Advanced Flower Capital Inc. Q2 FY2021 Earnings Call

Thank you, ma’am. Good morning, and welcome to AFC Gamma, Inc.’s second quarter 2021 earnings conference call. I am joined this morning by Leonard Tannenbaum, Chief Executive Officer; Jonathan Kalikow, Head of Real Estate; Robyn Tannenbaum, Head of Origination; and Thomas Geoffroy, Chief Financial Officer. Before we begin, I would like to note that this call is being recorded. Replay information is included in our July 14, 2021 press release and is posted on the Investor Relations section of AFC Gamma’s website at afcgamma.com, along with our second quarter 2021 earnings release and investor presentation. Today’s conference call includes forward-looking statements and projections that reflect the company’s current views with respect to, among other things, anticipated market size, expected consolidation in the industry, future events and financial performance. These forward-looking statements are subject to the inherent uncertainties in predicting future results and conditions. Certain factors could cause actual results to differ materially from those projected in these forward-looking statements. New risks and uncertainties arise over time, and it is not possible for the company to predict those events or how they may affect it. Therefore, you should not place undue reliance on these forward-looking statements. We ask that you refer to our most recent filings with the SEC for important factors that could cause actual results to differ materially from these forward-looking statements and projections. During this call, we will refer to distributable earnings, which is a non-GAAP financial measure. Reconciliations of net income, the most comparable GAAP measure to distributable earnings, can be found in our earnings release or in the investor presentation available on our website. The format for today’s call is as follows: Len will provide introductory remarks, an overview of our results and strategic commentary; Jon will discuss the real estate lending environment; Robyn will discuss the origination pipeline; and Tom will summarize the financials. We will then open the line for Q&A. With that, I will now turn the call over to our Chief Executive Officer, Len Tannenbaum.

Thank you, Francesca, and welcome to AFC Gamma’s second quarter earnings conference call. I would like to thank our current shareholders, prospective shareholders, and analysts for joining us. Today, I will provide you with an update on AFC Gamma’s business, the many opportunities we have ahead of us, and the current state of the cannabis industry. AFC Gamma is an institutional provider of loans to the cannabis industry, typically secured by three pillars: cash flow, licenses, and real estate. The companies that we lend to are domestic single and multi-state operators, which include those that are privately held as well as those listed on the Canadian exchanges. During the second quarter, we closed on new commitments of $71.3 million, and as of August 1, 2021, we lend to 14 borrowers with operations in 14 states. We are pleased that we have continued to diversify our portfolio across states and borrowers. In mid-June, we experienced a significant increase in the actionable pipeline, which was driven by an influx of deals from large multi-state operators as well as smaller multi-state and single state operators. Notably, this increase in the pipeline excludes any capital tied to New York, where we recently allowed adult use cannabis, as the legislation there is not yet finalized. Since mid-June, our actionable pipeline has remained at elevated levels, which was the primary reason for the follow-on offering that we completed in June. As a reminder, the deals in our actionable pipeline, should they convert, could take between three and nine months to close. Many of the deals that we complete are high touch, require significant due diligence, and potentially require regulatory approval, making it difficult to predict the exact timing of closings. Our robust pipeline of potential borrowers includes many operators expanding into new states. Growth and demand for debt capital that we provide will come from the issuance of new licenses in states such as Georgia and additional new licenses in states such as Ohio, Illinois, and Florida. We are pleased that one of the recently issued Georgia licenses was awarded to our largest borrower, Nature’s Medicines. We have also noticed that our customers are accelerating construction to meet these state-imposed limitations on build time and to gain a first mover advantage. During the quarter, we received an investment grade rating of BBB- from Egan Jones Rating Company. This is an important step as we seek to issue debt. Our actionable pipeline’s conversion to signed deals is our intention to seek long-term, unsecured financing for part of our capital needs. We believe issuing debt and establishing a benchmark for our debt cost of capital is important as we continue to execute on our business plan. Conceptually, we believe that using leverage against lower yielding assets of the portfolio is a good way to generate strong returns on equity for our shareholders. In addition, we are pleased that AFC Gamma was added to the Russell 2000, and we expect the inclusion in this world-class market index will bring increased visibility across the investment community. Turning to the industry, the legislative environment surrounding the cannabis market continues to evolve. Senator Schumer of New York recently put forth the Cannabis Administration and Opportunity Act, which if passed in its current form, would among other things, remove marijuana from the Controlled Substances Act. Given the current political landscape, we believe it is very unlikely this piece of legislation will succeed. That said, we remain optimistic that legislation consistent with the goals of the SAFE Act will eventually pass. The SAFE Act may allow for credit cards to be used at cannabis dispensaries and should certainly increase the number of banks accepting deposits from the industry. We recognize that increased competition because of the SAFE Act may drive lower yields for borrowers; however, the SAFE Act will also potentially lower AFC Gamma’s cost of capital as more banks could lend to us and more institutions can invest in us. Additionally, we continue to believe the states will have the right to set regulations around their own cannabis programs and will attempt to protect the significant source of tax revenue and job creation that cannabis provides in these states. The M&A boom that we mentioned during last quarter’s earnings call continues, with many large public multi-state operators using a combination of equity, debt, and cash as methods to acquire smaller single state operators. We believe that we are in a one to two year period of rapid consolidation, with the big operators continuing to get bigger. Our goal is to be the lender of choice to at least half of the top 15 multi-state operators, as well as companies that are seeking to achieve scale or be acquired by an MSO. We lend at different rates to the top MSOs, mid-sized operators, and smaller state operators. We are seeing some yield compression for the top-tier multi-state operators due to their size, scale, and access to capital. Going forward, we will continue to employ a high degree of selectivity in the deals that we underwrite and invest in. We have further expanded our team to over 20 employees and continue to build our corporate infrastructure to support our business plan. We are pleased to announce the hiring of Brett Kaufman, the new Chief Financial Officer for AFC Gamma. For the past 12 years, Brett served as CFO at Ladenburg Thalmann, a diversified financial services company, which generated $1.5 billion in trailing 12-month revenue prior to its sale in 2020. Before that, he spent nine years at Bear Stearns, serving in various roles of increasing responsibility, including Managing Director and Director of Financial Planning and Analysis. We are very excited to have Brett join our team and look forward to introducing him to our investors and analysts in the coming months. We would also like to thank Tom Jeffrey for his contributions, hard work, and diligence as AFC Gamma’s CFO. Tom will continue in his role as CFO of AFC Gamma’s external manager, AFC Management. Turning to our dividend policy, the Board of Directors intends to declare a dividend for the September quarter on or about September 15, which will have a record date of September 30 and be payable on October 15. It is anticipated that the quarterly dividend declared by the Board will be greater than or equal to the $0.38 dividend that was paid in the June quarter. This dividend schedule is similar to many other REITs. We intend to follow this schedule for future quarters as this timing provides our Board with additional visibility into the earnings of that given quarter when declaring the dividend. As a reminder, our dividend policy is to pay between 90% and 100% of distributable earnings over the year with a special dividend at the end of the year if necessary.

