- End-to-end value cannabis stocks operating in Canada are flying high, but a retracement to near fair value is imminent.
- The cannabis industry is changing due to vertical integration being scrapped and an influx of competitors.
- Equity values of key players are well below the current market prices; EV/EBITDA multiples are not looking up.
- The current options volume is unusually high with up to 100,000 options contracts traded on individual companies per day and 35% retail participation.
- Rising interest rates will likely cause a growth stock bubble, which includes cannabis stocks.
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We've generally seen choppy waters when it comes to cannabis stocks, but high mean absolute deviations are perfectly normal within a new industry where regulatory implications often cause bumps in the road - for both the profitability of companies and the growth in their stock prices. However, there's more to the regulatory obstacles than meets the eye, and short-term market sentiment leads us to believe the industry provides brilliant short opportunities.
For the purposes of this article, we've focused on stocks that have adopted the end-to-end value model in Canada. We also focused on large-cap cannabis stocks and excluded analysis of small-cap stocks. In determining which stocks to use as benchmarks, we looked at factors such as market cap, growth over the past 12 months, and trading frequency. Inclusions have been analyzed as ex-post and ex-ante. There are references to political events during the article, but the article isn't an analysis of the political climate.
End-to-End Value or Vertical Integration
The Canadian Cannabis Act, which allowed for commercial production and sales of medical and non-medical cannabis came into effect in August 2016, the legal requirement was that vertical integration had to be adopted if an entity wanted to participate. Legislation meant that end-to-end value was a requirement for a Good Manufacturing Processes license (this was used as a seed-to-sale license) where participants had to provide a seed-to-sale solution. Since then, the industry has become somewhat fragmented as deregulation changed the construct of the supply chain. Our focus is on the part of the sector that is still adopting the seed-to-sale method, including seeding, cultivation, distribution, and retail. We've eliminated top-heavy retail stocks in our analysis, as well as cultivators who operate in various industries as they form part of other peer groups. Our short bias targets companies who still adopt the end-to-end value model but are weighted toward cultivation and distribution.
Past and Current Performance
Cannabis stocks' performance has very much been bound to deregulation and globalization of businesses. Spikes and retracements in stock prices have occurred during regulatory waves and volatility has been amplified by short sellers and profit takers. We've taken a look at the performance of the Global Cannabis Stock Index over the past 10 years, as well as the past year for two different vantage points.
10-year Global Stock Index
Source: New Cannabis Ventures
1-year Global Cannabis Stock Index
Source: New Cannabis Ventures
Cannabis stocks have seen terrific gains since the start of 2021, with the global cannabis stock index gaining, trading up from $44.39 at pre-market on January the 1st to $92.48 by February the 10th, although prices have retraced to the mid $70s in the latter parts of February. Zacks Equity Research states that the main reason behind the surge is that investors believe the Biden administration will provide industry deregulation, making trade deals more accessible. Our belief is that this will have a knock-on effect on the industry as a whole, including the Canadian environment.
By looking at the cannabis index graph above, you'll notice that spikes and crashes have been a regular occurrence. Price volatility is normal in a new industry, especially one which is yet to experience significant deregulation; cannabis stock prices have also been very much bound to news instead of potential financial performance.
No scarcity and niche market
Cannabis has often been referred to as "Green Gold," but what participants and investors fail to understand is that cannabis grows quickly.
Canadian Supply & Demand Chart
Source: BNN Bloomberg
There is a lack of ex-ante statistical graphs available, we've presented the Canadian supply and demand graph reported by Bloomberg to paint a picture. The Canadian market is considered more mature than other/foreign markets and we'll use this supply/demand graph as we discuss exports later on. By looking at the graph we can see that in 2018 demand expectations were high but people in general failed to consider a few aspects and they still do.
These aspects are as follows:
- Nobody is considering how easy it is to boost supply growth. Marijuana in both forms' (hemp and medicinal) time to harvest is 2-3 months; this is the same as Corn's 60-100 days! In addition to that, according to Aleafia Health, one can produce roughly produce 102,000kg of Cannabis on a 3.7M sq. ft site per year!
