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Merida’s Coronavirus Hot Take: Insight Straight from the Goniophotometer

Ryan Allway

March 20th, 2020

Policy

The following is a guest post from Merida Capital, a private equity investment firm targeting fundamental growth drivers underpinning the rapid development of the cannabis industry.

First and foremost, we hope everyone reading this is safe, healthy and takes reasonable precaution. Be concerned, be smart, and be vigilant so that you don’t contribute to the spread of COVID-19.

We also wish for a collective calm. While we all have fears for ourselves and our loved ones in these times, the world is not coming to an end and we think this is a great moment for thought and introspection. Confinement can have benefits – take advantage!  Two weeks home with kids while schools try to reduce exposure risk has already been spun into a positive and given a name by our media overlords: Staycation! This isn’t to make light of the current situation and any fatalities are terrible tragedies. This is a serious time and but can’t help but try and let some humor show in the moment.

With all that said, people typically read our commentary for our views on the cannabis industry so let’s get to it. We believe there are several “bubbles,”or behavioral models, that are about to become significantly challenged by the reaction to COVID-19. As some examples, we see changes to debt-driven bubbles like student loans, while students realize they are paying $70,000 for remote courses; or the explosion in co-working spaces, which may face annihilation in the work from home movement; the Chinese supply chain for many goods, including pharmaceutical ingredients, is about to see pushback from many corners. “Buy local” is going to see a renaissance in the wake of COVID-19. Ironically, it is hard to predict any paradigm shifts in the cannabis industry at this time.

For that reason, we are far more interested in observing than predicting right now, and since our megaphone reaches into the cannabis space more than any other, we thought we would share our industry perspective of the potential impacts of the coronavirus. We are not advocating any stock buying, investment, or action other than to offer our humble thoughts on the current COVID-19-led concerns, and in some cases, panic. We also don’t want to hazard too many predictions since we are deep into the unknown here but we have spent years analyzing many different aspects of the space and can offer some baseline ideas to consider.

In times of utter chaos, as an asset manager focused on the quasi-legal world of cannabis, there is always some level of chaos. It helps us at Merida to take a step back and ask fundamental questions that get to the core of our mandate without interference from emotions. It is pretty simple at first. Our job is to manage risk and to generate strong returns for investors. How that gets done is where the art and science of our process meet, and can be challenging, particularly at a time when we are reaching epic levels of entropy in the financial markets, society, and in our little slice of heaven we call the cannabis industry. Our space has been facing systemic challenges since the decline of capital markets in mid-2019 led to pervasive capital scarcity. Throw in a dash of coronavirus and its effects on just about everything, and you have a level of unpredictability that would make even Rudolf Clausius sweat bullets

Merida combs through every shred of available information in order to make sure we understand the full picture of what we are analyzing. We sort, discuss, and then question how these facts affect a wide variety of other factors that can give us an informational advantage that we can monetize. This is a time when context and information are at a premium and our model and process help focus our effort to manage the chaos of the coronavirus.

We can leave the broad context of other epidemics or pandemics to the experts, but at a high level, reflecting on the Swine Flu epidemic (or H1N1), statistics in 2009 certainly make me wonder where the panic was back then. Anywhere from 11% to 21% of the global population contracted H1N1, and mortality estimates ranged from 150K all the way to 650K. H1N1 killed 12,469 people in the U.S alone. While fear of the unknown is a human instinct, let’s not forget that we have faced challenges before, and pause to reflect that the precautions being taken now are far more aggressive than any we can recall in 2009. While the precautions may hurt the business economy in the shorter term, I believe that they will benefit us in the long term.

Moving back towards our wheelhouse of cannabis, consider that there is a small cohort of people who have operated under varying levels of federal illegality for nearly 10 years (and for some in CA/CO, even longer) and started businesses in difficult, grinding conditions. This cohort, of which I count myself, spent the past three years watching the “Monopoly-money phase” transpire. We watched the rise and fall with a sense of awe, sitting on the sideline for the most part away from the Canadian LPs and largest U.S. MSOs, knowing full well how difficult it was to build the legal industry from scratch.  This legion, which ironically wasn’t fearful of the DEA/FBI in the early days, is now pretty scared by the effect of coronavirus. The point is, we have seen both feast and famine in the industry. The current environment is daunting, but as you will see, there is reason for cautious optimism for the industry.

