Cannabis Reclassification: A Green Light for Growth?

Reporting: Patrick Fitzgerald

The U.S. Department of Justice’s proposal to reclassify marijuana from a Schedule I to a Schedule III substance has breathed life into the turnaround prospects for the struggling cannabis industry, according to restructuring professionals interviewed by Reorg.

“The industry as a whole is going to benefit,” said Jason Rosell , a partner with Pachulski Stang Ziehl & Jones, on the long-term, general impact of reclassification. “You're going to have banking come in. You’re going to have institutional money come in. There should be more liquidity, and stock prices will rebound allowing [companies] to restructure their debt.”

More immediately, the implementation of the Department of Justice’s decision will remove one major obstacle to profitability for cannabis industry participants - Section 280E of the Internal Revenue Code.

Simply put, 280E prohibits businesses from deducting otherwise established business expenses from gross income associated with the trafficking of Schedule I or II substances as defined by the Controlled Substances Act and currently applies to all businesses that partake in the cultivation, sale or processing of the cannabis medical or recreational purposes since it is still a Schedule I substance.

With 280E becoming a thing of the past upon reclassification, an industry long beset by demand and oversupply headwinds should see improved cash flows and profitability overall for domestic market participants, with 2024 revenues expected to reach $42.98 billion, according to global consulting firm J.S. Held.

“[The removal] of 280E will have a massive impact from a cash flow and profitability standpoint for companies at least for the short to intermediate term,” said Timothy Bossidy , managing director at SierraConstellation Partners and co-founder of Emerald Peak Partners. “For companies that have been bumping along at breakeven or at a slight loss that have retail exposure because of not being able to deduct SG&A or interest costs, this massively improves their cash flow profile.”

Specifically, Bossidy explained that the types of cannabis companies likely to receive the biggest boost from reclassification are operators with outsize legacy tax liabilities, any debt on their balance sheet and retail-driven SG&A expenses such as lease and employee costs, as well as multistate operators, or MSOs, with meaningful corporate SG&A to manage their businesses across more than one state.“

MultiState operators that trade at relatively distressed levels on public exchanges should also see a meaningful lift because they've got pretty significant leverage,” Bossidy said. “Being able to deduct their interest expense and have a huge cash flow boost from their retail operations should immediately change their profiles, because right now they're not really generating meaningful cash to service their debt, and now they should be able to.”

Oversupply, Limited Capital Market Access

Although the decision to reclassify cannabis was met with a combination of relief and enthusiasm by industry participants and investors alike, its ultimate benefit is likely to be limited for a sector beset by demand and oversupply headwinds as well as a limited ability to tap debt capital markets for financing.

“It’s a positive development that will improve cash flows for many operators, but it’s still a very crowded space and competitive space, and ultimately a lot of the products that these companies are selling are more like commodities than they are not,” David Zubricki , the managing director at Ducera Partners LLC , said.

Although the decision is a definitive boost in the short to medium term, the industry overall still has yet to correct a supply-and-demand disequilibrium that persists to this day, the origins of which can be traced back to the end of the previous decade, not too long after geographies such as California and Canada made the decision to legalize, Zubricki said. Those developments inspired the view among investors that the trend toward legalization represented a generational opportunity to create wealth, resulting in an influx of capital flowing into the sector to build out cultivation facilities.

“The market is just significantly oversupplied,” Zubricki added. “It’s just that we’re at a point now where supply has outpaced demand.”

Looming Maturities

Additionally, the optimism that followed in the wake of Canada and California’s decision to legalize, in tandem with the sector becoming flush with capital, led to the so-called “green rush,” where it was easy for cannabis companies to raise funds in the form of convertible notes that were unsecured, Rosell said. Since these were two-year notes, companies were trying to go public as soon as possible and get listed, and in theory the notes would convert.

“We’re now facing a debt cliff where notes are maturing this year and 2025 that are secured, and there’s really no more runway,” Rosell said.

“What you’re seeing is a lot of extend and pretend, just as we saw in the subprime mortgage crisis where people rolled their notes, but that begs the question of what happens when the company is cash flow negative, which most of the companies are,” Rosell continued. “They may be EBITDA positive, but they’re not cash flow positive, and you have high interest rates. Nobody’s really putting money into the industry right now, and there’s certainly no equity raises that are happening.”

Capital markets are still not deep and open enough to cannabis companies where most regular-way institutional investors would feel comfortable enough in the space, and ultimately cannabis reclassification on its own is unlikely to change that dynamic, Zubricki said.

“In the medium term, once it gets approved, it will improve the cash flows for companies pretty significantly,” Zubricki said. “But I don't think it’s going to significantly open capital markets just yet, and companies will still have to address sizable maturities in ’25 and ’26.”

Competition From Legacy Market and Hemp-Derivative Market

Furthermore, both the legacy (or unlicensed) market and intoxicating hemp-derivative products, which are not subject to heavy local taxation and fee regimes, will remain price-attractive options for consumers, meaning cannabis’ swing from a distressed to prospering industry may not be as certain as some would hope in the wake of Section 280E’s removal.

"Competitive pressures from [intoxicating] hemp, and from the black market or legacy market are here to stay for a while,” Bossidy said. “[The industry] will continue to be distressed from that standpoint, but also for a lot of these operators that have been here for a while, their cost of capital is still extraordinarily high, and until there's some sort of banking or capital markets reform which should be mostly addressed through the SAFER Banking Act , I think that that the cost of capital piece is still going to be a drag as well.”

M&A

Another watch point for industry participants and advisors in a post-reclassification world is the potential for M&A activity in the sector, especially for medical-use cannabis products. Since Schedule III substances have accepted medical-use applications as defined by the Food and Drug Administration, consumers of medical-use cannabis products would need valid prescriptions for the substance from medical providers.

That means consumers would essentially need to obtain medical-use products from the equivalent of a pharmacy with a doctor's prescription, Rosell explained, raising the question of who will be the ultimate winners upon reclassification: smaller independent dispensaries, or even dispensaries run by large multistate operators? Or will it be the Eli Lillys and the Walgreens of the world where they can mass produce and are connected to the FDA?

“I think it'll be interesting to see the M&A activity,” said Rosell. “Are the Eli Lillys and Walgreens of the world going to purchase large cannabis operators, or will they use their infrastructure and push [the existing players] out? It’s going to be very interesting - especially if health insurance companies begin covering the cost of cannabis prescriptions.”