Thank you, Len. One of our core competencies and key differentiating factors as a lender focused on cannabis is our expertise and experience in construction financing. Construction lending itself is complex, and cannabis adds an additional layer of complexity. For example, cannabis facilities require unique heating and cooling units to regulate the temperature effectively to create the optimal growth environment. These units may require the buildings to be reinforced and must be installed correctly to prevent mold. Our in-house construction manager and team of construction professionals ensure that the borrower and its contractors understand these nuances. As a secured lender, we want to make sure the collateral securing our loans is built to the best possible standards by builders with requisite size and experience. As of August 1, about 70% of our loans by face value are our construction loans. Construction loans are drawn over time, and with each draw, we must make sure we have all needed lien releases and ensure our borrowers remain in material compliance with state and local ordinances, while building in line with the construction plans. Construction loans are relatively new to the cannabis industry; in fact, prior to AFC Gamma, sale leasebacks were a major source of external financing available to cannabis companies. Under a sale-leaseback, a cannabis company sells its property and takes a long-term lease with annual rent escalations, locking into such long-term and potentially expensive obligations is no longer necessary. The potential for legislation, such as the SAFE Act, along with more flexible financing options, encourages borrowers to own their real estate and to take loans they could refinance in three to five years, expecting the financing costs will decrease over time. Loans such as those provided by AFC Gamma will provide more flexibility over the near and long term.

Thank you, Jon. As a relationship lender, we strive to help operators in their businesses succeed while acting as a flexible partner to help meet capital needs along the way. Incumbency has proven to give us an important edge when sourcing potential deals as we’ve expanded loans with a variety of our existing borrowers as they continue to grow both organically and via acquisitions. For example, when one of our borrowers decided to purchase a dispensary rather than lease it, we were able to provide a simple amendment to increase the size of the loan to provide them with the capital they needed to execute on their business plan. Once we complete a loan, we have all of the documentation in place to grow with that borrower. In addition to our construction expertise that Jon mentioned, another key differentiator is AFC Gamma’s available capital and the ability of its external manager to act as lead agent. This allows our borrowers to deal with one lender when changes or amendments need to be completed, versus going to a larger syndicate of lenders. AFC Gamma seeks to hold the majority of a borrower’s debt tranche, and our external manager’s ability to act as lead agent is another differentiating factor that provides our borrowers with flexibility and speed of execution. As of August 1, 2021, AFC Management agents managed about 76% of our loans by face value. From January 2020 through June 30, 2021, we have sourced over $6.7 billion of transactions, which represents over 344 deals. We have built strong relationships with our borrowers, and we believe our reputation in the industry for being a trusted lender continues to grow.

