Why Pot Stocks Stink

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So even though you're operating illegally as a Schedule 1 drug, you still got to pay your taxes, right? Just like that's how they got Al Capone, right? So they essentially have to pay taxes on their gross profits, which for a lot of folks gives them an effective tax rate in the 70% range.

Hello and welcome to the Barron Streetwise Podcast. I'm Jack Howe, and the voice you just heard is Aaron Gray. He's a cannabis stock analyst at Alliance Global Partners. In a moment, he's going to explain to us why pot stocks have stunk so badly, even though the legalization effort seems to have growing bipartisan support. Listening in is our audio producer Jackson. Hi, Jackson.

Hi, Jack.

I know we have a listener question on cannabis. Who's it from again?

We have Brian from Hawaii.

Brian, I got good news. Today is your day to shine. This episode is all about your question on cannabis. We're going to get to it in just a few minutes. Maybe say a few words about golf first, right, Jackson? What do you think?

Oh yeah.

You told me that you're going to soon make your first visit to a Topgolf, and I recently wrote a little bit about Topgolf in Barron's Magazine. Uh, where are you going? Who are you going with? What are you up to?

I'm going to a bachelor party in Denver in October, and we're going to be going to a Topgolf as one of the activities, and, uh, I'm, I'm pretty excited.

I think that's a good fit. Bachelor party, you're going to have some fun. There's going to be some beers, going to be some wings. You're not going to get into too much trouble there. You might get some wing sauce on the golf clubs. You got to be careful about that.

And I'm so bad at real golf that I think maybe I could do better at Topgolf. It's kind of like—

Do you have clubs?

No, I don't.

What are they? You're going to rent them there?

Okay. Yeah, I think you rent clubs there. I'm not bringing clubs to Denver for Topgolf.

You're not going to bring them all the way through. You're not going to spend $1,500 on a new set of clubs and then drag them to the airport.

I'm on a saver fare. I don't know how that's going to work out, but I went bowling the other week and it didn't turn out that well because I was— I thought I was good at bowling, but I realized my memory was playing tricks on me and I was just really good at Wii bowling.

So maybe the video game, the Nintendo, is it?

Yes. Nintendo Wii Sports bowling. I'd consistently get 300s. I think I bowled like an 85 or—

doesn't translate.

But, but I'm hoping golf, it goes the other direction. So, so maybe I can get par on, on Topgolf.

I think you're gonna do great at Topgolf. Topgolf itself is not doing great. Let me explain. There is a company called Topgolf Callaway Brands, and it is the product of a 2021 deal between Callaway, which is a long-established brand of golf clubs and other equipment, and Topgolf, which is— I would say it's a, it's a fancy driving range slash restaurant. You hit high-tech balls. There are chips of some sort in the balls. There are sensors out in the area that you're hitting to. There are some lights if you hit the target. It tracks all kinds of statistics on a screen. It's a gamified experience. And it's for groups. It's for date night. Maybe it's for Jackson's bachelor party. And I have to tell you, I've never actually been to a Topgolf, so I'm going by what I've heard and what I've seen on the website. What I can tell you is that the company has been the subject of two analyst downgrades in recent weeks. Jefferies took the stock from buy to hold, and Raymond James took it from outperform straight through to underperform. And that means that the percentage of buys on Wall Street has slipped below 50% since July. And I guess you could call that a warning sign for investors, but probably a much bigger warning sign is the fact that the shares are down 62% over the past 3 years. And Jefferies says the problems definitely top golf. Sales at longstanding locations are sliding, and Jefferies predicts 15% declines for the rest of the year. On the company's second quarter earnings call in early August, CEO Oliver Brewer III explained the business is still strong and it still plans to add locations. We believe the correct answer for creating shareholder value is to continue to build the venues. We expect to add an average of 10 per year, some years a little more, some years a little less. That sounds promising, but the CEO also said the company is considering a possible sale. We're considering all alternatives, but we mentioned specifically a potential spin.

You know, we're looking at how do we best maximize long-term shareholder value.

The analysts who downgraded the stock recently say part of the problem is that the company never found what was supposed to be synergies between Callaway and Topgolf. Synergies. That's a Wall Street buzzword for what, Jackson? How would you describe it? 1 1 3. You can't— you combine these two things and you're supposed to get something, something more or better, right?

