3 Critical Metrics to Watch During This Earning Period

How to tell which multi-state operators are legit, and which are relying on hype.
3 Critical Metrics to Watch During This Earning Period
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Cannabis earnings, especially for the U.S. multi-state operators (MSOs), are notoriously tricky to follow as an investor.

Until recently, MSOs have been in startup mode, acquiring and building out their assets. As a result, markets often find themselves confused, buying into the hype and driving up stock prices, only to see them come crashing back down, rinse, and repeat.

But this earnings period, I am expecting strong beats to consensus forecasts for all MSOs, both in topline revenue and EBITDA. My prediction is partly due to COVID-19 and the surge in cannabis sales that it spurred. I also attribute it to markets like Illinois, Michigan, and Pennsylvania exceeding expectations, and MSOs finally beginning to achieve operational scale.  

All of the major MSOs are worth watching during this earnings period, including GTI, Curaleaf, Cresco Labs, Trulieve, Terrascend, Acreage Holdings, Harvest, and Ayr Strategies. 

We are moving into a more mature phase of the cannabis MSO market. The metrics are starting to get clearer, helping analysts and investors separate companies that perform from those that are still betting on unrealized hype and potential.

To help parse through the upcoming slate of earnings, I have laid out three key metrics that investors should keep in mind as they follow along.

Two are key indicators of current and future success in the U.S. cannabis market. The third is a popular metric highlighted by MSOs, but ultimately tells a murky picture and should be discarded by savvy investors.

Related: Why Some Cannabis Multi-State Operators Are Prospering During Tough Times

1. Gross margin

Strong gross margins are indicative of a well-run company. It is how you can tell a company is spending responsibly and appropriately capturing its value chain.

While gross margins can get a bit skewed for those heavy on the wholesale side of the business, the major MSOs should be sitting at a minimum of 45 percent, pushing 50 percent. Anything below this number concerns me at this stage of the game.

Trulieve is the ultimate goal for operators, though they get a bit of a boost because they capture the entire value chain as a single state operator in the vertically integrated state of Florida. This will change after their strategic acquisition in Pennsylvania, and as they become operational in Massachusetts.

GTI, Ayr Strategies, and Terrascend also find themselves well-positioned in this specific category. Curaleaf and Cresco Labs will trend in the right direction in Q3. They will continue to improve in future quarters as their strong penetration in Illinois and Massachusetts will propel them into continued improved margins in Q4. Curaleaf is also well-positioned in New Jersey and stands to gain from the passing of adult-use cannabis. Harvest has posted less than ideal gross margin in previous quarters. However, they stand to gain significantly in future quarters from the successful adult-use referendums in Arizona, where they are the clear market leader.

2. Free cash flow

We have reached a point in the maturation in the cannabis industry where all investors need to be seriously considering free cash flow on a company’s balance sheet. Free cash flow is an incredible measure of a company’s overall health, as it indicates whether companies have the ability to generate their own capital to reinvest and build out their operations without having to raise expensive outside capital.

Until this point, very few MSOs have achieved positive free cash flow. This is natural due to the developing nature of legal cannabis markets.
However, this is the quarter where I expect we will begin to see that happen with some of the major players. Companies are becoming more mature and entrenched in their markets. With the massive topline revenue and increased basket sizes driven by COVID lockdowns, MSOs should be extremely close, if not outright achieving positive free cash flow. If they are still a long way off, that indicates potentially massive structural problems.

3. Adjusted EBITDA 

Adjusted EBITDA is one of the most popular metrics featured prominently on any cannabis earnings press release. It is always one of the first metrics they advertise. The problem is that it doesn’t actually mean all that much and is not a consistent indicator of success. And frankly, I’m getting tired of seeing it everywhere. 

The key issue here is the “adjusted” part of adjusted EBITDA.

Many cannabis companies have historically taken liberties with their adjustments, which has only gotten worse during COVID-19. When looking at company financials, you see that expenses allocated to COVID-19 are being called one-time adjustments, which I find problematic. Considering we do not know how long the pandemic will last at this point, those expenses may be with us for an extended period.

Transparency is critically important at this stage, especially as large-scale institutional capital begins to kick the tires on cannabis operators. Investors deserve a more accurate picture of a company's health than adjusted EBITDA. To gauge companies' health during Q3 earnings, focus instead on gross margin and free cash flow.

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