Thank you, Robyn. We ended the second fiscal quarter of 2021 with total assets of $278.5 million compared to $221.5 million at March 31, 2021. Portfolio investments totaled $164 million of principal outstanding, with a carrying value of $153.3 million spread across 13 companies as of June 30, 2021. In July 2021, the company completed its secondary offering, which resulted in the issuance of 2,750,000 shares at $20.50 per share, with total net proceeds after fees and expenses of $52.6 million. In July 2021, the underwriters partially exercised their over-allotment option to purchase an additional 269,650 shares at $20.50 per share, resulting in $5.2 million in net proceeds to the company after fees and expenses. Currently, AFC Gamma has 16,386,527 shares outstanding. At the end of the June quarter, book value per share was $16.66 compared to $16.18 and $14.83 for the quarters ended March 2021 and December 2020, respectively. As of June 30, 2021, AFC Gamma's portfolio consisted of $187.7 million of transactions, with $163.7 million funded. As of August 1, 2021, we completed $195.3 million of transactions with $175.3 million of principal outstanding to 14 companies in 14 states. All of the loans in the portfolio are current and performing. The weighted average portfolio yield to maturity, which is measured for each loan over the life of the loan, is approximately 21% as of June 30, 2021, compared to 21% as of March 31, 2021. The weighted average yield to maturity of the portfolio as of August 1, 2021 was also approximately 21%, which is consistent with the last two quarters ended March and June of 2021. For the quarter ended June 30, 2021, we had GAAP net income of $4.6 million, or earnings of $0.34 per basic weighted average common share. For the three months ended June 30, 2021, we generated total investment income of $8.7 million and distributable earnings of $5.8 million, or $0.43 per basic weighted average common share. Distributable earnings represents net income computed in accordance with GAAP, excluding non-cash items such as non-cash equity compensation expense, unrealized gains or losses, and provisions for current expected credit losses, commonly referred to as CECL, or other non-cash items recorded in net income for the period. CECL was early adopted by the company in fiscal year 2020; as of June 30, 2021, the CECL reserve represents approximately 1.1% of loans at carrying value, compared to approximately 1.3% at March 31, 2021. Adjustments to arrive at distributable earnings of $0.43 per basic weighted average common share of common stock amounted to $0.09 per basic weighted average common share in aggregate and included both the impact of non-cash adjustments to the CECL reserve and changes in unrealized gains. We believe providing distributable earnings is helpful to stockholders in assessing the overall performance of our business. As a REIT, we are required to distribute at least 90% of our annual REIT taxable income. We believe that dividends are generally one of the principal reasons stockholders invest in our common stock, and we generally intend to pay dividends to our stockholders in an amount between 90% and 100% of our annual taxable income. On June 30, 2021, AFC Gamma paid a dividend of $0.38 per common share outstanding for the June quarter, which represented approximately 87% of distributable earnings for the quarter. The company has distributed $7.3 million of distributable earnings for the six months ended June 30, 2021, or approximately 80% of its distributable income. The Board of Directors intends to declare a dividend for the September quarter on or about September 15, which will have a record date of September 30 and be payable on October 15. It is anticipated that the quarterly dividend declared by the Board of Directors will be greater than or equal to the $0.38 dividend that was paid for the June quarter. In May 2021, the company amended its secured revolving credit loan agreement to, among other things, increase the loan commitments from $40 million to $50 million, decrease the interest rate from 8% to 6% per year, and extend the maturity date up to December 31, 2021. Currently, no draws on the revolving credit facility occurred during the fiscal year to date, and no interest or fee expenses were incurred related to the revolving credit facility. The revolving credit facility is an important component of the company’s business strategy to offer greater flexibility, manage liquidity, and bridge its investment commitments for future capital raises, thereby potentially reducing the impact of cash drag on returns to investors.

AFC Gamma has a best-in-class team, a strong balance sheet, and increased access to capital. During the second half of 2021, we are well-positioned as a first mover and leader in the rapidly growing cannabis lending market. I will now turn it back over to the operator to start Q&A.