That's a good way to put it.

As someone who's never been to a Topgolf, I wouldn't want to just spout off on what I think went wrong. But that said, let me spout off just for a moment about what I think went wrong here. I think I might have some understanding. There's a big difference, I think, between the person who's going to spend $600 on a new driver And that's the big long club in a golf bag that hits the ball the furthest. Between that person and the one who's going to go to a Topgolf. Jackson, as you just said, you're going there, you're not even bringing your clubs, right? You're not buying any, you're not bringing any. The thing about the golf business is this. I think of it as like a recreational sickness. Topgolf is different. Topgolf is for fun lovers. That's just pure fun. But recreational golf, there's like— part of it is a joyful experience. You're just hitting a little ball around a field, and that's pleasant. And part of it is just, why won't this ball go as far as I want in the direction I want when I want? Why just won't it? Why won't it? And then along comes the golf manufacturers, and they say, we have a new driver and our new alloy. We've got a new vibranium adamantium alloy that's going to get you 16 more yards., right? Oh gee. And you don't stop to think, wait a second, you promised me 14 yards last year. And the year before you said you had found 17 yards. And if you add up all these yards over time, it's like you should be hitting the ball how far?

You should be just going from hole 1 to hole 18.

Okay.

So a golfer will spend that money on clubs. And then I just, maybe I'm wrong about this. You folks can email me if you think I'm wrong. They're not going to a Topgolf. The, these people, you're not looking for blinking lights. You're not looking for wings. You're not looking for high fives. You're going to the outskirts of town. You're paying $12 for a jumbo bucket of balls and you're going to hit them until your back hurts. And there's not going to be any high-fiving. There's not really going to be any witnesses. If there are other people at the range, they're just looking straight ahead.

Nobody's, uh, this sounds oddly specific.

And I don't know what the EBITDA looks like at a, uh, at a venue like this, but I don't imagine it's great. So that's what I think is going on here. I think the, I think the person who's buying those pricey clubs is not the same as the person who's going to the Topgolf. But no, no synergy, no synergy. And if I were doing my strategic review, I'd say, you know, probably just better off by themselves. I'd say oopsie to call a, uh, what do you call it, a mulligan, right, Jackson? Yeah. Do they have those at Topgolf? You'll see. Okay, should we get to cannabis?

Let's get to cannabis.

I want to hear from Brian from Hawaii.

Let's roll it. Aloha, Jack, Jackson, and Meta, if you're listening. I have a question regarding the current state of cannabis investing. Despite some regulatory progress that will remove the wild tax rate of multi-state operators and the growing state-level legalization efforts, cannabis stocks have not performed as well as many had anticipated. What do you believe are the primary factors contributing to this underperformance? And what are some potential catalysts on the horizon? Thanks for considering my question. Keep up the great work on the podcast. P.S., I'd like to give a shout out to any travelers looking for a destination if possible. After the devastating Lahaina fire, our tourism numbers have gone down significantly. In the pandemic, Maui County had the highest unemployment percentage in the United States. I didn't go on unemployment. I started DoorDashing. Which led me to your podcast so I could kill time when I was driving around. So I've kept DoorDashing on the side and kept listening to you guys. So thank you so much. Yeah, it's been a rough couple of years for Maui. If anybody out there wants the best beaches, snorkeling, and Mai Tais out there, please consider Maui.

Mahalo and aloha, everyone. Thank you, Brian, for the question and the vacation recommendation. Maui sounds great. I'm going to put it on the list. Anybody looking for a trip? Party at Brian's house. And aloha to you too, and possibly mahalo, Jackson, if aloha is both hello and goodbye. What— where does mahalo come into that?

Oh man, I gotta brush up on my Hawaiian.

Don't you Google it.

Don't you Google it. I liked— wasn't there a period of time in the '50s where Hawaiian music was deep in the cultural zeitgeist?

Something, something, mahalo is the way to say—

Yeah, that's a Merry Christmas. That's a mele Kalikimaka is the one you're thinking.

