Despite regulatory headwinds, Curaleaf's strong EBITDA margins, cash flow, and undervaluation present a significant upside potential with limited downside risk.

I am initiating coverage on Curaleaf Holdings (OTCPK:CURLF) stock with a "Buy" rating and an investment horizon of 24 months. I believe that Curaleaf stock is attractive after a meaningful correction of 23% for year-to-date. A reversal rally seems likely from oversold levels on the back of multiple impending catalysts.

This initiating coverage discusses the key factors that are likely to impact growth and value creation. At the same time, the possible risks to the bull thesis are discussed.

As an overview, Curaleaf has cannabis operations with a focus on the United States. However, the company has been pursuing international expansion and has a presence in multiple European countries. For financial year 2023, Curaleaf reported revenue and EBITDA of $1.35 billion and $304.5 million, respectively.

Before getting into the possible catalysts, it's important to understand the reasons for a correction in Curaleaf stock. I believe that there are two major factors.

First - Regulatory headwinds have sustained for the industry. While there seems to be progress towards regulations getting friendlier, the process remains slow.

Second - Curaleaf has disappointed on the growth front. For 2023, the company reported 6% year-on-year growth to $1.35 billion. Further, for the first six months of 2024, revenue increased by 2% on a year-on-year basis to $681.2 million. In an industry that's still supposed to be at an early growth stage, the numbers sound dismal.

Having said that, the markets have priced-in the sluggish growth factor. Curaleaf stock can witness a sharp reversal if growth accelerates and regulatory headwinds decline on a relative basis.

I believe that a big catalyst for Curaleaf is the likely rescheduling of cannabis as a Schedule III drug. The Drug Enforcement Administration has scheduled a public hearing on December 2, 2024. This is a part of the "formal rulemaking process required by the CSA, allowing the DEA to gather expert testimony and public input on the proposed rescheduling."

It's worth noting that cannabis rescheduling is different from federal level legalization. The latter is a bigger catalyst. However, there are some benefits of cannabis being reclassified as a Schedule III drug.

First, a Schedule I drug implies that there is high potential for abuse. On the other hand, Schedule III drugs have a lower potential for abuse/dependence. It's worth noting that even without federal level legalization, the U.S. cannabis market is expected to be worth $71 billion by 2030. With a presence in 17 states, Curaleaf would be positioned to benefit.

Second, the possible reclassification of cannabis as a Schedule III drug would have a positive impact on the medicinal cannabis industry. Schedule III drug includes prescription medication. Acknowledging medicinal use would positively impact growth. At the same time, I expect bigger investments in evidence-backed cannabis medicines.

Third, if cannabis is classified under Schedule III, it would remove the 280E tax provision. Under 280E, deductibility of operating expenses is disallowed and taxation on cannabis operators is at the gross profit level. Curaleaf believes that it would save $150 million in 280E related taxes in 2024. Therefore, the impact on profitability and cash flows will be significant.

Of course, the rescheduling will happen at its own pace. However, I see things moving in the right direction on the regulatory front. Further, when the rescheduling happens, Curaleaf stock is likely to skyrocket and will not provide a good entry opportunity. The best time to buy is when sentiments are bearish.

I must add here that Donald Trump recently backed cannabis rescheduling and the cannabis banking bill. As a Vice President, Kamala Harris had also voiced a positive opinion on cannabis rescheduling. These views are in-sync with most Americans supporting the legalization of cannabis. I therefore expect a positive outcome on the regulatory front in the coming quarters.

Curaleaf has a presence in 17 states in the U.S. with 147 retail locations. At the same time, the cannabis company is pursuing aggressive international expansion. Curaleaf already has a presence in 12 countries, with a focus on the European region.

It's worth noting that for Q2 2024, the company reported international revenue of $25 million, which was higher by 78% on a year-on-year basis. The positive is that top-line growth has been robust. However, international revenue for Q2 was just 7.3% of the total revenue. Therefore, the impact on overall growth has been insignificant.

There are two important points to note from the perspective of Europe being an important market.

First, Germany has legalized cannabis and Curaleaf has presence in the country through its premium flower brand, Four20 Pharma. It's likely that the country will support sustained growth in the international markets.