We have the first question from Gerald Pascarelli of Cowen. Your line is now open. You may ask your question.

Great, thanks and good morning team. Thanks very much for taking the questions. Len, I think it’s definitely encouraging that the notable pipeline increase that the company has seen from early June through current dates and include New York. But just sticking with the Northeast, can you just talk about how you view the potential white space opportunity not only in New York but in states like Connecticut, Virginia, and New Jersey that recently legalized for adult use that are presumably going to require notable capital expenditures to build out capacity over the medium to long term. Any color you could provide there would be helpful. Thank you.

I think it’s very exciting that a lot of people that have been sitting on their licenses are finally starting to take action in building those licenses to benefit the consumers in that state. The states are realizing that they issued these licenses with the purpose of having cultivation and dispensaries built. States like Missouri are watching as they pull licenses from people that haven’t started building or are not building according to plan. So that goes for New Jersey as well. There are several New Jersey licenses that just happened and haven’t been built yet. What we’re seeing is a huge demand for capital to start building out these licenses as per the agreements that were established when they were issued, which is a large supply-driven demand.

Got it. That’s helpful. Another one from me is just on the competitive landscape as of today. You are the only cannabis mortgage REIT trading on a major exchange. I guess like over the past few months in your conversations, what are your expectations for the evolution of the competitive landscape maybe over the back half of this year into early 2022 with more competition coming online to capitalize on these high yields.

From a public standpoint, not just with the public currency being really important, it’s very hard for a new competitor to scale. Every day that passes increases the moat around our position and our competitive position at least from a public standpoint. I will say that there is plenty of competition to our large multi-state operators; there are large private companies, large hedge funds, and large institutions investing with the multi-state operators. It’s really about relationships and what we can deliver to help them in their business plans. We continue to be a partner in helping them, providing them with more capital because there is plenty of capital available at very high levels where the new institutions and large institutions feel most comfortable.

Thank you. Next question comes from the line of Aaron Hecht of JMP Securities. Your line is now open. You may ask your question.

Hey, everyone, good morning and great job putting capital to work this quarter. Had a question around that, the active pipeline obviously up pretty significantly, about $300 million give or take, quarter to quarter. The terms in that pipeline, the yield profile, is that changing much? And I guess part of that is going to be involved with the larger MSOs and kind of the exposure there. So any insight on the exposure to the larger MSOs within that pipeline would be helpful. Thanks.

The pipeline itself has a mixture of the large MSOs, which are much safer and lower yielding, the mid-tier providers focusing on a couple of states, and the single state operators, which are starting to build a license. So we’ve backed them with a certain amount of equity. There are some seller notes, or sometimes unsecured debt, and then we will lend the senior debt with first liens on the property. They all hold different yields. As we look forward to the deals that we’ve done, the deals we announced would look at the quarters with health consistent with over 20% weighted average yield held to maturity. By the way, when I say that we all know that assets aren’t held to maturity. There’s going to be velocity. Therefore, the yields are actually higher if a deal pays off early. So when we say it’s 20% held to maturity, it’s actually conservative. It depends on which deals we close and when, and how that weighted average yield changes. Our intention is to relever the return to increase the return on equity for the investors just by applying a better cost of our cost of leverage versus their cost of leverage and capturing a spread. So it’s hard to tell where weighted average yield goes. It depends on the mix, but we’re very focused on the return on equity to our shareholders.

Great. All right, makes sense. And then the deployment pace, obviously very strong in the second quarter. If we look into the first month or so of the third quarter, it’s a little bit slower, but the commitments are up in total. Any insight you can give us on the pace of deployment over the remainder of the year or how we should think about it as a chunky situation?

You’re right. I’m a little disappointed that some deals didn’t close in the beginning of the quarter, which could have. You can see in our 10-Q and our disclosures that we got partway on some loans and they haven’t closed all the way yet. It is chunky; we are sitting in August, which is interesting; it’s typical for many deals. In the past, when I’ve managed money, there was definitely a spurt after Labor Day and that’s what everybody likes to close. This could be the back end of the quarter, and all that may slip into October, November. We just don’t know because these deals are cannabis-related and timing of closing is very uncertain. We plan to continue announcing material agent closings as they occur, and I think that will be the best indicator of our advancement.

And then one more from me, if I could, you did make the comment that New York wasn’t included in the deal pipeline, then why are you already looking at deals there? What does that mean for the more near-term as opposed to the long-term?