Yeah, mahalo is thank you. Mahalo is thank you. Of course it is. And mahalo. Now, what are the factors leading to cannabis stock underperformance? We'll come to those in a moment. Let's talk about the factors that sound like they should be leading to rip-roaring gains for cannabis stocks, even though they're not. There's a ballot measure in Florida, so people are going to vote for it in November, and it's going to decide whether to make recreational use of cannabis legal for adults. And it's polling well. It has somewhere around the 60% voter approval that it would need to pass. And the Republican Party of Florida does not officially support the measure, but Donald Trump posted some comments on Truth Social. They seem to take, if not a favorable view, a flexible view. Let me read some of what he wrote. He said, whether people like it or not, this will happen through the approval of the voters, so it should be done correctly. We do not need to ruin lives and waste taxpayer dollars arresting adults with personal amounts of it on them, and no one should grieve a loved one because they died from fentanyl-laced marijuana. There you have it. And analysts say that's another sign that cannabis legalization is increasingly a bipartisan topic. Did you know that 7 in 10 Americans favor legalization according to Gallup, the pollster? And the number is close to 9 out of 10 for people who call themselves liberals or Democrats. And for people who call themselves Republicans or conservatives, it crept over 5 out of 10 a couple of years ago, and it's been nudging higher. And there was a summer poll from YouGov, and it found that more Americans reported smoking marijuana every day then reported drinking alcohol every day. Jeffrey says that cannabis is taking market share from alcohol. It cites the rising sales of beverages that contain THC, which is the psychoactive compound in marijuana. We'll come to that a bit later. Meanwhile, the federal government is considering whether to reclassify marijuana as a so-called Schedule 3 drug. Those are defined as having, quote, moderate to low potential for physical and psychological dependence. Current examples of Schedule III drugs include testosterone and Tylenol with codeine. In other words, if marijuana were one of those, you wouldn't be picking it up at the checkout counter of your local drugstore, but you might be walking in with a prescription for it. There are bigger implications involving taxes, which Aaron at Alliance is going to explain to us in a bit. Currently, marijuana is listed as a Schedule I drug. That includes drugs like heroin, and they're defined as having, quote, no currently accepted medical use and a high potential for abuse. And earlier this year, Vice President Kamala Harris called that absurd. I don't want to make it sound like everyone is on board with full cannabis legalization. There's still a lively debate on the subject. Today's strains of marijuana are far more potent than Woodstock-era weed.. And in polls, slim majorities say that the stuff harms society and individuals, just not as many people say those things about cigarettes and alcohol. There have also been some lumpy results from state legalization efforts. In New York, we've ended up with a relatively small number of struggling approved shops and a vast ocean of thriving illicit ones. As we'll hear in a bit, that has to do with the legal limbo that the cannabis industry finds itself in. Some states have approved it, but the federal government hasn't. Okay, so back to Brian's question: what has gone wrong for cannabis stocks? There's an ETF called AdvisorShares Pure US Cannabis, and that's down 80% over 3 years. That includes an 8% slide this year. And if you look at the fund's top holdings and the number of analysts covering each of those stocks, that number has tumbled over the past 2 years and some smaller rival funds have been closing. Aaron explained to me that cannabis investor sentiment seems to have peaked in early 2021. That was after a runoff Senate election in Georgia where Democrats gained a 50th seat in the Senate, which, if you count the tie-breaking vote from the vice president, gave them effective majority control. And the Senate leader at that time, Chuck Schumer of New York, said that cannabis legalization would be a priority for the Senate, but nothing much happened on it. So investors turned their attention to the possibility of a narrower banking bill. If cannabis is legal in a particular state but not for the country as a whole, banks aren't sure what to do. They don't want to take a chance on offering normal accounts or merchant services to cannabis businesses. So these companies can't accept credit cards, they can't do business across state lines, and so on. A banking bill would have fixed that, but that hasn't happened either. So the most recent thing that investors have pinned their hopes on is this rescheduling, and they were hoping that something would happen there before the election. But late last month, the U.S. Drug Enforcement Administration announced a December 2 hearing on the matter. That means two things: cannabis will definitely be an election issue and nothing will get done this year. And that cannabis ETF I mentioned a moment ago, that fell 13% in a day on the news. Cannabis investors just seem to be running out of patience. But Aaron remains long-term bullish on the industry. His buy-rated stocks include Green Thumb Industries, Verano Holdings, Curaleaf Holdings, and Trulieve Cannabis. That's Trulieve like believe. Up next is my conversation with Aaron about the industry's finance and his outlook and what investors should look for in cannabis companies. Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks. Balance your trading strategy by adding futures. CME Group helps you manage risk and capture opportunities in all market environments. Capitalize on around-the-clock access to highly liquid global futures and options markets across all major asset classes. Visit your online broker to get started. See what adding futures can do for you at cmagroup.com/podcast. Derivatives are not suitable for all investors and involve risk of losing more than the amount originally deposited and any profit you may have made. This is not a recommendation or offer to buy, sell, or retain any specific investment or service. Welcome back. We're still answering Brian from Hawaii's question about what has gone wrong with cannabis stocks. Let's get right to part of my conversation with Aaron Gray. He's a cannabis analyst at Alliance Global Partners. So supposing that cannabis investors get the best possible news on regulation, now it then comes down to the business fundamentals, right? I have read about glut of cannabis available and a lot of illicit sales, you know, just supply and demand. There's a lot of supply and that's making it difficult for the companies that are involved here to make money. Is that what you're seeing? And is that something that you think is changing? Would it change going forward? How is the economic health? Oh, and also the fact that there is so much regulation for these companies that it's expensive for them to operate relative to the illegal operator who's out there who doesn't have to care about catering to whatever local rules there are.

