In this episode of Industry Focus, Emily Flippen chats with Anthony Coniglio, the CEO of NewLake Capital Partners, a real estate cannabis investment business, about the cannabis industry. Discover the risks and rewards for investors, employees, and businesses in this space, how COVID-19 has impacted the industry, and how the industry is evolving. There are tips for investors and much more.

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This video was recorded on April 21, 2020.

Emily Flippen: Welcome to Industry Focus. It's Tuesday, April 21, and I'm your host, Emily Flippen. For this week's Consumer Goods deep dive, we have a really special guest with us, so joining us over Zoom is Anthony Coniglio, the CEO of NewLake Capital Partners, a real estate cannabis investment business that's doing something actually really important in the burgeoning cannabis industry: That's freeing up capital for cannabis businesses by entering into what are often very lucrative lease agreements.

So if that sounds confusing to you, don't worry, Anthony is going to help us break it all down over the next half hour or so. Anthony, thank you so much for joining.

Anthony Coniglio: Thank you for having me.

Flippen: So I'm really excited about this week's episode, because you're going to help our listeners and investors understand what I think is probably one of the most convoluted consumer packaged goods businesses out there, and that's cannabis. And especially what they should be thinking about the space amid this global pandemic.

So for anybody listening who may be unaware, we're coming off the backs of what is traditionally a pretty big holiday in the cannabis world, that's April 20, and we wanted to have a little bit of a belated celebration and mostly an educational opportunity for our investors who may be new to investing in cannabis or really just interested in hearing more about it.

But before we dive into all that, Anthony, it would be great to hear a little bit more about yourself and about your company.

Coniglio: Great. Well, thanks again for having me. Over my 30-year career, I've been fortunate to work at both Fortune 100 companies and start-ups. I started my career at Pricewaterhouse, auditing real estate companies and asset management businesses. I later spent about 15 years at JPMorgan, where I was running various investment banking businesses. And then, about 10 years ago, I started my entrepreneurial part of my career, where I left JPMorgan to launch a financial services start-up, and we scaled that business nationally, ultimately selling the company prior to starting NewLake.

And so, at NewLake, we're a real estate company that's focused on building a diversified portfolio of retail and industrial properties that we lease to companies in the cannabis sector, as you pointed out. And those properties are used for dispensaries as well as cultivation, processing, and manufacturing facilities. Our properties are acquired using something called "a sale leaseback transaction," and our tenants are some of the most-respected and well-run businesses in the industry. Names such as Grassroots, Columbia Care, PharmaCann and PurePenn.

And to just summarize our business model, it's really simple. We earn revenue by charging rent, our investors receive a nice, healthy quarterly dividend, and we believe there will be significant appreciation in the value of our portfolio as the legal status of cannabis changes over time.

Flippen: And you're really downplaying the importance of the work that companies like NewLake do for the cannabis space, because a lot of the assets -- and as a cannabis investor myself -- a lot of the assets that cannabis companies are invested in, it's real estate, that's what ties up their cash. So NewLake, your company coming in and, essentially, freeing up cash for the companies is actually really important to allow them to put capital where they need it the most, [laughs] which is not necessarily in real estate, right?

Coniglio: That's right, that's right. When you think about triple-net leasing, these are not new leasing arrangements, these are strategies or leasing arrangements that are utilized by other, what I would call, more mainstream companies. It's a very common leasing arrangement used by national platforms such as Starbucks, Walgreens, Home Depot, and even Amazon. Companies such as these, they realize that their capital is best used to grow their business and invest in people or technology, not to tie up their capital in a hard asset like real estate.

And so what we're doing is we are aligning traditional real estate investors with the real estate asset, unlocking capital for the cannabis companies, so they can do what they do best, which is develop a brand, grow a business, and create a national retail or manufacturing platform, whatever their focus is.

Flippen: Yeah, so the sale leaseback is, obviously, a critical part of capital not just for the cannabis industry but for many different industries. But NewLake, clearly, works closely with a lot of U.S.-based cannabis retailers and cultivators, which makes the risks and rewards of your business, in particular, really interesting. What are some of the risks and opportunities that you're seeing with these businesses that you think, whether they'd be your own employees, people at NewLake, or they'd be retail investors, what they should be aware of in the space?

Coniglio: Wow! The risks and opportunities are many for each category. So why don't we do this: I'll mention a few and talk about each a little bit more specifically. I'd say there are top three risks that people should be aware of. I put them in the following categories. One, legal and regulatory risks. Second, economic risk; and I'll talk more about what I mean by economic risk. And then third, this general category of uncertainty or lack of predictive capability in the industry. And then on the opportunity side of the ledger, I'll talk about, I think there are opportunities abound.

