Initiating Coverage of Green Thumb Industries

We are initiating coverage of Green Thumb Industries GTBIF, a U.S. cannabis producer operating in 12 states. Our fair value estimates are $18 per share and CAD 23.50 per share, based on a 10-year explicit forecast that assumes a nearly 37% revenue CAGR and a 2028 operating margin before plant adjustments of 32%. At current prices, shares look undervalued as the stock trades in 4-star territory. In our view, it offers investors attractive exposure to the fast-growing U.S. market.

In line with our other cannabis coverage, we assign the firm a no-moat rating and a stable moat trend, as the probability of material value destruction over the next 10 years remains high. We also assign a very high uncertainty rating, which includes impacts from the pace at which legalization is passed, distribution is expanded, and the prevalence of cannabis consumption.

Green Thumb offers pure-play exposure to the United States, which we believe has the highest potential and fastest growth of any market. As of 2018, U.S. recreational and medicinal cannabis have penetrated just 8% and 21% of their estimated markets, respectively. Based on our state-by-state analysis, we forecast nearly 25% average annual growth for the U.S. recreational market and nearly 15% for the medical market through 2030.

It continues to generate negative free cash flow, as its capital expenditures will remain elevated while it expands operations to meet demand in this budding industry. However, we think the company has made promising strategic decisions, including focusing on limited license states with large populations. It strategically operates in states with robust medical cannabis markets with momentum around recreational legalization, such as Illinois, Massachusetts, New York, Florida, and Ohio. In states with numerous producers, Green Thumb purchases cannabis from third parties in order to forgo cultivation. This minimizes capital spend in markets where competition should keep wholesale prices reasonable.

Firm Eyes States With Large Populations Green Thumb Industries is headquartered in Chicago, Illinois, and produces and sells medicinal and recreational cannabis through wholesale and retail channels in the United States. It has a presence in 12 states and operates over 30 cannabis stores under the chains Rise and Essence. Green Thumb is focusing its expansion on limited license states with large populations, and it does not currently export into the global medical market due to U.S. federal prohibition. It offers multiple products under a portfolio of cannabis consumer packaged goods brands, including Dr. Solomon's, Dogwalkers, and Beboe.

Green Thumb Industries cultivates and sells medicinal and recreational cannabis through wholesale and retail channels in the United States. Unlike its Canadian peers, the firm is more vertically integrated as it owns dispensaries in addition to the cultivation and processing of value-added products. It has a presence in 12 states through 13 production facilities, 34 stores, 96 retail licenses, and six brands. Compared with Curaleaf CURLF, another U.S. multi-state operator, Green Thumb is less involved in cultivating. In some states with more mature cannabis markets, such as Colorado and California, it believes there are enough cultivators available and purchases cannabis from third parties.

Its growth strategy focuses on states with large populations and limited licenses. It strategically operates in states with robust medical cannabis markets with momentum around future recreational legalization. Two of its large markets, Illinois and Massachusetts, have already legalized recreational use.

We think the U.S. has the highest potential and offers the fastest growth of any market. But the U.S. regulatory environment is murky, with individual states legalizing recreational or medical cannabis while it remains illegal federally. Eventually, we expect federal law will be changed to allow states to choose the legality of cannabis within their borders. Based on our analysis, we forecast nearly 25% average annual growth for the U.S. recreational market and nearly 15% for the medical market through 2030.

Due to federal illegality, the firm does not operate internationally, placing it at a disadvantage. The global market looks lucrative given higher realized prices and growing acceptance of cannabis' medical benefits. Exporters must pass strict regulations to enter markets, which protects early entrants like many Canadian cannabis companies. Future production will likely come from countries with cheaper labor--the single largest production cost. We think it would need to open cultivation internationally if it wants to compete in the global medical cannabis market--an unlikely event until federal laws are changed.

