Cresco Labs Stock: An Impaired Acquisition

For a drug that’s illegal at the federal level, cannabis sure has built a strong brand for itself. Nearly half of all Americans polled by Gallup said they’ve tried cannabis. That’s up from 38% in 2013. One wonders if the uptake is more attributable to changing attitudes towards something Americans declared war on in the 1970s. Even Bill Clinton said he “tried” cannabis, but nobody wants to say they “smoke” cannabis. Saying you tried drugs once makes you edgy, but saying you do them regularly makes you a junkie. Perhaps that’s why only 12% of Americans admit to smoking cannabis, up from 7% in 2013.

Did that many people suddenly decide to start smoking cannabis recreationally in the past nine years? Hardly seems likely. People have always smoked cannabis; they’re only recently feeling more comfortable admitting it. If you’re someone who has established the slightest semblance of a career, what’s the upside to admitting that you smoke cannabis? There’s only downside, and the taboos surrounding cannabis are stronger than ever.

With an estimated $100 billion black market in the United States, legalization promises to bring with it a large total addressable market (TAM) opportunity that multi-state-operators (MSOs) are scrambling to capture. The six biggest MSOs by market cap are collectively worth around $20 billion and generate around $4.2 billion in annualized revenues (last quarter revenues X 4). The middle four MSOs are all producing annualized revenues in the range of $650 to $750 million.

Of course, these numbers are already outdated because MSOs are buying up their competitors at a rate that’s impossible to keep up with. This has resulted in a great deal of intangible assets added to balance sheets to account for things like licenses and goodwill (a premium paid over the fair value of assets during the purchase of a company). The company we’re going to talk about today, Cresco Labs (CL.CN), has been making a fair number of acquisitions over time.

As a result, Cresco Labs has taken on quite a bit of goodwill and intangible assets. Here’s how these metrics look for Cresco Labs compared to the three largest MSOs out there – Green Thumb Industries (GTII.CN), Trulieve Cannabis Corp (TRUL.CN), and Curaleaf (CURA.CN).

Cresco Labs used to have an even higher balance of intangible assets before their recently announced impairment charge. Don’t worry, we won’t assume everyone knows or cares what an impairment charge is. More on this in a bit.

About Cresco Labs

The last time we looked at Cresco Labs was back in February 2020 when they were vying with Curaleaf for the title of biggest cannabis company in the United States by market share. Like every other MSO out there, Cresco Labs is expanding by acquiring competitors. To expand that quickly when other big MSOs are doing the same thing, you cannot shop around for bargain bin prices. On the contrary, you can expect to pay a premium because many other buyers are looking at the same merchandise you are. When you pay too much of a premium for an asset, you may eventually need to revalue it. That’s what happened to Cresco Labs this past quarter.

A Large Impairment Charge

Stocks become increasingly difficult for retail investors to follow when strange things happen. For example, how is it possible for a company to have negative revenues? That’s a question our research team is working on now in our coming piece on Plug Power (PLUG). Or how is it possible for a company to incur several hundred million dollars’ worth of losses out of the blue?

The nice steady trend seen above shows growth in revenues along with losses being consistently reigned in. That is until it’s entirely ruined by that big blue bar thrusting downwards. How is it possible that Cresco Labs lost $264 million in Q3-2021? The answer can be seen below.

An impairment loss is when a firm adjusts the value of intangible assets downwards. Simply put, rules state that firms must monitor intangible assets to make sure they’re actually generating value for the firm. It’s all extraordinarily vague, leaving lots of leeway for interpretation. When a firm decides to record an impairment loss, they are simply admitting that an asset they hold turned out to be less valuable than originally thought. This could result from any number of causes such as a change in accounting principles, a regulatory change, or a change in the value of something acquired. In the case of Cresco Labs, this impairment charge relates to an acquisition they made which didn’t realize as much value as originally thought – like $290 million less. We can interpret this news from two different perspectives:

• Existing investor: I’m glad the management teams changed their business strategy and then was honest about the impact that decision had on the fair value of intangible assets.
• Would-be investor: I’d rather not invest in a management team that has been acquiring left and right and made a $290 million mistake. Maybe they’ve made other mistakes too.

