2019 has been an extremely disappointing year for investors in cannabis stocks, with the overall market, as measured by the New Cannabis Ventures Global Cannabis Stock Index down 20% after a 55% decline in 2018. The market, which has declined over 71% since early 2018, has moved to three-year lows:
New Cannabis Ventures Global Cannabis Stock Index – October 25, 2019
The current environment is challenging, as funding has dried up, a situation I discussed a month ago. Many companies won’t make it or will have to raise capital on extremely unfavorable terms that will substantially dilute shareholders, as they aren’t adequately capitalized. Investors are quickly figuring this out, and the broad selling has certainly hurt the companies with high cash-burns and weak balance sheets the most.
With that said, the aggressive selling over the past seven months has impacted companies that appear to be adequately capitalized as well. The cannabis industry has attracted many growth investors over the past few years, but the steep decline across the board has left some companies that I think should appeal to value investors.
In Canada, there are 51 public companies that grow or process cannabis that own just some of the 245 licenses issued to date by Health Canada. Value investors should relish in the overabundance of names, as it makes thorough diligence of the sector quite challenging. In other words, with so many companies, it’s quite possible investors could make mistakes, creating opportunity for investors who are able to find the proverbial baby in the bathwater.
In the September edition of the monthly 420 Investor Newsletter, I shared this concept with my subscribers, focusing on value metric “price to tangible book value” (P/TB) as a way to assess value. The ratio looks at the market cap of the company in relation to the assets less liabilities. Unlike the traditional price to book value, it removes “goodwill” and “intangibles”, as these soft assets are difficult to assess.
Most investors and research analysts in the space have been focused on metrics that traditionally appeal to growth investors, like price to sales or enterprise value to EBITDA, typically on a forward basis. I don’t think P/TB should ever be used exclusively, but it’s a helpful method of assessing companies, especially from the perspective of downside.
At the time of writing (August 11th), I noted that there were 20 Canadian licensed producers with a P/TB ratio of 3 or lower. Value investors seeking a margin of safety like to see the ratio closer to 1. There were actually 4 at 1.1X or less, but, as I explained in the piece, these can often be value traps. Most of the companies in Canada haven’t yet scaled production and don’t yet have stable revenue streams. With operations typically consuming cash, companies that look “cheap” today may not look so tomorrow as their balance sheet erodes. Be careful blindly buying stocks with low P/TB!
Prices are lower today, and the ratio looks better for many of these companies, but there is also a more cautious outlook. With that in mind, I would suggest that investors try to focus on those companies that have scaled, are adequately capitalized and are not consuming substantial cash to fund operations.
At New Cannabis Ventures, we offer readers a resource to identify which companies are generating substantial revenue, and we also include a metric that we call “adjusted operating profit” to assess the profitability. The number is calculated by taking the reported operating profit and removing any one-time accounting impact from changes in the fair value of biological assets, which is required by IFRS accounting standards but that doesn’t necessarily translate into future profitability.
In Canada, two companies that have substantial revenue with strong growth and that are not drowning in operating losses but that trade at reasonably low P/TB are Organigram and Supreme Cannabis, which trade at 2.3X and 1.5X, respectively. Both companies have debt, but it is due in more than a year. While many smaller companies trade at lower valuations by that metric, none have yet scaled. With that said, a few have very substantial cash resources that will permit them to weather the storm and fund their expansions.
In the U.S., most of the very large operators trade at high P/TB ratios. One exception is Columbia Care, which trades at 2.6X. While it appears to be adequately capitalized for now, its operational losses have been large, making it difficult to assess the risk. In Q2, it lost almost $34 million on sales of $19.3 million. The stock has very poor liquidity, as its primary listing is on the NEO exchange, and a move to the CSE, where almost all of its peers trade, could help address that issue. Another MSO that has a relatively low P/TB is Vireo Health, which trades at 2.8X. The company generated revenue of $7.2 million in Q2 with an adjusted operating loss of $3.1 million, ending the quarter with cash of $30.3 million.
Looking beyond multi-state cannabis operators, Elixinol Global, which has substantial cash but a recent outflow of capital to fund its operations in contrast to its history as well as in comparison to peers, trades at 1.6X tangible book value. An unexpected CEO change, a slowdown in growth and, more recently, a quality control issue have all pushed the stock back to multi-year lows. Liberty Health Sciences, which trades at 2.1X tangible book value, operates solely in Florida and will be reporting financials next week. Hopefully the operating loss has improved as its revenue has increased with additional store openings and the ability to sell flower, a change earlier this year.
While the capital markets aren’t entirely closed to cannabis companies, the ability to raise equity at reasonable prices has greatly diminished. Investors have responded by sending prices to multi-year lows. The broad sell-off has hit all stocks, but some companies have better balance sheets and operating models than others. Using a value investor metric, price to tangible book value, can help identify potential opportunities, but I caution readers to relying solely on this metric. Instead, investors should favor the companies with low valuations for strength of balance sheet and avoid companies with high operating losses, as they will be swimming upstream as the tangible book value erodes.
Disclaimer: I mentioned Liberty Health Sciences, Organigram, Supreme Cannabis and Vireo Health, which are clients of mine at New Cannabis Ventures, where we provide investor dashboards on their behalf. We disclose all public company clients here. I do not own any stocks mentioned in this article, though I may include them in one or more model portfolios at 420 Investor.