We assign Green Thumb Industries a no-moat rating. Although the intangible assets and cost advantage moat sources could gradually develop over time, we see several barriers that currently prevent the firm from earning a narrow or wide economic moat rating. Although our base-case scenario assumes that Green Thumb Industries will achieve economic profit generation by the end of our 10-year explicit forecast period, the probability of material value destruction for stakeholders remains too high to assign anything other than a no-moat rating at this time. Regulation Intangibles We believe the most likely moat source would come in the form of intangible assets stemming from regulation or brand development. Cultivators and dispensaries require government licenses to operate in every market where cannabis is legalized in some form. However, a regulation intangible only exists if governments issue a limited number of licenses in order to not imbalance supply and demand for cannabis. For example, Oregon issued too many cultivation licenses upon recreational legalization, leading to significant oversupply and very low prices. When too many licenses are issued, the power of each individual license is weakened. A low selling price also reduces tax revenue collected by state governments. We believe it is unlikely that a significant over issuance of licenses will occur again as Oregon's mistake has served as a lesson for regulators to have a more deliberate pace in license issuance. This same risk exists for dispensaries if too many dispensary licenses are issued relative to demand. As a result, companies with licenses could potentially be protected from outside competition, helping establish pricing power. This could prove particularly true if holding an existing license provides an advantage when new licenses are issued. History suggests this could be a relevant consideration, as Illinois' recreational legalization process handed an advantage to companies with medical cultivation and dispensary licenses. Green Thumb's focus on limited license states with large populations, robust medical cannabis markets, and momentum around future recreational legalization provide potential for a regulation intangible in the future. Brand Intangible Assets The creation of brand-driven intangible assets could help cannabis companies establish pricing power and generate economic profits. For comparison, alcohol and cigarettes are typically highly taxed, but producers of these products have established strong enough differentiation and brand intangibles that consumers are willing to pay price premiums. Although Green Thumb Industries and its competitors are attempting to establish brand equity, we see the creation of the intangible asset moat source within the next decade as unlikely since the industry remains in a very early stage. However, compared with Canada, restrictions on the packaging and advertising of cannabis products are less strict in the U.S. Additionally, direct contact with "budtenders" is allowed in the U.S. This could pave the way for brand development over time. Green Thumb's acquisition of Los Angeles-based For Success Holding Company, owner of the cannabis brand Beboe, allows the firm to better distribute brands at scale in California and Colorado. It might be able to leverage its coast-to-coast footprint to help create a national brand. However, the key to a brand intangible is the ability to command premium pricing and, in turn, deliver economic profits. At this point, we believe that market share is not indicative of brand strength and may be more reflective of distribution power, especially as federal law creates friction for national brand creation. We think that brand power may strengthen eventually, but we think it is highly unlikely that any brand will be strong enough in the next 10 years to command pricing power. Once federal regulations are changed and interstate trade is permitted, there will be intense competition in the cannabis market as companies attempt to establish and strengthen their brands. This would create a highly competitive environment that would likely limit the potential return on marketing spend for any single brand. As consumers can find many similar cannabis products across various dispensaries, cannabis companies will also have to differentiate their products from their competitors and establish brand equity in order to potentially create brand intangibles in the future. Additionally, dispensaries, like most retailers, sell multiple brands on their shelves, including their own branded products. However, brand recognition is more likely to center on the products rather than the retailers. While typical consumer products companies, and even tobacco companies earlier in their history, have built brand recognition through advertising campaigns, we expect cannabis will face the same, if not stricter, advertising limitations as tobacco in the U.S. We believe this makes it even harder for cannabis companies to build a recognizable brand, as opportunities to directly address the consumer will be limited. Under the Family Smoking Prevention and Tobacco Control Act, tobacco product advertising faces restrictions including outdoor advertising near schools and playgrounds, sports and entertainment brand sponsorships, and point-of-sale advertising. Advertising on television and radio has been banned since 1971 by the FCC. Although tobacco companies spend roughly $10 billion in marketing in the U.S., roughly two thirds was spent on price discounts to reduce the cost of cigarettes to consumers. While this may help tobacco companies protect existing brand intangibles with its customers, we don't think the same strategy could build a new brand intangible in cannabis. Cost Advantage We think it will be unlikely for Green Thumb Industries to establish a cost advantage. A change in federal regulation would clear the way for interstate trade between legal states. At that point, states in the West and Northwest would likely be able to cultivate at a lower cost through outdoor operations versus states that need to use higher-cost greenhouse or indoor cultivation methods due to their climates. While Green Thumb purchases cannabis from third parties in mature cannabis markets on the West Coast, it has cultivation facilities in the Midwest and East Coast. The firm's production is currently widespread, and we don't think its overall cultivation and production costs would be low enough to warrant a cost advantage, even if the federal law is changed. Challenges to Economic Profit First, given that the cannabis industry remains in the growth stage, we think that years of significant investment will be necessary to support robust growth for the industry. An extended capital expansion cycle through the next several years means that companies will be unlikely to generate economic profits in excess of their costs of capital for quite some time. Second, we see both governments and the black market squeezing cannabis cultivators and dispensaries and preventing excess economic profit generation. With governments on national, state, and local levels reeling from budget problems, the emergence of cannabis as a legal product has come to be viewed as a funding panacea. For example, Washington has implemented a 37% tax rate on recreational cannabis. We see this as early evidence that governments, with full control over licensing, will attempt to maximize their economics. All else equal, on the other end of the value chain, consumers would likely bear any government tax increase, like what we've observed in the cigarette market. However, we believe the existence of a large and accessible black market effectively serves as a price ceiling regarding what consumers are willing to pay. When California legalized recreational cannabis with a relatively high tax, the legal market shrank as consumers moved back into the black market.