To better understand Cresco Labs’ impairment charge, we can examine the below statement taken from the Q3-2021 earnings call (our emphasis in bold).

During the quarter, in connection with our exit from third-party distribution agreements in California, we followed applicable accounting rules to evaluate goodwill and other intangibles associated with the Origin House transaction and took a non-cash impairment charge of approximately $290 million.

The Acquisition of Origin House

Origin House was a cannabis distributor that Cresco Labs acquired back in 2019 for around 66.5 million shares which equates to $536 million based on today’s share price. When the deal closed, Cresco Labs was then selling into over 575 dispensaries (65% penetration in California market) with 13 third-party brands. Then, in September of last year, Cresco announced their intent to “exit agreements under which Cresco Labs served as the exclusive distributor of certain third-party branded products in California.” The value of those exclusive agreement seems likely to be related to the $290 million impairment charge.

Strategically, the deal could have made sense. Get access to 65% of all Californian distributors, start to heavily upsell all your own products, then eventually dispense with your competitors quickly by choosing not to distribute their products. One wonders how the dispensaries might perceive this move as their selection gets reduced and they’re no longer being sold the brands their customers have become accustomed to.

Regardless of what actually happened behind the scenes for Cresco Labs, there’s one thing we can conclude. The value of these intangibles isn’t likely to appreciate over time. Everything points to companies overpaying to buy their competitors as every MSO out there hoovers up competitors of all sizes. Plenty of firms out there are probably glad to be acquired as they were facing an uncertain future. All things being equal, we’d prefer MSOs that have lower intangible asset balances which reduces our exposure to future impairment charges.

In highly competitive markets, there are alternatives to buying up your competitors. Don’t pay a premium for their shoddy businesses, just beat them at their own game. Figure out how to operate the most effective dispensary possible, then replicate that configuration across all your locations. Once the dust settles from all the M&A activity, focus will then be placed on operational efficiencies and optimal business models that will be unique to each state.

Wholesale vs. Distribution vs. Retail

In researching this piece, we came up with some questions surrounding how companies operate in various states across three dimensions:

• Wholesaler: Grows weed and turns it into products
• Distributor: Buys product from wholesaler and distributes it to dispensaries
• Dispensaries: Sells cannabis products to end consumers

If you own all three of these areas, you’re said to be “vertically integrated.” But there must be some rules in place for companies to solely act as distributors. Being one of a handful of distributors in California, and then choosing to only distribute your own products, seems like a regulatory problem waiting to happen.

This also raises questions about how advantageous it is to be a wholesaler vs. a retailer vs. someone who is vertically integrated. For example, Cresco Labs claims to have 100% wholesale penetration in both Illinois and Pennsylvania, and maybe that’s the best business model to have when you operate in states that cap the number of dispensaries you can buy.

Notice in the above slide how Cresco Labs can only have 10 dispensaries in Illinois and 6 in Pennsylvania. Cresco says they’re the first Illinois operator to reach their cap of 10 stores. Up until now, we didn’t know there are limits on the number of stores an operator can operate. That certainly constrains expansion plans in Illinois for Cresco Labs, at least on the retail side of things. Cresco’s investor deck also shows caps for at least six states where cannabis is legalized.

With these limitations in place, MSOs trying to expand in these states will only be able to get so far. Then there are questions about what happens when two companies consolidate. If two Illinois operators merge who are both at their maximum cap, do they then need to sell 10 dispensaries so they hold 10 instead of 20? It probably depends on the state, which is another example of why the world of cannabis will remain extraordinarily complex until legalization happens at a federal level.

Conclusion

Is Cresco Labs the first cannabis company to admit they overpaid for assets during the acquisition frenzy and others will follow? Or was the Origin House acquisition a Trojan horse that cost $290 million but managed to capture some serious market share across the California wholesale market? We don’t know, and the answer doesn’t matter much anyway as Cresco Labs won’t be a company we’ll be investing in soon. Once the dust has settled from all their acquisition activities, maybe they’ll merit another look.