So on that first risk, legal and regulatory. I think it's important to understand, as you know and probably some of your listeners, that cannabis is governed by a patchwork of regulations. Thirty-three states have legalized medical use, while 11 of those are permitting adult recreational use. And then at the federal level, the product continues to be illegal. To add additional complexity, regulations are structured very differently from state to state, and as a result, the growth dynamics and business opportunities can be quite different by location. So focusing on these factors and understanding how a company intends to capture the market they're targeting, that's a good way for investors to really judge if that's a strategy they want to invest in, that they want to focus on Canada, the U.S. western states, eastern states, or national platform. They all have different regulatory considerations to consider. So I'd suggest to investors that it's not one-size-fits-all, and people should give considerable thought about what opportunity they want to pursue.

On that second risk I mentioned, economic risk, where any venture has some element of economic success or failure, the cannabis sector is different in that there are more obstacles, in my opinion. There are more obstacles than normal to achieving profit and cash flow. There's no blueprint to follow, since the legal cannabis industry is relatively new. The rules of the road are evolving. And literally, they're evolving as these operators are trying to drive their business forward.

Take all that uncertainty, and then you have the federal government charging exorbitant taxes under 280E, which drains a fledgling business of much-needed cash flow. And without going into too much detail here, because I could spend a whole half hour on this topic alone, I guess, I would summarize this category to say, investors should understand that cannabis businesses have additional obstacles to success. And, investors, I would suggest to focus on companies' capital position and the management capabilities as those key tools to achieve the goals that those teams are setting forth.

Let me touch on that third risk before I get to opportunity; I don't want to be all negative here. The third risk I think is important to mention is uncertainty. The industry is drenched in uncertainty, uncertainty at the federal level, at the state level, and even at the municipal level. Even for states and municipalities where there's legalization today, rules are evolving, green zones are evolving as well.

What's also interesting in this industry is that there is little historical data to help management teams make decisions. If you wanted to start a restaurant today -- maybe today wouldn't be exactly the right time -- but if you wanted to start a restaurant or a retailing business or just about any other business, you could look at decades and decades of experience in how those businesses grow and thrive. Here, that doesn't exist. Consumer demand is evolving, supply chains are being developed, and the entire supply-demand dynamics of the industry are still being formed.

So what does that all mean? That all means that you want to invest in a company that has the ability to navigate that changing environment and be responsive to the shifting dynamics in the industry. It's really, really important in my opinion.

So let me talk about some of the opportunities. There are many in this fledgling industry. Investors just need to figure out how they want to play it. Do they want to invest in what's called a plant-touching operator, which either cultivates or manufactures or they sell cannabis, or do they want to invest in what's called an ancillary business, one that provides goods and services to the industry?

For NewLake, we saw an opportunity to fill a major need for real estate capital, since traditional providers can't service the industry due to the federal classification of cannabis. We assembled a world-class team of entrepreneurs, business executives that had the experience in cannabis and real estate and financial services to go and capture that opportunity.

So if you think about this for a moment from a real estate perspective, the cannabis industry requires significant investment in real estate for facilities to grow, manufacture, package, and sell the product. And we, at NewLake, can provide nondilutive capital to the operators for the real estate they either own today or for locations they wish to operate in the future. So again, I come back to companies such as Walgreens or Amazon, cannabis operators today, not only out of necessity, but I think what they're realizing is that it's not a good use of their capital to own real estate, and so they should be more capital light, focused on either developing best-in-class growing procedures or best-in-class retail platforms or best-in-class brands.

So let me summarize the opportunity set, as I think it's broader than just about any other industry I've observed. But I believe where you want to pursue opportunity for returns should really be guided by tolerance for risk, and maybe I'm showing my stripes as a bit more of a risk manager here, but I do think that you could run after opportunity and see great, great opportunity, but without mitigating those meaningful risks that are in this industry you may be in for a rude loss.

So if you understand where your tolerance for risk is, I think you can well place your bets and find meaningful opportunities in the sector.

Flippen: I am extremely impressed by how succinctly you have summarized both the risks and opportunities of the cannabis sector, something that I've been trying to do for years now. You managed to get in there in a matter of minutes. So I'm impressed.

And I'm even more impressed, because one of the things that you highlighted when you talked about the risks and how you mitigate risks for the companies that you look at for NewLake are looking at capital structure, you know, their own liquidity plus management. And it got me thinking that I'd have to imagine any retail investors looking at very similar aspects that you might be looking at for clients at NewLake when they're making their own investment opportunities. So what are some of those qualities in addition to the management structure, obviously, being important, but what are some of those qualities that you happen to look for?

Coniglio: Yeah. We try to focus on the differences between states in terms of the operating environment. We focus on limited-license states. The reason we do that is, we like in these limited-license states where the property and the license to operate the business are intertwined. And again, it's this concept of understanding the structural differences state to state that is key to mitigating, in our opinion, our risk.