- Our second factor is regarding the long-run aggregate demand; sure short-run aggregate demand has seen a spike, but who's to say that long-run aggregate demand will be sustained? There is no clear indication that cannabis will all of a sudden replace the traditional medicines market, replace the bulk of snacks on our shelves or be the choice of recreational substance.
Effect on Demand due to a growing Export Market
Canada has seen a growing cannabis export market as global deregulation has taken place. According to Health Canada, the bulk of the Canadian exports since 2019 have been concentrated on a few countries -- namely Australia, Denmark and Germany.
Canadian exports have increased at an exponential rate, there's been an increase of 151% in exports of dried flower as well as a 169% increase in oil exports.
The increase in exports looks great at face value but according to Marijuana business daily, the marginal revenue hasn't improved while marginal cost has increased and many companies are considering cutting international market operations for now. Our thinking behind the reason for an increase in marginal cost would be because of an increase in fixed operating costs while the company is expanding. We think that marginal revenue is impacted by an estimated lower price for cannabis as demand increases due to further deregulation, Marijuana Business Daily also states that foreign buyer markets are developing slower than Canada.
Let's consider a couple of factors when it comes to exports in a new industry:
- Does short-term growth in exports justify sustainable export growth? We hypothesize that it doesn't and this is due to the fact that export growth isn't sustainable in the event that more resources are being supplied than required, our Canadian supply and demand graph from earlier indicates that supply will likely eventually exceed demand due to the product's lack of scarcity.
- Nobody's considering the possibility of a diminishing comparative advantage.
Source: Wall Street Mojo
According to the CFA Institute, a comparative advantage is beneficial to a country's export market and can be achieved by efficient resource allocation (including labour and capital). Wall Street Mojo adds to the argument and states that in order to maintain a comparative advantage, you need to be able to export to jurisdictions which don't have the same production ability. Without going into too much depth about the theoretical side of things, we just think that there might be less costly resources abroad and that cannabis can be grown in most legal/future legal jurisdictions (especially since it can be grown indoors and the matter of there being better climactic areas than Canada), which will potentially see a diminishing comparative advantage.
According to PWC, the Cannabis Act replaced the ACMPR act in October 2018, which allowed for greater flexibility within the industry and removed vertical integration requirements in Canada. Although the act allowed many market entrants, big players still either own the entire value chain or participate in the chain in an evenly distributed manner. As the industry becomes more fragmented due to vertical integration not being an issue anymore, competition arises. The knock-on effect of fragmentation caused an increase in competition due to lower barriers to entry and diminishing pricing power, eliminating the potential game theory.
We think cannabis stocks and specifically end-to-end value stocks are valued irrationally in the market, and we've made an effort to outline why and presented asset-based valuations on our selected key players to illustrate fair versus actual market value. We opted for current data from Yahoo Finance, but in certain instances, these weren't populated, and we used implied models from Finbox.
Source: Yahoo Finance
Although the price/book value for Aurora (ACB) is reasonably good, this is due to good cash flow management; the real figure which is a cause for concern is the EV/EBITDA multiple. Operating costs are high, and with increasing operating income deficits, the company will continue to be worth less than its trading in the market, which has been in a range of C$12.11 and C$23.96 YTD.
According to Seeking Alpha, Tilray (TLRY) has a tangible book value per share of $0.13, which is well below the range of $9 & $63.91, which the share has been trading in since the start of 2021. When looking at the financial statements, it's worth noting that the company's running on a debt/equity ratio of 91.28, which is understandable since it's an acquisition vehicle, but this, along with a -46.63 EV/EBITDA ratio as well as potential further cash acquisitions will drive down the equity value of the company in our opinion.