I would think New York is a next year event from a deal flow perspective because New York still hasn’t figured out its own regulations. The opt-out programs for the different locales won’t be finalized until December 31. Many people are talking to us about New York, but there are no definitive plans around how much they need or how big they want to build. But New York is just one opportunity; I think Florida is going to be very active, I think Georgia, which has announced licenses will start being active, even with only six winners. I think Ohio, with its 72 dispensary applications, will start to build them out, which also means they’ll need cultivation. We’re seeing Illinois stagnate due to lack of retail distribution, but new retail allocations are expected. Therefore, we anticipate demand. All of this flows into capital expansion as new licenses across the country are issued. We are also considering California now, where we haven’t done anything yet. We’re considering opportunities there especially given the $1.2 billion compensation we saw as the black market starts to get restricted. California is becoming more interesting to us.

Thank you. We have the next question from the line of John Hecht of Jefferies. Your line is now open. You may ask your question.

Good morning, guys. Thanks very much for taking my questions. I’m just wondering how do we think about cost of capital opportunities and how you would toggle that average given the rating you just got.

We have one benchmark out there, which is the industry leader in sale leasebacks, IPR, whose debt about $300 million trunk trades. That trades pretty liquidly at sub-4.5% yields on the 5-year unsecured piece. Their Egan Jones rating is BBB+. So those are all facts. I’m not saying we have anything close to 4.5% cost of capital, but at least that’s the benchmark which people are looking at. We are getting a pretty good idea of where the market is moving, but I don’t want to put on leverage until we are close to putting on the assets that I would want to take leverage against. So it’s always a timing issue. We do have a credit line we could use as well and we anticipate putting on leverage in the medium term.

Okay. And then you guys have remarkably stable yield to maturities in your book. Assuming you hit your objectives for the year, do you still think you’d be in the low 20% range, or how do we think about the migration of that over time given the pipeline and so forth?

This year, we’re on plan. We have an aggressive plan, and we’re currently on it. Next year, we know we’re going to experience growth, but we don’t know where that growth is going to come from. It could be in all three segments. Watching the forward-looking discussions, M&A activity is driving growth where you see acquisitions of companies at multiples of, say, seven times EBITDA, tiered out by equity to sellers and senior debt where we typically hold three times senior debt—similar to what I used to do in normal middle-market lending. There’s a variety of drivers for growth as this market is fast-paced. We’re pleased that the yields right now are holding up over 20%, and if the SAFE Act passes, we could see some yield compression. But those refinancings could raise our earnings even higher as we’d have prepayment penalties, write-ups, and exit fees that could further contribute to income.

Hi guys. First question for me is on the pipeline; it looks really solid out there. Do you have everyone on the team that you feel you need at this point, or are there additions in human capital you need to consider making?

Okay, I got to make an advertisement for more employees, which is always a positive on the call, so thanks for asking the question. We’re looking to hire many people. We’ve grown nicely to over 20 employees, and we’ve added Brett recently, which adds institutional strength to the infrastructure and team. We’re continuing to hire; we need another originator for sure, because as good as Robyn and Chris are at uncovering opportunities and managing processes, we continue to need more touches. Origination is a very intensive process. We are hiring more underwriting staff; our underwriting team is coming up to speed very nicely. We have in-house construction management, which has been a huge plus for our customers and our underwriting. We have probably four or five open positions at any given time, and we expect anyone who knows people looking for a terrific job in a fast-growing company in this industry to send them our way.

Perfect. And then you touched on it a bit and earlier in your commentary early in the Q&A, but looking at geographic expansion, a lot of people are talking about New York, and people are focused on the Northeast. But as we look at the rest of the country, what other states seem attractive as you consider moving into smaller states where licenses might be appealing? Will increased competition push you into smaller states at some point?

We are looking throughout the country at the limited license states and their supply and demand dynamics. We now have much more data than we did a year ago, especially via the supply and demand equation. We know price per pound and how it fluctuates seasonally. Our new data helps us apply seasonal changes in price and demand on a state-by-state basis. Smaller states like Arkansas are definitely on our radar. However, there are not a lot of players in the smaller states and not much room for new entrants. I think demand will continue to be driven by states like Illinois, Ohio, New York, and West Virginia. Maryland needs a lot of growth and build-out, which seems to be happening. In Virginia, if they expand their licenses further, that’ll be a good growth area. Also, Arizona is a terrific state; it has one of the highest throughputs in the country, and the distribution side is very valuable. So our interests are everywhere, and a third or 40% of the volume is in states where we do not yet lend. So we’re starting to evaluate select opportunities in California that could expand our vision by 30% to 40%.

Thank you. There are no further questions at this time. I would like to turn the call over to Len Tannenbaum.

Thank you so much, and thank you all for listening to the call.

Thank you. This concludes today’s conference call. Thank you all for participating. You may now disconnect.