Warning Signs to Watch as Cannabis Sector Shrinkage Looms

- February 17th, 2020

Experts discuss what investors should know when it comes to their cannabis stock picks as potential company shutdowns loom.

If a wave of closures and company shutdowns is really on the way for the cannabis industry, what can investors do to stay ahead of the curve?

Despite lofty valuation projections, the rise of marijuana in the public markets has left turmoil in its wake.

While leaders in the space have been able to establish solid foundations through investment deals and continued expansion, experts are starting to grow worried about a very real wave of companies going out of business — an eventuality that could leave investors with empty hands.

The Investing News Network (INN) asked several experts what retail investors should be aware of when it comes to this potential state of shutdown.

“The analogy that I would use is that there are 300 passengers on the boat, (but) the boat can only fit 50,” Andrew Udell, a financial expert with popular research group The Cannalysts, told INN.

The Canadian Securities Exchange (CSE) quickly became a hotbed for marijuana listings both from Canada and the international markets. According to an updated list of its constituents, the CSE currently has 196 cannabis stocks.

While that was once an exciting development for the industry, it has now become a warning sign for what’s to come, because a variety of experts don’t think the cannabis stock market is capable of sustaining the high number of listings.

“The common thinking or the common repeated phrase is that a lot of companies are going out of business,” Udell said.

Warning signs for cannabis investors to watch

After the trials and tribulations of 2019, investors in the marijuana space want to make sure their picks are the right ones. While many advisors and industry players are advocating for a long-term outlook for the market, quite a few companies operating today may not make it that long.

What is one of the big red flags an investor should look for in their portfolio right now? According to Nawan Butt, associate portfolio manager with Purpose Investments, if a company is not already selling its products at this point, that’s a big cause for concern.

“If you’re still putting together a cultivation or an extraction facility (with promises) of tomorrow, then it’s a difficult place to be,” Butt told INN.

From his perspective, all cannabis companies should also be on the path to becoming earnings before interest, tax, depreciation and amortization (EBITDA) positive and cash flow positive.

Butt stressed that cannabis companies will need to have strong cash balances in order to support the needed growth over the next few years.

Udell agreed with this concept, mentioning that one of the first things an investor should look for when evaluating companies in the current marketplace is their cash position and whether or not that figure will get the company to its next benchmark.

The expert from The Cannalysts also said it is a positive sign for a company to be EBITDA positive.

“Capital has been very challenging for companies lately,” said Udell. “Companies that have demonstrated earnings and demonstrated EBITDA-positive status are going to be able to access capital.”

The hunt for cash has become a dominant topic in the cannabis industry, as companies are forced to adjust to the ever-more-challenging landscape attached to raising capital with the current state of the market and investor sentiment.

The shift in sentiment from investors of all sizes and strategies relates to the challenges seen by industry-leading players trickling down across the board.

In 2019, the Horizons Marijuana Life Science Index ETF (TSX:HMMJ), a broad index for the marijuana stock universe, fell in value by over 40 percent.

With such challenges in the market, a variety of players are also poised to engage in merger and acquisition (M&A) tactics as a way to prevent company shutdowns and continue operations.

But what will really dictate the direction these deals in the cannabis space take?

A stock chart for HMMJ

Strategic M&A to be dominated by desire for cash

When it comes to the possibility of using M&A as a way to join forces in the industry, Butt said mergers might not be the option most commonly used in cannabis.

“Yes, even though I do think there will be bankruptcies and operations shutting down, there’s less of a chance of more mergers,” Butt said.

From his perspective, businesses that lean towards branding or technology will be more desirable acquisition targets compared to heavy cultivation and extraction operations.

For Udell, there’s one clear thing that’s going to dictate all M&A activity moving forward.

“At the very bottom of it, it’s a hunt for cash,” Udell told INN.

During his time at the recent MJBizCon in Las Vegas, Nevada, one expert outlined how the rapidly evolving metrics from investors and analysts have helped to adjust the financial reality for cannabis companies operating in the current market.

“We think (investors) will focus much more on (asking,) ‘If it’s not profitable now, what are the specific losses and the path to profitability?’” Mike Regan, equity research analyst with Marijuana Business Daily, told INN.

When asked about the challenging landscape for raising capital for cannabis companies at this time, Regan said at the end of the day it’s always better for companies to keep operating.

“It’s better to still have a business and survive … If you need the cash you need to do what you need to do to survive,” said Regan. “If you don’t survive it doesn’t matter.”

The analyst believes that realistically the path for a lot of cannabis companies will be costly due to the structure of deals available out there.

Despite all the promise of change attached to the marijuana industry, it remains a consumer business that must generate cash — that was one of the leading premises for Regan and his collaborator Craig Behnke, fellow equity research analyst with MJBiz Daily, during a presentation to investors at MJBizCon.

Investor takeaway

As a last bit of advice, Butt told INN that investors need to be critical of the geographical element for cannabis companies.

The promise of a nascent global cannabis industry has led a variety of Canadian players to pursue ventures in different countries.

With that in mind, Butt suggested investors favor companies in markets beyond Canada.

“Those companies that are limiting themselves to Canada do need to understand that even on a terminal basis, the size of the Canadian market is much smaller than the production or the supply of product that’s out there right now,” he said.

This article was originally published by the Investing News Network in January 2020.

Don’t forget to follow us @INN_Cannabis for real-time news updates!

Securities Disclosure: I, Bryan Mc Govern, hold no direct investment interest in any company mentioned in this article.

Editorial Disclosure: The Investing News Network does not guarantee the accuracy or thoroughness of the information reported in the interviews it conducts. The opinions expressed in these interviews do not reflect the opinions of the Investing News Network and do not constitute investment advice. All readers are encouraged to perform their own due diligence.

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