So in these limited-license states, as you would assume or expect, there's a more friendly operating environment for our tenants, given the limits on competition. And so their opportunity to generate cash flow and profitability will be better than states where there's significantly greater competition. And for sure, we've seen that in California or in Oregon or in Colorado, where there's a lot of competition on the retail side in particular.

Additionally, when there is a limited number of licenses, that means that each license has intrinsic value to the holder of the license, which makes it more likely that in a distress situation, the holder of the license will sell to a buyer that has to be approved by the state. And so if a healthy company acquires that license, they will then want to operate out of our location, and thus preserving our cash flow. And so, we look at that as a real key mitigant to the risk that you're talking about.

But furthermore, and this may sound [laughs] very onerous, given the nascence of the industry and the inevitable volatility in performance over the next decade, we actually underwrite and structure our transactions with the expectation that each tenant will experience financial distress. And I know that seems overly harsh, but given the uncertainty that I mentioned, whether it be regulatory or environmental or the evolution of the business, we just don't see another way. We think it's critically important to understand how the management teams will respond in crisis and how you can protect your interests.

Flippen: I love that answer, and maybe my next question is a little bit of a moot point, given the fact that you seem to have find value in the intrinsic licenses that these companies have, but I know that on a Federal level with cannabis still being a Schedule I drug, there are concerns about what happens to these companies if and when they do become financially distressed, they can't go to the federal government for help in terms of bankruptcy. So how does that frame into how you start to look at these businesses coming in as essentially somewhat of a debt investor on the lease side?

Coniglio: So you're correct, we don't think bankruptcy courts are available to the industry given they are governed by federal law. It's a big unknown about how financially distressed or insolvent companies will be sorted out without the assistance of bankruptcy protection and the rules of the road that bankruptcy precedent provides.

But as I said earlier, we're in a bit of a different position in that we own the underlying real estate and don't have to rely on foreclosure or legal remedies to deal with a distressed situation. And there are a number of situations that are going on right now where, I think, will be very instructive about how do some of the meaningful debt investors in the sector handle distress and what do they do to force companies to resolve the cash flow or repayment difficulties that they're experiencing.

Flippen: Yeah, that makes sense and that's on top of some of the issues that we're seeing in the industry, that both existed in 2019 heading into 2020, but also just over the past few months as we've seen COVID-19, this global pandemic, start to develop. What impacts, if any, have you seen from COVID-19 on the industry?

Coniglio: Yeah, I actually think -- to play off your point about last year -- I actually think that 2019 and the lack of access to capital that occur in the second half of the year, I think it created a tremendous amount of discipline, or growing discipline, in the cannabis sector that is serving the industry well today. I think companies were already thinking about how to focus on driving down costs to get to cash flow positive. They were focused on getting to profitability.

And now as COVID evolves, I think they're a little battle tested from the second half of 2019. And so, more specifically, with respect to COVID-19, while we still see many companies working toward cash flow and profitability, the impacts on the industry are still being assessed.

On the one hand, there's been a boost to awareness of cannabis as a medicine for pain management, anxiety, sleep difficulties, and many other conditions. And the "essential" designation will certainly help the industry long term in winning new customers, new patients, and I believe even at the legislative level, both at the state level and nationally. And so that will take more time to unfold, but in my opinion, it's a significant positive step on those fronts.

Furthermore, the stay-at-home orders and the longevity of this crisis are playing into the demand for cannabis. Again, whether it's from people who are seeing higher levels of anxiety and sleep difficulty, as just one example, or those that are seeking cannabis as a way to relax from a more recreational perspective, spending more time at home.

Furthermore, I'd say that the stay-at-home orders and the longevity of the crisis -- on the other hand, the industry has had to adjust to modifications in operating procedures promulgated by states and focused on employee, patient, and customer health, and reacting to the new patient or customer behavior, whether it's more curbside pickup or delivery or fewer customer visits, but larger basket sizes, as people pantry-load. All of that is going to have a yet-to-be-known impact on margins and profit. So we need to keep an eye on that and understand how that impacts the industry, but all in all, I think the industry has done a wonderful job serving patients and customers, and I'm seeing that adaptation and creativity, and I think the industry will come out of this much stronger.

Flippen: Yeah, I have to say, that's a really unique perspective that I haven't heard before, given the fact that so many of these cannabis companies are distressed. And a lot of people have jumped to the conclusion that when times are hard, companies that were in distress beforehand will continue to be even more distressed during a crisis. But I love that you highlight how adaptable some of these companies have had to be over the past year and how they'll continue to be during this crisis.

It sounds to me as if this pandemic has almost made you believe that the maturity process for these companies has been sped up as a result of the crisis as opposed to hurt?

Coniglio: Yeah, in my opinion, it has indeed. I think something that's not being talked about enough is how the pandemic has forced industry and regulators to work together in a manner like never before. And I think the industry is demonstrating that it's a responsible and important member of the communities in which they operate. And I expect that that's going to bode well as more states consider either passing legislation for medical-use cannabis or expanding existing regulatory constructs.