Source: Yahoo Finance
Again, Seeking Alpha reports a tangible book value for Canopy (CGC) of only $8.32 which is much lower than the market value range in 2021 of C$33.41 to C$66.21. Negative EV/EBITDA is witnessed again, a big concern for us is the fact that the company has 604.9 million of total debt on the balance sheet, it seems as though they tried to reduce capex in 2020 to stabilize liquidity & solvency, the 68.5% reduction in capex still leaves the company with a -96.9 million levered free cash flow, which isn't going to help their cash balance decrease of 51.2% in 2019, and 30% decrease in 2020. These factors combined could lead to a much lower equity value in the future.
Source: Finbox (Unedited)
Yahoo Finance didn't reflect data on Aphria (APHA), so we used a 12-month implied model from Finbox, which actually illustrates our argument well. Financial statements for Aphria show that the company has improved on free cash flow, which has caused a higher equity value; their free cash flow per share has been improved from -0.75 to -0.66. This has largely been due to gains in minority interest of 42.1 Million, as well as reductions in capex of 23.63%. A sample of analysts' consensus' drawn by Simply Wall Street shows that the company has less than one year in cash runway left, shareholders have been diluted in the past year and might be diluted further should the company run out of cash and raise additional capital. The stock has been trading in a range of C$25.10 and C$27.70 in 2021.
Valuation In a Nutshell
End-to-end value stocks in the cannabis industry are fueled with debt, which will absorb equity value, cash levels aren't sufficient to cover these debt levels, and if the companies wanted to add more cash to their balance sheets, they'd need to issue more shares which would see shareholders diluted in any case. Negative EV/EBITDA multiples reflect the fact that these companies are still in their early stages. We, however, don't expect this to change as our bearish industry analysis specifically outlines diminishing profitability outlook due to an industry eventually reaching perfect competition instead of remaining an oligopoly in the way it was when our vertically integrated key players were first established.
We've taken a look at the broader market consensus and broke down ratings on our key players within the end-to-end value bracket. We had a look at the likes of Zacks Equity Research, TipRanks, and Barchart.
According to TipRanks' sell ratings, the fundamentalists in the market such as Needham, GLJ Research, and Wells Fargo are in sell territory on various end-to-end value companies. After listening to an interview from Matt Bottomley, who's one of the Directors at Canaccord Genuity, we thought that by paraphrasing him would sum up the current consensus; he said that there's exuberance in the markets instead of fundamental value and that investors should take a step back and think about whether the current prices makes sense. Matt went on to say that the industry looks saturated, revenues look flat, and that retail investor hype has driven the stocks away from their fundamental value.
It's clear that with a Zacks Rank of 4-sell and TipRanks' analyst consensus of 7 sell recommendations, 4 holds, and 0 buys that there isn't much optimism to speak of from the fundamentalists. This TSX stock sits at a 12-month price target of C$11.99, according to a TipRanks mean sample from big banking analysts.
Both Zacks and TipRanks place a Hold position on Tilray; we assume this is because market sentiment might be filtered into ratings, analysts might believe that they can't provide a buy or sell rating until the stock acts in a rational manner. When saying: "In a rational manner," we're referring to the Reddit wave that has influenced the stock's price of late. Bloomberg reported on February the 10th that Reddit-inspired traders have turned their attention to cannabis and Tilray specifically after the GameStop (GME) frenzy had cooled down. We're very sure that some sell ratings will come out on this one once speculative activity settles down.
Canopy growth falls into the same boat as Tilray; when we cover options activity after this section, you'll see why. Zacks have placed a Sell-4 rating on the stock, and TipRanks' consensus is a hold; we're again sure this will turn into a sell as soon as call options activity slows down.
Rated a 4-Sell by Zacks rank, we also saw noted that the company is trading at a negative EPS of -33%. Although this is a cannabis stock, which makes it unsurprising - the broad consensus regarding growth stocks is that as soon as interest rates rise, investors will shift to value, and if you're looking to categorize a stock according to growth, then an EPS of -33% pretty much does that for you already.
