Weekly Cannabis Report: The Demise Of Canadian Small-Caps

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Includes: ACB, ACRGF, CRLBF, CRON, EMHTF, GTBIF, HMLSF, HRVSF, HSDEF, ITHUF, MJ, SNNVF, SVVTF, TLRY, WDDMF, ZBISF
by: Cornerstone Investments
Summary

Cannabis stocks continued to drop last week amid Q2 earnings.

Small-cap cannabis stocks in Canada are suffering from a prolonged selloff and we think the worst has yet to come.

U.S. earnings have so far outperformed Canadian and we continue to overweight U.S. stocks due to superior growth profile.

Welcome to our Weekly Cannabis Report, a reliable source for investors to receive the latest developments and analysis in the cannabis sector.

Trading Summary

Cannabis stocks continued to decline last week. Horizons Marijuana Life Sciences Index ETF (HMLSF) fell 2.6%, ETFMG Alternative Harvest ETF (MJ) lost 3.1%, and Horizons U.S. Marijuana Index ETF dropped 0.6%.

(Source: Bloomberg)

Canadian Large- and Mid-Cap: Canadian large-caps declined across the board reflecting the current downturn. Tilray (TLRY) dropped 9% after acquiring a Canadian cannabis retail chain for C$110 million.

Canadian Small-Cap: WeedMD (OTCPK:WDDMF) rose 3% after reporting a big jump in revenue. Emerald (OTCQX:EMHTF) dropped 8% after reporting Q2 results. Zenabis (OTCPK:ZBISF) rebounded 8% after falling 28% in the prior week due to a financing deal.

(Source: Author, based on public data)

U.S. Large-Cap: Last week was busy as many MSOs reported earnings. Post earnings, Cresco Labs (OTCQX:CRLBF) gained 10%, Harvest Health (OTCQX:HRVSF) gained 6%, Cresco Labs (OTCQX:CRLBF) gained 5%, Green Thumb (OTCQX:GTBIF) gained 8%, and iAnthus (OTCQX:ITHUF) dropped 2%. Acreage Holdings (OTCQX:ACRGF) dropped 20% as we think the stock is facing the biggest fear we outlined when it sold itself to Canopy earlier this year.

U.S. Small-Cap and Ancillary: Sunniva (OTCQB:SNNVF) dropped another 10% after reporting a 64% drop in revenue. TILT (OTCQB:SVVTF) fell 14% after reporting lower-than-expected revenue growth. Harborside (otc:HSDEF) gained 42% after announcing Q2 results along with a Normal Course Issuer Bid which allows repurchases up to 5% of its shares.

(Source: Author, based on public data)

Industry News

Looking Ahead

When we issued our 2019 Top Cannabis Picks, we explicitly warned investors that the Canadian small-cap space will likely face a bumpy ride this year. As the Canadian market got off to a tough start, the sector is facing tough financial realities after several quarters of disappointing results. Most of the companies lack substantial revenue and are highly unprofitable. Even the largest players are struggling to get it going - just look at Canopy Growth's disastrous Q2 2019 results and its free-falling share price. We also expected the sector to evolve into a small number of successful large corporations with the rest of the small guys facing a limited set of choices:

  • Gradually go out of business amid lack access to capital
  • Acquired by larger players with little to no premium or combine with other small to mid-cap peers for scale in order to survive
  • Be very good and very efficient but valuation will normalize to a traditional CPG company based on sustainable EBITDA and earnings
  • Continue to see their valuation deflate to the point where it doesn't make sense to stay as a public company anymore

The struggle facing the small-cap space can be seen in the chart below which shows the 2019 YTD performance of a basket of stocks. The best performer is WeedMD which is up 22% this year. Most of the stocks are down significantly this year with Zenabis and FSD Pharma falling 82% and 65%, respectively. In contrast, most of the large-caps are still slightly in the green including Aurora (ACB) and Cronos (CRON). Tilray is the worst performer among large-caps but it has its own issues and remains one of the largest cannabis stocks in the world even today.

(Source: Bloomberg)

Our view towards the Canadian sector remains the same: valuations remain hefty due to the lack of profitability. There is very limited near-term upside from international markets and companies have to prove their ability to operate profitably before we could get comfortable with their valuation. It has taken most LPs way too long to scale up their operations, partially due to delay at Health Canada, but it just seems like a futile task to assess valuation for the industry at this point. Eventually, an 8-12x EV/EBITDA could be the range for most Canadian cannabis companies depending on the long-term growth profile of the legal market. In the meantime, we continue to overweight the U.S. cannabis market and the largest players in Canada. We believe the small-cap names remain too risky for average investors.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.