Flippen: I love that. So you know, we're still in very early stages for the cannabis industry, but looking back after this pandemic -- it's impossible right now, because we have no idea how it's going to evolve -- but let's try to look forward a year into the future, where we're no longer constantly considering when the next time we're going to be able to leave our houses may be. How do you see the industry evolving? Because we're entering a really aggressive shakeout stage it seems.

Coniglio: Yes. We're very early, in my opinion. I do see more states legalizing. I think the pressure on state budgets is significant from COVID, and any opportunity to broaden the revenue base for states will be very attractive. So whether it's expanding existing programs or looking to implement new programs, I think that's going to be a positive for the industry.

I do ultimately see federal legalization. However, I want to temper excitement because I've learned long ago that these things always take longer than you want, they're harder than you want them to be, and they usually cost a lot more than you want them to cost. So while I'm optimistic about the long-term trends and opportunities, I'm expecting it will take longer than one to two years to get there, which I hear some prognosticators talking about. So positive, yes.

As far as a shakeout, yes, there will be winners and losers. I believe the winners will be defined by those companies that have the capital and the skill set to meet the needs of the longer-term path I just described. And along the way, there will be consolidation of the weaker platforms and elimination of companies that don't have a value proposition for patients and customers or in turn a value proposition for acquirers. If you're not going to fill in a geographic need or a product need or an efficiency need, it's hard to see an M&A path.

And if investors want to avoid the latter category, that M&A, they should ask themselves, what's different about this company that I'm investing in versus its competitors? Does it have an edge, does it have a cost advantage, is there a value proposition to the customer? Because those are the never-ending qualities of a good company that may find itself in financial distress, but still has a great product or a great team or a great strategy, just needs the gas in the tank that's in the form of liquidity and capital.

But if you don't have the liquidity and capital and you don't have the management team that knows how to navigate these uncharted waters and you don't have a real value prop, it's a short ride to an alternative job.

Flippen: You know, I think I was one of those prognosticators that you mentioned. Being relatively young myself, I think I saw the path to legalization much quicker than it's shaken out. And I'll tell you what, it really hit me last year when I watched New Jersey, a state that really wanted to legalize adult use of cannabis, proceed to squabble over the details, the tiny legislative details, that come along with the actual nuances of passing legislation that impacts so many people's lives. So I love the fact that you highlighted that. I've tempered my own expectations for regulatory changes in the cannabis space as a result of what we've seen over the past few years. And I'm sure as I age and become more experienced and a more experienced investor, that will continue to shift.

But I do have one last question for you, and I'll tell you what, I'm full of unfairly broad questions for you today, so I'm going to end strong on an also very unfairly broad question. But if you could leave one thought for our listeners or just an investor who was just thinking about investing in the cannabis space, whether that be through ancillary, whether that be through pure play, but they haven't pulled the trigger, what would you tell them?

Coniglio: I would say it's not for the faint of heart. There's great risk but great opportunity. I think the way to approach it is to -- again, here's my stripes as a risk manager. I think the way to approach it is to choose your level of risk tolerance and let that lead your decision making. What's your risk for liquidity; do you want to be in a private company or a public company? What's your risk of where you want to be in the capital stack; do you want to be in debt, or do you want to be in equity? If you want to be in debt, do you want to be secured or unsecured? And then what's your appetite for regulatory risk; do you want to be in a direct plant-touching business, or do you want to be invested in an ancillary business?

And that's really where I'd leave that thought with your listeners is, do your homework. This is not like investing in Apple or another smartphone maker. It really requires, I think, a significant investment in understanding how you want to play it, what your level of risk is. And then going deep on the management teams, getting behind what's on the website, getting behind what's on the investor presentation to truly understand, does this company have the capital and liquidity necessary to achieve their goals? Do they have the access to that capital? Because listen, you could have the best management team in the world. If you don't have capital and liquidity, there's not much of a future.

And once you check that box, does this management team have the chops to navigate the business through all the uncertainties that we've talked about?

And so I think if you do your homework, hold on, it will be a wild ride, but I believe, ultimately, this category is in a long-term secular growth trend and I think there's great opportunities for all of us in it.

Flippen: Oh, what a positive note to leave that on. Anthony, this has really been an amazing podcast, and I appreciate you joining me so much today. It's been such a pleasure.

Coniglio: Thank you for having me. I really enjoyed chatting with you.

Flippen: Listeners, that does it for this episode of Industry Focus. If you have any questions or just want to reach out, shoot us an email at [email protected] or tweet us @MFIndustryFocus.

As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear.

Thanks to Austin Morgan for his work behind the screen today. For Anthony Coniglio, I'm Emily Flippen. Thanks for listening, and Fool on!