We have watched recently as the broader financial markets went into hyper-volatility, and most cannabis stocks got pummeled as the coronavirus outbreak accelerated. We have had hundreds of conversations with companies and investors inside and outside our industry over the past week to obtain a broader perspective on the industry and to determine the most effective ways to satisfy our core mandates. One thing we kept coming back to is a fact, as in: What are the irrefutable facts that we can rely on when considering any action or even inaction? Building off our core of knowledge, we’ve put in the time to scenario-analyze the more difficult aspects of what may occur. It became fairly obvious early in our analysis that we needed to focus initially on the macro effects of COVID-19 on the cannabis ecosystem to form an understanding of the future micro outcomes. The future remains bright in our opinion and further, we believe a sober approach to the current landscape could end up rewarding those who take a measured view as they look at the cannabis landscape for value.

So, let’s start with some of the straightforward observations we can all agree on before we get to potential effects and conclusions.

Broad market observations

  • The Dow was at 30,000 when COVID-19 fears hit the market.

  •  The combination of markets well above historical ranges and potential Black Swan events are bad for investors generally.

  •  The cannabis industry was already struggling with capital scarcity over the past nine months.

  • Sentiment for broad cannabis investment has been as negative as we’ve seen since our early days in the space in 2010-2012.

  • Cannabis consumption has sequentially grown at rapid rates that rival the CAGR of any industry in modern history.

  • Due primarily to creeping legality, on either a U.S. state or federal level, or even globally, both medical and recreational cannabis consumption is exploding.

  • The biggest competitor and headwind to growth of the legal cannabis market is the black market.

  • Cannabis is a hyperlocal industry whose supply chain and end-users are often found within the same county, or potentially even the same city. This is a huge industry-wide advantage in this current environment.

  • The strongest companies in cannabis are either profitable or moving towards profitability on a definable path.

  • Based on New Frontier’s landmark consumer study, we know that many cannabis consumers are either using cannabis for chronic pain, stress or anxiety, or are self-medicating in some manner.  That type of consumption is often recession-proof, or at worst, strongly inelastic.

  • The cannabis industry is largely unlevered, which largely insulates it from any type of debt bubble implosion due to COVID-19. If debt capital becomes scarce, the cannabis industry would barely notice.

Effects of COVID-19 on Cannabis

Bear in mind that a longer period of quarantine and social distancing could significantly impact cannabis and virtually every corner of life, but we assume that after this first societal pause, infection rates and disruption slowly level off so that some sense of predictability and normality return in Q2 or early Q3.

Portfolio company TOKR has seen a rise in delivery requests and larger basket sizes, which is what we are hearing systemwide, showing that cannabis may see changes but people are going to try and purchase cannabis and consume if possible. We acknowledge the effects on our lives but focusing on business and commercial effects, here are our top considerations.

  • We believe that the primary effect of COVID-19 is that it has stressed the broader cannabis ecosystem and will make capital even more scarce.

  • Public companies in need of capital will have to accept financing options that in previous months would have been unthinkable.

  • COVID-19 has accelerated the Darwinian process of destroying weaker companies in the cannabis ecosystem but could also damage good companies that need capital to support their growth.

  • Incredible value can be found by discerning between the two silos of companies described in the previous bullet.

  • COVID-19 has reset valuations in the public cannabis landscape such that value investors, contrarians, and other opportunistic investors will begin showing far more interest in it.

  • We do not believe that COVID-19 will significantly affect the growth curve of cannabis consumption or the long-term prospects of the industry.