Mike Khouw from CNBC provided an example of Options activity in January for Canopy Growth; he reported that on average approximately 100 000 contracts were traded daily on Canopy Growth. To contextualize this, an S&P 500 company typically has an options volume of around 23 000 contracts per day. This example provides an illustration of the artificial movement in price, especially considering the bandwagon effect currently present in the markets. We think that factors such as the loss aversion bias of investors, profit takers of underlying assets, and the fact that available short contracts outweigh long contracts by 1.3x will create a potentially dangerous scenario. We referred back to our cannabis index and the sharp downward patterns to consolidate our thought process. David Borun from Zacks Equity Research says that implied volatility of the options market presents a fantastic sell-opportunity as you want to sell options as the market's implied volatility is high.
Source: Wall Street Journal
By looking at the VIX from a 3-year vantage point, we saw the largest spike in 2020; we also noticed that it's recently been trading higher in general, and this has persisted since the start of 2019; based on the mentioned consensus by Zacks Equity Research, we think the VIX is priced high and that selling short at the top of the next spike will be the one where put options will end up in the money, especially cannabis put options.
According to Business Insider, retail participation in stocks and options has grown up to 25% when measured in June 2020, comparing this to around 7% when measured in 2018, a conclusion that can be drawn is that speculative activity has increased and will increase as retail investors make up for a larger part of the trading volume.
To further contextualize the speculative nature of cannabis stocks. Joe Saluzzi from Themis Trading reported that 35% of options in cannabis stocks were traded by retail investors in January 2021. Finishing our argument regarding a bearish options outlook, we recognized that mass sell-offs of retail traders are skewed towards a few factors, namely: flocking, loss aversion, and bandwagon effects. This will have a knock-on, on options in our opinion.
When Will the Bubble Pop?
In order to answer this question, we're considering cannabis stocks as growth stocks due to our valuations we covered earlier. In addition, we think that they'll be one of the first growth stock sectors to experience a sell-off; this is backed by looking at historical price volatility in our Cannabis Stocks Index as well as the fact that they're trading far above fair value.
We think that when interest rates kick in, and bond yields move higher, we'll see a sell-off by investors and subsequently see a lot of downward options activity. Cannabis stocks are perceived growth stocks, and growth stocks tend to do well in low interest rate environments because of lower discount rates causing higher free cash flows as well as cheaper borrowing costs, causing margin trading to become popular.
Interest Rates vs. Growth Stock Performance Chart
Source: Fred for Interest Rates
Taking a look at growth stocks multiples versus historic interest rates we used the U.S. market as a global benchmark. We used a price-to-cash flow chart as our main argument for price movement. Our rationale for this is that the free cash flow, as this is ultimately used to find intrinsic value, the intrinsic value might not hold in the short run, but in the long run, earnings releases and the correlation with sell-offs and options activity in the modern day causes for the efficient market hypothesis to hold in the long run.
To conclude, as to when to short the market, we'd rather say that you should keep a close eye on rising interest rates and bond yields while deciding for yourself. Below is a bubble chart, which applies to stocks that hold little value and are trading at high multiples (we illustrated low cannabis stock fundamental values earlier in our analysis to find this correlation). By looking at the chart, we can definitely conclude that we're in the public phase due to an increase in retail trader participation, especially in cannabis stocks and our key players in particular.
Formation of a Bubble Chart
Takeaway for Investors
The expectation versus the reality of financial performance in vertically integrated cannabis stocks is somewhat far apart. We're looking at an industry where the underlying businesses will have further diminishing profitability as fragmentation happens within the value chain, which will cause more competition.
Stocks have been very reactive to deregulation, but we're seeing options activity and market sentiment orientated investors profiting from their trades. Our feeling is that once the growth stock frenzy ends, cannabis stocks and particularly end-to-end value stocks will be the first to plummet back to earth.
This article was written by
Quantitative Fund & Research Firm with a Qualitative Overlay.
Coverage: Global Equities, Fixed Income, ETFs, and REITs.
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