So even though you're operating illegally as a Schedule I drug, you still got to pay your taxes, right? Just like that's how they got Al Capone, right? So even though you're operating illegally, you got to pay your taxes, but you can't take your standard deductions. In simplest terms, you can't deduct any of your SG&A.

You can deduct some of your COGS.

Cost of goods sold.

Yeah, cost of goods sold. In other words, some of the manufacturing expenses would be your cost of goods sold and the SG&A, selling, general, administrative, that would be like your corporate overhead type of expenses.

Correct. So they essentially have to pay taxes on their gross profits, which for a lot of folks gives them an effective tax rate in the 70% range. So they've been having a very onerous tax and obviously that has huge implications on the actual cash flow they're able to generate. So just moving from Schedule 1 to Schedule 3, because in Schedule 3 that 288 tax does not apply, would have a huge economic impact on the industry. And that's really the biggest impact that the industry would have from moving from Schedule 1 to Schedule 3, and that's now being put off. Now, moving back to the other part, in terms of supply-demand dynamic, it's certainly something that's impacted the industry. It depends by geography because it's a Schedule 1 drug right now. There's no interstate commerce, so you can't grow your product in California and then sell it in New York. Anything you grow in California needs to be sold in California, right? So all these supply dynamics differ by states., and it usually depends on the license structure. So in very open license states where it's very easy to get a license and there's no limit on the number, then yes, you have this oversupply dynamic that you talked about. Um, some examples of that might be in Oklahoma. Then you have other states where they're more limited license in nature. So the regulators purposely limited the number of licenses they're going to issue. So then those licenses have a little bit more of a moat, right? So then the pricing dynamic and oversupply, you don't have as much of that. So a lot of the companies where they're profitable and producing cash flow, they're in a lot more of the limited license states, and Florida is one of those.

I've read about— there are these drinks, they have like THC in them, and that they've been pretty popular, they're selling pretty well. I guess that's in the states where they're legal. Is that a business that you have looked at, and what do you think of the trajectory for that business? And it kind of sounds like it starts to compete with the alcohol business, right? I mean, you wonder about maybe market share being displaced Oh yeah, Jack, absolutely. We actually put out a white paper on this. I sound like the kind of guy who, like, you know, I'm drinking these two at a time and I'm trying to come across like I've never heard of them before. Like, a friend of mine was talking to his uncle about—

but I really do. Well, you can find them in your liquor store now.

I really did just read like a report the other day on them.

So anyhow, go ahead. A lot of those are hemp-derived Delta-9 THC beverages, right? So the THC is derived from hemp versus marijuana. So they're both from the Cannabis sativa plant. Hemp is the male version and marijuana is the female.

Yeah, that sounds cheaper, right?

