Cannabis Credit Risks Will Disrupt Lending While Modest Recovery Emerges

Key Takeaways

• Expansion beyond real estate lending may increase growth opportunities but heightens risk of credit quality deterioration and unstable margins.
  
• Easing cannabis regulations could boost capital access but intensify competition, compress yields, and restrict earnings growth due to legacy loan issues and regulatory barriers.
  
• Credit quality deterioration, shrinking loan opportunities, regulatory risks, and transition uncertainties threaten Advanced Flower Capital's margins, earnings, and competitive position in the evolving cannabis finance market.

Catalysts

Advanced Flower Capital Inc. originates, structures, underwrites, invests in, and manages senior secured loans and other types of mortgage loans and debt securities for established companies operating in the cannabis industry.

• While the proposed conversion from a REIT to a BDC could meaningfully increase Advanced Flower Capital's addressable market and future lending pipeline by allowing investment in non-real-estate-backed operators, the company may face significant downside risk as this exposes its portfolio to unsecured or less collateralized loans, which could adversely impact credit quality and net margin stability.
  
• Although federal rescheduling and gradual legalization of cannabis could unlock institutional capital and boost recoveries on legacy troubled loans, the influx of new capital will also intensify competition among lenders and compress yields, making it more difficult for AFC to maintain its historically high portfolio yield and putting downward pressure on revenue.
  
• While the broader opportunity set from direct lending to middle market companies outside cannabis initially appears positive for growth and risk diversification, expanding focus away from the firm's core competency raises the risk of mispricing credit and underestimating sector-specific risks, potentially resulting in higher loan losses and pressuring distributable earnings.
  
• Despite long-term trends toward normalization and mainstreaming of cannabis finance that could legitimize AFC's platform, the company remains exposed to costly underperforming legacy loans and continuing high CECL reserves, with no near-term resolution in sight-these factors will likely constrain earnings and impede improvement in book value per share.
  
• Although access to a larger revolving credit facility suggests potential for future growth, persistent regulatory restrictions mean few banks will participate in cannabis lending, which could raise AFC's cost of capital or limit its ability to refinance, ultimately constraining profit margins and undermining the long-term growth trajectory.

Advanced Flower Capital Future Earnings and Revenue Growth

Assumptions

• This narrative explores a more pessimistic perspective on Advanced Flower Capital compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts.
• The bearish analysts are assuming Advanced Flower Capital's revenue will grow by 108.9% annually over the next 3 years.
• The bearish analysts assume that profit margins will increase from -107.2% today to 68.2% in 3 years time.
• The bearish analysts expect earnings to reach $54.2 million (and earnings per share of $2.37) by about August 2028, up from $-9.4 million today. The analysts are largely in agreement about this estimate.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 2.7x on those 2028 earnings, up from -9.8x today. This future PE is lower than the current PE for the US Mortgage REITs industry at 13.6x.
• Analysts expect the number of shares outstanding to grow by 7.0% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 6.78%, as per the Simply Wall St company report.

Advanced Flower Capital Future Earnings Per Share Growth

Risks

• There remains significant credit quality deterioration and persistent defaults among the company's legacy cannabis loans, reflected in a high current CECL reserve of 14.6 percent of loan value and a net loss of $13.2 million for the quarter, which are likely to weigh on future net margins and lower overall earnings.
  
• The company's existing pipeline of loan opportunities has been shrinking due to a lack of creditworthy real estate-backed cannabis borrowers and the volatile operating environment, constraining revenue growth until the business development company structure can be implemented and successfully executed.
  
• Exposure to real estate-dependent loans in a federally illegal and highly fragmented cannabis market leaves the company vulnerable to regulatory setbacks and borrower failures, which risks continued loan write-downs and further negative pressure on distributable earnings and book value.
  
• The planned conversion from a REIT to a business development company in order to broaden the lending universe introduces transition risks, including uncertainty over shareholder approval, untested credit underwriting in non-real-estate assets, and potential operational challenges that could result in volatile or reduced profit margins.
  
• If regulatory reforms or federal rescheduling accelerate capital inflows and unlock mainstream financing for cannabis operators, Advanced Flower Capital's unique lending niche faces the threat of margin compression and increased competition from institutional lenders, potentially reducing long-term revenue and earnings growth.

Valuation

• The assumed bearish price target for Advanced Flower Capital is $4.5, which represents the lowest price target estimate amongst analysts. This valuation is based on what can be assumed as the expectations of Advanced Flower Capital's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
  
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $13.0, and the most bearish reporting a price target of just $4.5.
  
• In order for you to agree with the bearish analysts, you'd need to believe that by 2028, revenues will be $79.5 million, earnings will come to $54.2 million, and it would be trading on a PE ratio of 2.7x, assuming you use a discount rate of 6.8%.
  
• Given the current share price of $4.05, the bearish analyst price target of $4.5 is 10.0% higher.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.