Further, I believe that with Germany pursuing legalization, other European countries are likely to follow suit. A survey indicates that 8% of European adults (22.8 million aged 15 to 64) have used cannabis. Further, 3.7 million people are "daily or almost daily users of cannabis." There continues to be illegal trafficking of cannabis in Europe. It makes more sense for regulators to legalize, and I expect more countries to follow Germany.

It's worth noting that Curaleaf has been pursuing acquisitions to boost growth in Europe. In February 2024, the company acquired Can4Med, which is a pharmaceutical wholesaler with strong presence in Poland. In March 2024, Curaleaf acquired Northern Green Canada, a vertically integrated Canadian licensed cannabis producer. NGC is among the few Canadian cultivators with EU-GMP certification.

Curaleaf therefore has a clear intent of making significant inroads in Europe. Among various factors, the growth acceleration depends on the regulatory stance in the next few years.

As I mentioned at the outset, sluggish revenue growth has been a key reason for Curaleaf stock remaining depressed. However, if we go by the management guidance, that's likely to change in the coming quarters.

Boris Jordan, Executive Chairman of Curaleaf, opined that:

We are starting to see the benefits of the work we initiated 18 months ago to streamline the business, drive efficiencies in our cultivation facilities, and leverage both domestic and international growth opportunities. Looking to the second half of the year, these actions will drive an acceleration in both our revenue and margins as state and country catalysts develop further.

With the possibility of accelerated growth and potential margin expansion, I expect an uptrend in Curaleaf stock. The markets, however, remain sceptical if we look at the stock price-action. I would not consider a big exposure. In one of my recent coverage, I discussed Cronos (NASDAQ:CRON) as a good cannabis play. However, some exposure can be considered. If the catalysts materialize, the upside can be significant from oversold levels.

Another point to note is that Curaleaf has been investing in research and development. The company launched 179 new products in 2023. Further, 26% of FY2023 revenue was generated from products launched in the last 12 months. Continued investment in R&D is another trigger for growth acceleration. In June, hemp-derived products were launched that includes Select Gummies and Zero Proof Seltzers. Curaleaf estimates that the market for US Hard Seltzer is to grow at a CAGR of 14% between 2024 and 2030.

The management view, launch of new products, and global market expansion increases optimism related to growth acceleration. I believe that Curaleaf stock will react when the guidance translates into actuals.

If we look at the financials, an obvious concern is sluggish growth. In terms of positives, there are few factors to note.

First, Curaleaf reported adjusted EBITDA of $304.5 million for 2023, and it implies an EBITDA margin of 23%. For the first half of 2024, the adjusted EBITDA and margin were $149.7 million and 22% respectively. The EBITDA margin is healthy in an industry where companies are still struggling to achieve EBITDA breakeven. Further, the management has guided for margin expansion.

Second, Curaleaf reported operating and free cash flow of $91.2 million and $25.8 million for FY2023. I believe that with possible cannabis rescheduling and elimination of 280E related taxes, cash flows can increase significantly in the next 24 to 36 months. This will provide Curaleaf with higher financial flexibility for organic and acquisition-driven growth.

Third, Curaleaf reported total debt of $563 million as of Q2 2024. Considering the trailing-twelve-month adjusted EBITDA, the leverage stands at 1.8. With EBITDA margin between 20% to 25% and expectation of accelerated revenue growth, I believe that credit metrics will improve.

From a valuation perspective, Curaleaf stock trades at a forward EV/EBITDA of 9.87 as compared to the sector median of 13.73. This implies a valuation gap of 28%.

There is a valuation gap even if we look at the Price-to-Sales and Price-to-Book metric. A meaningful correction for year-to-date is therefore a good buying opportunity.

This would imply an upside potential of over 150%. I, however, believe that this target is achievable only if all the catalysts discussed unfold. Having said that, it seems clear from analyst ratings that Curaleaf stock is undervalued.

The cannabis industry has been impacted by regulatory headwinds, over capacity, and cash burn for emerging companies. However, the addressable market is significant and there is a gradual move towards relatively friendly regulations. Curaleaf seems to be among the companies that's positioned to survive and grow. With the stock trending lower, I see a good buying opportunity.

In my view, the reclassification of cannabis as a Schedule III drug is the biggest catalyst in the given time horizon. Additionally, the management has guided for accelerated growth and EBITDA margin expansion. If that's seen in the next few quarters, I expect a sharp rally from oversold levels.

Based on the valuation gap and analyst estimates, the downside seems to be capped. On the other hand, the upside potential is significant.