SNDL: Federal Government Begins Rescheduling Process For Cannabis (Buy)

SNDL Inc. (NASDAQ:SNDL) and other cannabis stocks (CGC, GRWG, VFF) rallied on renewed news of federal cannabis rescheduling. The rally was short-lived because investors need to unpack the development and see what it implies. On the surface, it seems to be a reiteration of last week’s news of rescheduling. There are a few details to consider.

SNDL has seen a lot of action in the recent cannabis rallies. There is additional news with the company, who just released its Q1-2024 results, worth noting. For instance, the structuring of SNDL’s SunStream USA has been approved by NASDAQ. SNDL is now positioned in a similar way to Canopy Growth Corporation (CGC), to benefit from US cannabis markets and soon directly participate.

I will cover both items below along with SNDL’s recent financial results. I recently covered SNDL and gave it a rating of Hold. Today, I am updating that rating to a Buy and will give more details below. I plan to upgrade a few other Canadian LPs to Buy in future articles, so stay tuned. Market conditions are changing quickly.

Announcement From the US Federal Government

Last week, news dropped that the DEA had made its recommendations to the HHS, DOJ, and Attorney General. This event would begin a process of rescheduling cannabis from Schedule I to Schedule III. We were unsure when the process would begin and the process itself does not ensure successful rescheduling. Today, more information was released.

The news this week from Marijuana Moment is twofold. It indicates that the attorney general will go forward with the process of rescheduling and that the DEA reiterates the illegality of cannabis going into this process. The DEA has traditionally been in charge of rescheduling drugs according to the Controlled Substance Act of 1970 (‘CSA’). The DOJ also has the ability to reschedule according to the CSA.

I believe it has been thought that the DEA typically goes against rescheduling cannabis because of the agency’s role in the Drug War. It makes revenues through its active pursuit of busting illicit drugs/narcotics. This money is made through asset seizure and asset forfeiture from Drug War suspects. Readers will want to research the Drug War and asset forfeiture to understand how this process has, in my opinion, incentivized federal and state agencies from reclassifying commonly used drugs. You will also find long-standing disputes between the DOJ and DEA on reclassifying other drugs, like MDMA. Revenues received through asset forfeiture become part of the DEA’s operating budget for fighting the war on drugs.

It is not surprising that the DEA both recommended reclassification and at the same time reiterated its position of the drug being highly addictive and illegal. The agency has a long history of not rescheduling cannabis. The attorney general has overridden the DEA’s role in rescheduling cannabis and has taken over the process by its agency.

This process includes a 60-day public review during which the public may make comments and some lawsuits against rescheduling will emerge. According to the announcement this week, the attorney general is confident that rescheduling will be successful, which signals a new direction in US federal drug policy.

The Health and Human Services (‘HHS’) made its recommendation to reschedule cannabis and the Attorney General is using his authority to begin a rulemaking process. It is not as easy as waving a magic wand. The process will take time and obstacles may appear.

Cannabis as a Schedule III drug does not amount to federal legalization nor less regulations for the plant. The DOJ points out that the plant is still regulated by the FDA, by interstate commerce laws, and by international treaties. The federal government will still prosecute based on existing laws. During the 60-day review, the DEA believes information will come forward which may influence the final decision. Although it is not clear whether it would change rescheduling.

As stated in Marijuana Moment, there is a disconnect between the DOJ and DEA over the recommendation. For this reason, the DOJ is initiating the process. The Office of Legal Counsel (OCL), which supports the rescheduling from a legal aspect, says that the DEA has too narrow guidelines for determining the acceptability or medical usage of a drug.

The OCL has determined that HHS’s recommendations would be binding on the DEA. The agency will have to defer to HHS’s medical research and advice. The OCL also said that international treaties do not forbid the rescheduling of cannabis. These complications should not stop rescheduling, but a national debate will occur. Lawsuits may be filed to stop the final decision.

Besides rescheduling, Senate and Congress members say more has to be done. The plant needs to be federally legalized, and the industry must have access to banking practices. There is also an additional need to get justice for those potentially harmed by the federal and state war against cannabis users. At the end of the day, DOJ appears confident that the drug will be rescheduled.

