Weekly Cannabis Report: Natural Selection By COVID-19
Summary
- The cannabis sector has underperformed the broader equities market as risk-off sentiment hurt many speculative cannabis stocks.
- Pockets of outperformance can be found in top players that possess fortress balance sheets, free cash flow, and growth runway.
- We believe the pandemic will weed out weaker players and force surviving entities to become leaner and more focused on profitability.
Welcome to our Weekly Cannabis Report, a reliable source for investors to receive the latest developments and analysis in the cannabis sector.
Trading Summary
We are resuming our weekly cannabis coverage. The global pandemic has upended the global financial markets, ending the 11-year bull market in the U.S. and wreaking havoc in many industries. In 2020 so far, the Horizons Marijuana Life Sciences Index ETF (OTC:HMLSF) has fallen 28% and ETFMG Alternative Harvest ETF (MJ) has lost 32%, underperforming the S&P 500 which is down 12%. The risk-off sentiment has hit the cannabis sector hard with only the strongest players set to survive in the long-term.
(Source: Bloomberg)
Canada: While global equities market plunged, cannabis stocks were not spared. Consistent with our long-term conviction, the cash-rich players fared better than companies with weaker balance sheets. Canopy (CGC), Cronos (CORN), and Aphria (APHA) performed much better than others, with each down 20-30% in 2020 so far. Weaker players such as Aurora (ACB), Tilray (TLRY), and HEXO (HEXO) suffered significantly more damages as capital became scarce. The extraction players dropped in-line with the broader cannabis sector as Valens (OTCQX:VLNCF) and Medipharm (OTCQX:MEDIF) suffered steep losses.
We have removed the following names from our watchlist due to their fallen market cap and weak long-term fundamentals: Supreme (SPRWF), The Green Organic Dutchman (TGODF), Aleafia (OTCQB:ALEAF), and Canopy Rivers (OTCPK:CNPOF).
(Source: Author, based on public data)
The U.S. and International: In general, the U.S. cannabis sector fared better than Canadian peers due to better growth prospects and stronger fundamentals going into the crisis. One of our top picks for 2020, Trulieve (OTCQX:TCNNF), was a top performer with only a 9% drop YTD, outperforming most peers and the broader market. Two of our other top picks, Curaleaf (OTCPK:CURLF) and Green Thumb (OTCQX:GTBIF), also performed better than most. Acreage Holdings (OTCQX:ACRGF) and Harvest Health (OTCQX:HRVSF) were two of the hardest-hit stocks due to M&A-related woes and balance concerns. MedMen (OTCQB:MMNFF) continued fighting for its survival after management changes.
Similarly, we removed several stocks from our watchlist including iAnthus (OTCPK:ITHUF), Green Growth (OTC:GGBXF), KushCo (OTCQX:KSHB), Pyxus (PYX), CV Sciences (OTCQB:CVSI), and Vireo Health (VREOF).
(Source: Author, based on public data)
Looking Ahead
Since our last update on March 4, the world has changed dramatically due to COVID-19. The cannabis sector has also been impacted in profound ways and we have summarized three key trends below.
First of all, we think the most direct impact on cannabis companies is the acceleration of natural selection and consolidation among the remaining players. Since the market turned in mid-2019, a number of weak players have already ceased operations or became distressed including CannTrust, James E. Wagner, Wayland, Invictus, and MedMen. However, the pandemic further exacerbated the financial burden on companies that have low cash balance, no access to additional capital, and negative operating cash flows. We think 2020 will result in the elimination of additional weaker players and further consolidate the remaining industry with stronger players picking up select distressed assets. Companies that are on high alert for potential stress include HEXO, Aurora Cannabis, Tilray, MedMen, and Harvest Health.
(Source: TMX)
Secondly, the cannabis sector is forced to adapt by accelerating online penetration and increasing operational efficiencies. Just like most industries, the mandatory shelter-in-place order throughout North America has placed a huge burden on the industry that generates its sales predominately from physical stores before the pandemic. For example, Ontario was in the process of issuing up to 250 retail store licenses that could materially increase its distribution network and generate additional sales. Certain markets in the U.S. have not developed mature e-commerce platforms but in select cases, companies have benefited from existing e-commerce infrastructure such as Trulieve in Florida. While it is still too early to judge the long-term impact on cannabis consumption from the pandemic, there has not been any evidence to suggest permanent damage to consumer demand for cannabis.
Lastly, the recent stock market rout and disruption to businesses only further illustrated the importance of liquidity and profitability. As we have repeatedly emphasized before, only the strongest players will be able to survive the oversupply issues and enjoy the benefits of an eventual rebound in profitability. In Canada, where the regulatory regime is more established, we think this pandemic will take out a significant portion of the industry supply as distressed operators cease operations in the coming months. Players like Canopy and Cronos are well-positioned to enjoy a potential tightening of supply in the future. In the U.S. where cannabis remains illegal on a federal level, we think the key to success is a company's ability to obtain profitability and access to capital to fund its growth pipeline. We have witnessed the aggressive dealmaking and land grab during 2019, many of which are unraveling now due to unsound strategic direction and poor execution. We believe investors will take a step back from the expansion mode and instead favor companies that are positioned to prosper with their existing assets.
In summary, we believe the pandemic has not fundamentally changed the outlook for the cannabis sector as a whole. However, the consequences of social distancing and capital markets winter will foster the natural selection among cannabis companies. Stronger players with capital will be able to weather the storm by cutting costs and shedding non-core assets. Weaker players will be eliminated which in turn helps rationalize the oversupply issues in markets like Canada and California. We believe investors should focus on only a small number of companies that have a demonstrated track record and path to profitability, as we highlighted in our 2020 cannabis sector outlook for both Canada and the U.S. market. We will also provide detailed updates on the top players.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.
This article was written by
Analyst’s 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.
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Comments (45)
What do you anticipate for the companies that don't survive? It's easy to see a future where Harvest, Medmen, and others aren't able to weather the storm. Does this create a unique growth opportunity for the surviving companies to swoop in and purchase the scraps off of creditors for rock bottom prices? Or do you see that process unfolding differently?
Thanks for sharing your thoughts. Cash will continue to be king in the US. I'd be really happy if I was Kim Rivers right now...generating cash from ops to buy up licenses on the cheap as the overly aggressive, early spenders shed licenses. A lot of people disliked the single state approach but it's proven to be the right move by a wide margin.
..... cornerstone ? : )