In Conclusion

We think the most effective way to invest in the current cannabis landscape is to focus on companies that have the simplest value propositions and appropriate levels of capital, or access to capital. Examples include vertically integrated companies in a single state, of which Merida has several significant investments with the largest retail footprint in Michigan and Dharma Pharmaceuticals, one of the five vertical licenses in Virginia and the only one approved to operate as of this moment. We also believe that operations that span multiple states with lean SG&A line items, and ancillary companies whose products are an essential part of the supply chain or are integral to the production of legal products, could be attractive. Merida is constantly looking for companies who are shorter value production channels and have direct lines to the end-user of their products.

While evaluating existing investment it’s important to consider that access to capital could be constrained for an extended period and that companies without large capital reserves or easy access to capital should run as lean as possible, even if that means curtailing growth. In our diligence process, we have always asked our portfolio companies to demonstrate what they look like as profitable companies so we could assess their business philosophy and ability to pivot. We have often passed on investing in companies whose vision didn’t seem to match any realistic path we could identify, or relied on variables that would clearly be completely out of their control. The companies that impressed us most could articulate a very clear and simple model of how they could run profitably and were honest about what their growth would be if they were forced to implement such a model. Now is the time for this more than ever.

Since chaos destroys value for the most part, we view these realistic profitable operating models as a survival guide that will ultimately create value. Nothing is assured in this world however. Companies that survive the current chaos are likely to emerge as winners, so chaos will arguably elevate these companies. Merida has always tried to empower the smaller operator by giving them capital and tools to which larger operations had access. In this world, this strategy has incredible power to help companies persevere under intensely stressful circumstances.

We feel fortunate that many of our portfolio companies have heeded our warning to expect a tight or non-existent capital landscape and have acted to structurally improve their businesses. These warnings stretch back to June 2019, before we could even envision an exogenous shock to the cannabis ecosystem like coronavirus. Now that it’s here, we continue to work with our existing stable of 43 portfolio companies to optimize their operations, make the most of their available capital, and find synergistic value within portfolio ecosystem. That could mean defensive mergers, strategic partnerships, or any manner of cooperation. We have already seen creative thinking amongst companies within and outside the portfolio and we have a great deal of faith that the entrepreneurial spirit within our industry will help it rebound from any setbacks dealt to it in this challenging period.

One thing that we believe without question: The TAM of cannabis is as enormous as it is diverse, from medical to consumer products, agricultural aspects to hardware for quality control, canna-tourism to regulatory licensing.  The cannabis industry encompasses 20-30 ancillary industries and as legality progresses, all of these verticals are likely to grow alongside it. It is for this reason that we continue to expect that the industry is going to be better off, and much bigger, five years from now. That belief has sustained Merida through the challenging times we faced from our early cannabis origins, through our first fund’s humble beginnings, to our current third fund, a public SPAC, building several large state operational footprints, and nearly 90 transactions over the past three years.

Now is a good time to question those core beliefs and nothing we have yet seen as a result of COVID-19 has impacted that long term view of the cannabis industry and its potential growth and impact on the financial, medical, pharmaceutical, health and wellness and consumer landscapes.

We hope that this has helped give you some perspective, and we wish the best of health to you and your families.

Best regards,​

Mitch

This article was published by CFN Enterprises Inc. (OTCQB: CNFN), owner and operator of CFN Media, the industry’s leading agency and digital financial media network dedicated to the burgeoning CBD and legal cannabis industries. Call +1 (833) 420-CNFN for more information.

About Ryan Allway

Mr. Allway has over a decade of experience in the financial markets as both a private investor and financial journalist. He has been actively involved in the cannabis industry since its inception, covering public and private companies.

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CFN Enterprises Inc. (OTCQB: CNFN) owns and operates CFN Media Group, the premier agency and financial media network reaching executives, entrepreneurs and consumers worldwide. Through its proprietary content creation, video library, and distribution via www.CannabisFN.com, CFN has built an extensive database of cannabis interest, assisting many of the world’s largest cannabis firms and CBD brands to build awareness and thrive. For more information, please visit www.cfnenterprisesinc.com.

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