Rescheduling cannabis will allow for looser state business regulations and the ability for US cannabis operators to take some federal tax deductions for their businesses. The move will also signal a greater acceptance of the plant and the indication of future reform from the Federal government, in my view. To the investors, this may indicate a good time to buy up cannabis stocks while they trade at a discount. It will be interesting to see how the 60-day review process evolves. Investors should watch for developments.

News about SNDL

SNDL released its Q1-2024 results earlier this month on May 9th. There are some synergies at play, which indicate a Buy rating for the company. The company’s cannabis operations segment posted positive gross profit and positive operating income within the segment. Other Canadian cannabis LPs, like Village Farms International, Inc. (VFF), also saw improvement in performance in the Canadian cannabis markets. Although not certain, it seems that the Canadian cannabis LPs are doing better in the Canadian markets. Both companies found ways to cut operating costs and become more efficient in product offerings.

The other tidbit from SNDL’s release concerns its US cannabis holdings via SunStream USA. SNDL announced that NASDAQ has approved its SunStream USA structure. SunStream USA, a part of SunStream Bancorp, has been bankrolling US cannabis MSOs, and it holds conversion rights to US cannabis operations. SNDL states that it would rank as a top five MSO in North America, if it exercised its ownership rights upon US legalization. The company is set to have a large North American footprint when cannabis is legalized.

The company considers this approval a significant milestone for its US cannabis strategy. For investors, it may also indicate that Canopy Growth’s similar strategy with Canopy USA will also receive approval. SNDL’s positioning to enter the US cannabis markets is another reason I rate the company as a Buy.

Q1-2024 Results

Net revenue for the quarter was CA$197.8 million, representing a 4% increase YoY and a 20% decrease QoQ. Cannabis retail and cannabis operations segments led this growth. While liquor and beer retail sales caused the decrease from the previous quarter. The company stated that Q1 is seasonably low for its liquor segment.

The company reported gross profits of CA$50.4 million, representing a 55% growth YoY and 25% of total revenue. The gross margin has improved overall by 850 basis points. The company credits its cultivation consolidation, i.e., the closure of its Olds facility, and the employment of the company’s proprietary data analysis program. The company has followed through with its commitment to lower operating costs and better operating efficiencies.

The company posted a negative CA$6.1 million cash flow, which was a marked improvement of 91% YoY (compared to negative CA$66.3 million). Operating loss was CA$4.4 million compared to CA$32.2 million YoY, representing an 86% improvement. The company credits higher profit margins to the improved operating loss.

Revenue from liquor retail sales was CA$116.1 million compared to CA$115.9 million YoY. Revenue from cannabis retail sales was CA$71.3 million compared to CA$67.4 million YoY, representing a 6% increase. Revenue from cannabis operations was CA$22.4 million compared to CA$19.1 million YoY, representing a 17% increase. This segment posted a 138% improvement in gross profits.

SNDL had CA$594.2 million of capital deployed in cannabis investments. Of this number, CA$560.3 million is with SunStream Bancorp. For the quarter, the portfolio made CA$13.1 million compared to CA$8.7 million YoY. SunStream Bancorp formed SunStream USA in 2023, which holds SNDL’s US cannabis investments. SNDL received approval for SunStream USA’s structure earlier this on May 2nd. The portfolio includes five investments: Jushi Holdings, SKYMINT brands, Ascend Wellness Holdings, Surterra Holdings (dba Parallel), and Columbia Care. SNDL holds the right to acquire Parallel and SKYMINT upon US legalization.

The company has no debt currently. It holds CA$783.2 million in cash and short-term investments. It has a net book value of CA$1.2 billion. The market consensus on SNDL’s Q2-2024 revenue is US$175.84 million, representing an increase in QoQ and YoY.

Valuation and Investment Strategy

SNDL stock price has been up 62.58% over 1-year. Over the last 6 months it is up 77.85% and over the last month, 33.84%. The recent news over the last 5 days gave it a 10% increase. The book value per share for SNDL is US$3.53 and its current price is US$2.65 per share. The company’s forward multipliers (NTM Total EV / Revenues = .97x) also imply that the stock price is undervalued. SNDL’s median street price target is US$4.96 per share.

