty much say anything to get a deal with some of their large clients. The Wall/Bay Street brokers were very well aware that their metric “planned buildout facility’s potential output x 20 = valuation” was rubbish. It only caused Canadian LPs to build expensive production plants all over the world, most of which have now been mothballed. The assumption was that they could sell all their production, that they know how to grow efficiently and that they could put together strong teams that could simultaneously build and run various large production plants around the world. Now we are learning that their production is not exactly that efficient and they are all turning towards outdoor growing as the panacea. The story is actually pretty simple. Just look at the pricing in the illicit market and if you can’t beat that price / quality metric then you have a problem, period. The quality may not always be there, but the underground growers are certainly efficient. 

For all these reasons we decided to stay away from the flashy public markets and focus on our quality and ability to produce consistent low cost products on a large commercial scale. We brought in experienced growers from California and use a NorCal style of growing, with the majority of our product being organic and sungrown in greenhouses because the environment in Macedonia is similar to NorCal:  Sunny and dry, good elevation and a constant breeze which the cannabis plants love. Picking our production location was thus not only determined by the low production costs and low taxes, but also the microclimate for cultivation. However, it is not enough to bring in growers from Cali’s Emerald Triangle which is considered the Mecca of Cannabis. The difference between medical cannabis in the US and Europe is so vast that transitioning US operators to adhere to the EU GMP and the GACP guidelines is more difficult than it seems. Most US companies have been accustomed to just squeak by the required benchmark on pesticides and heavy metals to pass the tests. Compared to that, there are 10 times more SOPs, Procedures and compliance in general in Europe. Thus, the ability for US and Canadian companies to reach the EU GMP level necessary to sell into this market is rare. Most fail the stringent tests and a lot have already given up.

The other difference I have noticed is the difficult hurdle from “hobby” growing to commercial growing.  One grower I interviewed told me “I just give the plants what they need regardless of the cost”. The key is to be able to grow outstanding quality while gauging costs from day one. Thus, our decision to grow organically is not only because patients would prefer it due to its higher quality and purity, but also because it is more cost-efficient. It might take more effort in the beginning, but creating a self-sufficient environment for the plants to thrive cuts the OPEX significantly in the long term. Anyone can nurse a couple plants and go for the Cannabis Cup for bragging rights but the real art is to produce quality by the tonnes for many years.

I believe that we are slowly starting to realize that growing medical cannabis in places where it is not cost-efficient just because it was first legalized there does not make sense anymore. As the number of countries legalizing the production of medical cannabis increases, most of these companies are going to start closing down their operations in places like Canada, Denmark and even Germany. In Germany for example, labor, rents, electricity, security, and compliance are all very expensive. At the same time the German patients are continuously pushing for lower prices. Thus, it makes no sense whatsoever for countries like Germany with public healthcare systems to push for expensive indoor cultivation of cannabis. This is already becoming obvious in Canada where the LPs are starting to realize that their production is more expensive than they expected and now they are all starting to turn toward outdoor cultivation even though Canada was never known for agriculture. Furthermore, growing medical cannabis indoors has such a large carbon footprint that it is even larger than bitcoin. Not only is this expensive production passed directly through to the National Healthcare Budget but it also leaves a big Carbon Footprint at a time when everyone is supposedly “Thinking Green”. Let’s just say Greta might not approve.

I am so surprised that I still bump into people who run around saying “I’m getting a license in Greece or Denmark, Macedonia, Israel or somewhere”. The days of a license holding value, especially in a market like Greece where they gave them out like baklava, are over. In the medical cannabis industry in Europe, a license is simply a piece of paper that allows you to try. That’s it. It allows you to make a plan, raise capital if you don’t have it (this is not the hardest part by the way), put together a team, learn the local laws, deal with the language barrier, find local contracts - weed through them and learn the hard way as one after another doesn’t know what they are doing or takes advantage of you because you are on “their” turf.

Finally, cannabis companies are beginning to understand the difficulty in standardization across multiple markets. Many brands in the US need to find companies to produce or White Label their products across state borders. The oversight in the standardization of these products is only understood by mature CPG companies. CV19 supply line issues put another layer of potential risks to this method and now the reliability of the base product will exaggerate the importance of cultivation and the ability to find reliable, consistent, quality supply. Supply began to tighten last fall and now with CV19 halting so many projects in their footprints I am guessing that supply will become a major issue in the second half of 2020. I guess what I am trying to say is that we all need to plan for the world post-CV19. One blatant take away from CV19 is the need to “control your supply lines” and if you haven’t figured that out yet, then you have probably been asleep for this whole lockdown.

Overall, I just wanted to share a few first-hand thoughts and observations on the European market compared to the US. These are some of the issues shared at the cannabis conferences around the world and now that we are waiting for the storm to pass, I thought I would open up a few subjects to different observations, opinions and questions so please share.