Hemp is the stuff that is generally cheaper.

It's—

there's a couple of different dynamics. Generally easier to grow, more outdoor. But by legal definition, it would— that is federally legal via the 2018 Farm Bill. Now, when it was legalized, it was meant for non-intoxicating hemp below 0.3% THC. Right now, what's eventually evolved from that is you have some either natural or synthetic dried products that are intoxicating, but they're still derived originally from hemp that's less than 0.3%. But through different extraction or otherwise, they can create a product that is intoxicating. So going back to your point, that's where these beverages you're referencing are. And because they're coming from an initial legal product, the argument is that they can be sold in mainstream retailers. So most of this, again, depends by the state in terms of how it can be distributed. But there's some states that have rolled out and said they can legally be distributed here in liquor stores and otherwise. The most notable state is Minnesota, right, where you can go to liquor stores and bars and get these hemp-derived THC beverages. And they actually have the similar intoxicating effect as actual THC that you're getting at a cannabis store or dispensary. But because they're coming from the hemp-derived THC that's legalized through the Farm Bill, it's kind of this loophole that's allowed for it to be sold through mainstream retailers.

And even if it starts off with a tiny percentage of whatever the active thing is, you could just distill it until it's a high— I mean, that's the whole booze business, just distilling until you get more of the stuff you're looking for. Exactly.

Some of the states do put limitations on it. So some states ban it completely, some states allow for it, some states have a carve-out to where it's only, uh, to a certain 5 or 10 milligrams. But yes, it starts with the legal, and then they distill and then get to that through the extraction process.

So if you're an investor, do you view this space as attractive right now? In other words, are there better days coming for cannabis operators? Are those better days close enough and better enough that it's worth it to take positions in these companies now?

Over the long term, there's no question in my opinion, right? You're seeing a lot of the trends.

You're seeing lower incidence of alcohol, particularly among young adults.

Young people don't drink like the older people drink. 100%. And you're seeing an increased use of cannabis among that same cohort. And we've written a number of times about this dynamic that's occurred, and it's been occurring for some time and it's actually accelerating in many ways. So when alcohol companies are looking at these trends and they're seeing cannabis, I think they're going to be eyeing it for the long term because a lot of these companies and shareholder base look at things on a long-term basis. So over the long term, we think cannabis will be consumed as a mainstream product. We think it's still in its early days. It's still mainly being sold through these dispensaries. It hasn't gotten to mainstream distribution yet. So we still think it's in the very early days and there's still a lot of growth opportunity. Consumers overall, when's a good time to invest? We still find now a good time to invest in companies in the space. The best place to invest is those companies that have a strong balance sheet and that are cash flow positive, so they're not as at risk to the current dynamics of needing to raise capital and risk dilution when the market's at these lower valuations, and they can wait it out until better times. And they're able to rely on their own cash flow to fund any CapEx needed.

What are the differences between the cannabis stocks out there? Some of them have stronger balance sheets, but there are some that are operators in Canada, some are in the U.S., some are in different kinds of businesses. What, what's the right mix of characteristics that you should look for? Strong balance sheet, and what type of operations?

What should these companies be doing? So a strong balance sheet, certainly. And then when we look at the operations, a great one is states that are on the precipice or just converted from medical to adult use, or just states that just legalized medical, because that's, uh, almost immediate growth opportunity. A lot of times when you switch from medical to adult use, the market will increase 2 to 3x. And we've seen that in a number of markets, and Maryland early data from Ohio is looking that way as well.

So those are great opportunities for those markets. Thank you, Aaron. And thank you, Brian from Hawaii. Jackson says he's going to put off his Denver trip and change his bachelor party to Topgolf in Maui if there is one, right, Jackson?

I'll need confirmation from the other guys, but we'll just do it.

Just do it. All you can mahalo me later. Jackson Cantrell is our producer. You can subscribe to the podcast on Spotify, Apple, wherever you listen. If you have a question for the podcast like Brian did, Don't keep it to yourself. Don't hold it in. Let the world know. Use the voice memo app on your phone, record it, send it to jack.hough@barons.com. Thanks, and we'll see you next week. Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data, so you have the right ingredients to help you shine. Morningstar, where data speaks.