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*Valuations from TIKR.com

Compared to its peers, SNDL is undervalued and outperforming. Village Farms is also in a similar valuation situation. Tilray and Canopy Growth show signs of overvaluation and underperformance. Each company has its own strategy and advantages in the cannabis sector.

SNDL itself is at low risk of poor financial performance in my opinion. The company will continue expanding its vast liquor and cannabis retail outlets, while amping up its cannabis cultivation operations. The company’s assets far outweigh its liabilities. The company’s investment strategy and US entry strategy are both promising for future gains. Investors will want to see SNDL report net revenues and consistent positive free cash flow in the future.

Even if cannabis is not rescheduled, SNDL still makes investment revenue from its SunStream Bancorp and SunStream USA holdings. The company’s future success is not fully dependent on US rescheduling or legalization. If these events happen, I believe SNDL’s valuation will increase instantly.

I rate the company as a Buy because of its undervaluation, its current operating success, and its clever US entry strategy. I recommend a long-hold strategy for the company, and it comes at a moderate to high risk. SNDL’s stock may downtrend from future news, and it may not ever realize its target price.

Risks

There is a risk in a long-hold, long-term position for SNDL. Before news about rescheduling and news last fall about the SAFER Banking Act, cannabis stocks were down trending as a whole. Since then, there has been improvement in the sector and cannabis stocks are trading higher.

The cannabis markets in the US and Canada are still experiencing shrinkage and other issues. The uptrend in cannabis stocks does not necessarily reflect conditions in the US and Canadian cannabis markets. All the companies have different business strategies for dealing with the issue.

SNDL increased its revenues and operations by buying a liquor and beer distribution and retail chain. Other companies export cannabis internationally and/or sell CBD products. The bottom line is that cannabis stocks may easily downtrend again and return to multi-year lows. A stopgap should be set for any long-term cannabis stock investment.

I feel that there is enough momentum behind the current rally and that investor sentiment is positive towards the sector. The stock prices should continue to rally on developments in the industry and the company’s performance. It is a moderate to high risk because SNDL has only recently begun reporting improved financial results and because the future of the Canadian and US cannabis markets is uncertain and volatile. Gains between 33% and 87% may be realized if SNDL’s stock price reaches its book value or median target value. Call options volume has increased for SNDL and further gains may be found by playing covered calls.

SNDL versus Other Canadian LPs

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*Financial Data from Seeking Alpha. Valuations from Seeking Alpha and TIKR.com.

SNDL and Village Farms both make revenues from non-cannabis business operations. SNDL operates a liquor, beer, and wine retail chain and Village Farms grows and distributes produce. Both companies have lowered their operating costs and are performing better than the rest of the Canadian LPs.

Canopy Growth sees the largest uptrend in stock price compared it its peers. Canopy Growth seems to be a darling of cannabis investors. The company, just like SNDL, has a firm US entry strategy. Canopy Growth recently ended its retail cannabis operations, while SNDL has embraced a large cannabis retail network. Tilray has its US craft beer operations and reports the highest revenue numbers of the group.

All the companies operate at a net loss. SNDL, Tilray, and Village Farms trade below their book value. Canopy Growth remains overvalued, and the trend will likely continue because of positive investor sentiment on the company. In my opinion, SNDL and Village Farms are performing the best compared to their peers. These metrics change a lot from quarter to quarter. Investors should watch all four companies.

Conclusion

The news from the federal government shows great promise for the rescheduling of cannabis. The DOJ is taking charge of the process and setting up the steps to change the law and scheduling around cannabis. There will be some barriers along the way, but the news this week from indicates that the outcome will likely be positive. SNDL has shown improvement in its Canadian operations, and it is positioned to enter the US cannabis markets. The company’s stock has been on an uptrend along with other Canadian LPs and US MSOs. I rate the company as a Buy and encourage investors to watch for developments.