The U.S, House of Representatives is voting today on the Marijuana Opportunity Reinvestment and Expungement (MORE) Act, which will kick off a pivotal year for U.S. cannabis companies. Yet no matter what happens with today's vote, the fate of cannabis legalization -- and therefore cannabis stocks -- will likely fall to the Senate, where the path to passage is highly uncertain at best.
If you don't understand how pivotal these votes are to U.S. cannabis stocks, recent earnings results confirm they really, really need regulatory relief. Without it, cannabis stocks will be hard to own in 2022 versus other sectors.
The MORE Act
The MORE Act, introduced by Representative Jerrold Nadler, a New York Democrat, would accomplish the following:
- De-schedule cannabis, which is still currently a Schedule I drug.
- Impose a 5% federal tax on marijuana sales, rising to 8% over three years, to fund the Opportunity Trust Fund.
- Create an office of cannabis justice to oversee social equity in the industry.
- Assure that the federal government cannot discriminate on the basis of cannabis use for employment or immigration status.
Coming into this Congress, the cannabis industry was looking for more-incremental measures, including the SAFE Banking Act, which would allow large financial institutions to deal with cannabis companies in states where the substance is legal; or the STATES Act, which would give companies complying with state laws relief on taxes and other measures, without going all the way to full legalization.
However, it appears that both the House, and as we'll see, the Senate, are going for the whole enchilada, attempting to fully legalize cannabis all at once, even with slim Democratic majorities. That's a higher-upside but much riskier path. Passage is far from assured in the Senate, even if the House passes the MORE Act today. The House already passed it in late 2020.
The problem with the Senate
As with most legislation, the problem for legalization rests in the Senate's 60-vote threshold to overcome a filibuster. While there are some Republican senators who might vote for legalization (68% of Americans, including half of Republicans, believe cannabis should be legal) picking up at least 10 Republican votes seems like a long shot.
Yet Senate majority leader Chuck Schumer, a New York Democrat, is also pressing for full-on legalization in his own bill, called the Cannabis Administration and Opportunity Act (CAOA), rather than passing an incremental measure.
The outlines are likely to be similar to the MORE Act, although an initial draft of the CAOA had a 10% tax, rising to a 25% rate over five years, to fund enforcement, prevention, and social equity -- not the 5% to 8% in the MORE Act. Even cannabis advocates were alarmed at this number, fearing it would allow the tax-free illicit market to thrive.
Sources indicate that the CAOA will be introduced in the Senate in late April. Until then, investors won't know the full details of the proposal. And if both bills pass, they then have to be reconciled.
Cannabis companies need relief; without it, they are tough investments
Amid soaring inflation, higher interest rates, and headwinds coming out of the pandemic, I've lowered my cannabis stock holdings in recent months. Yet one that I've kept is Trulieve Cannabis (TCNNF 1.80%). Other investors might like other U.S. pot stocks better, but Trulieve has traditionally had best-in-class margins and prudent capital allocation when it comes to growth. In a more difficult environment, this conservative approach is likely the better one.
Despite these positive attributes, Trulieve's numbers show the need for regulatory reform more than ever.
Most cannabis stocks, Trulieve included, will point to their relatively high adjusted EBITDA figures (earnings before interest, taxes, depreciation, and amortization). However, that metric excludes stock-based compensation, depreciation costs (which do matter and are ongoing), and interest and tax rates that are extremely high due to cannabis being illegal. So most cannabis companies have low or negative earnings and cash flows, despite healthy-looking EBITDA margins.
Trulieve is one of the rare U.S. companies that actually make positive net income, and it doesn't pay its executives outsize stock comp. Adjusted EBITDA came in at $384.6 million in 2021, up 47.9% over 2020 and good for a healthy 41% EBITDA margin. Yet the company's net income figure (adjusted for one-time acquisition costs) was up only 2% over the prior year, to $123 million.
Part of this was due to higher depreciation, as the company has been actively building out grow facilities and stores for future growth. For the year, depreciation rose 292% to $48.1 million, from 2% to 5% of revenue.
But the real headwinds were high interest and tax burdens. Interest expense rose 72.2% to $34.8 million, as the company took on more debt to fund growth and integrate new acquisition Harvest Health & Recreation, which closed in October. The bulk of Trulieve's debt carries an 8% interest rate, which is onerous for a normal company, but actually best-in-class in the cannabis space! Other notes bear an interest rate of 9.75%.
Finally, taxes are a true killer. Since cannabis is a Schedule I drug, it is subject to Section 280e of the tax code, which means U.S. cannabis companies cannot deduct any business expenses other than costs of goods sold. So they are taxed on their gross margins, not their pre-tax margins. Last year, Trulieve's tax burden rose 54.6% (also higher than EBITDA growth) to $146.1 million! That amounted to 25.8% of gross profits and a whopping 89% of pre-tax income -- 89%!
Amid so many headwinds, making $123 million in adjusted net income is a huge feat. But given that Trulieve is still investing in growth, 2021 capital expenditures of $275 million still meant that the company had negative free cash flow.
Why regulations are a double whammy
If Trulieve had more-reasonable interest and tax burdens, its adjusted net income would likely be double what it is today. Even though the company's stock has been more than cut in half from its highs, it still trades at 32 times those adjusted trailing earnings. Relieving the tax and interest burdens alone would bring the valuation down to 16 times or so -- clearly a much better deal.
However, the effect would actually be magnified. Without the extra tax and interest rate burdens, Trulieve would likely be able to self-fund its growth. Instead, it has to tap either the debt or equity markets to fund growth. That means the company has to increase its high-interest-rate debt, or dilute shareholders with its stock down more than 50% over the past year.
Keep in mind that Trulieve is among the best-in-class in terms of profitability. So if alleviating the 280e rules would make that much of a difference to Trulieve, imagine the difference it would make for others in the cannabis space.
Furthermore, while the pandemic was a boon for cannabis sales, amid high inflation and weakening consumer spending, cannabis companies will likely face higher costs yet lower growth this year. Trulieve forecast solid but unspectacular growth in the year ahead, noting some headwinds coming out of the pandemic. Additionally, higher interest rates will hurt the value of growth stocks, and cannabis companies are certainly in that category.
The difference is that cannabis companies would instantly get a big profit boost from legalization, which would almost make them value stocks and totally change the calculation in an instant. But if legalization gets held up in Congress, they are still looking expensive in this higher-inflation environment.
And it's even scarier, since many predict Republicans will take back the House and/or Senate in the midterm elections. If passage fails and that occurs, cannabis reform could be put on the back burner for another two years at least. That means these companies will continue to face huge costs and burn high-cost capital in order to grow.
So this legislative process is a binary event for cannabis stocks. It's an unfortunate situation for investors, since the industry does appear to have so much long-term promise. Needless to say, the coming months in Washington will be massively important for the intrinsic value of these stocks.