3 Reasons Cannabis Stocks Face-Planted in 2019
Following years of outperformance, marijuana stocks flopped in a big way.
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A Fool since 2010, and a graduate from UC San Diego with a B.A. in Economics, Sean specializes in the healthcare sector and investment planning. You'll often find him writing about Obamacare, marijuana, drug and device development, Social Security, taxes, retirement issues and general macroeconomic topics of interest. Follow @TMFUltraLong
This was supposed to have been the year that marijuana stocks became the complete package. We knew that the industry offered high growth potential, as evidenced by the tens of billions of dollars in weed sales annually on the black market, and we were expecting cannabis stocks to take the turn toward profitability in 2019. But that turn never happened.
Following an impressive first quarter that saw more than a dozen pot stocks rise by at least 70%, the final nine months of the year have been a veritable house of horrors for cannabis investors. Since the end of March, the Horizons Marijuana Life Sciences Index ETF, which holds around five dozen pot stocks of various weightings, has lost 58%. And, mind you, this includes the benefit of dividend distributions.
How did things go so wrong, so fast for the hottest investment on the planet? Blame the following three factors:
1. The regulatory learning curve was much steeper than anyone had thought
To begin with, it's easy to overlook the fact that there's no precedent in the modern era to marijuana being a legal drug. This has led to a trial-and-error process that's been heavy on the errors.
For instance, Canada has dealt with persistent supply issues since the green flag waved on marijuana sales in October 2018. Part of the blame lies with regulatory agency Health Canada, which has been unable to approve licensing applications in a timely manner, thereby keeping cultivators waiting a long time to get approval to plant their crops.
Likewise, Ontario's lottery licensing process has been a mess. At the one-year mark of adult-use legalization (Oct. 17, 2019), Canada's most populous province only had 24 open dispensaries. That's one store for every 604,000 people in the province. That's not nearly a large enough physical presence for consumers, and it's led to a supply bottleneck in the province.
Meanwhile, U.S. states are learning that overtaxing legal cannabis can drive consumers back to the black market. California, the largest weed market in the world, is notorious for taxing the daylights out of consumers. End users are essentially paying a state and local sales tax, a 15% excise tax, a wholesale tax, and other added costs, such as laboratory testing. There's no way that legal growers can compete on price with black market producers. This is why California's annual weed sales are nearly flat between 2017 and 2019 (the Golden State opened its doors to recreational pot sales on Jan. 1, 2018).
The good news is that all of these regulatory issues are resolvable. The problem is that fixing these issues isn't going to happen overnight. This means the supply challenges in Canada and tax problems in the U.S. are liable to persist for the foreseeable future.
2. Financing continues to be a major concern
The second thing we learned about the marijuana industry in 2019 is that financing concerns have not been put in the rearview mirror.
With North American cannabis sales ramping up slower than expected, we've witnessed consensus sales estimates come way down on Wall Street, while pot stocks have often reported larger-than-expected losses. Given that fixing supply and tax issues will take time, a number of cannabis stocks have turned to cost-saving measures to conserve their capital and better align demand with production.
For example, Aurora Cannabis (NYSE:ACB), HEXO (NYSE:HEXO), and The Green Organic Dutchman (OTC:TGODF) all announced production cuts during the fourth quarter. Aurora is halting construction at two of its largest facilities, taking more than 300,000 kilos of peak annual output off the table. HEXO and Green Organic Dutchman expect peak production of around 100,000 kilos and 20,000 kilos to 22,000 kilos, respectively, in 2020, down from peak estimates (if all facilities are operational) of 150,000 kilos and 219,000 kilos.
Aurora, HEXO, and Green Organic Dutchman have taken these measures because access to capital remains dicey. Even with access to a $360 million Canadian credit facility, Aurora Cannabis continues to sell its own stock to fund acquisitions and debt conversions, and has had its outstanding share count balloon by well over 1 billion in five years.
Similar financing concerns are impacting U.S. pot stocks, with a number of multistate operators (MSO) recently turning to sale-leaseback agreements to raise cash. Under a sale-leaseback agreement, an MSO sells a cultivation or processing facility to a real estate focused company in exchange for cash, then leases the property for an extended period of time from that same real estate company.
Expect financing to continue to be a problem for cannabis stocks throughout 2020.
3. Investors lost trust in cannabis stocks
Lastly, there was a clear lack of investor trust when it came to pot stocks in 2019. Aside from the fact that cannabis stocks failed to deliver, there were a number of instances of wrongdoing that have been tough to gloss over.
In July, Ontario-based grower CannTrust (NYSE:CTST) came clean that it had been growing marijuana in five unlicensed rooms at its Niagara cultivation farm for a period of six months (October 2018 to March 2019). Subsequent to this finding, CannTrust's CEO was terminated, the company destroyed $58 million worth of illegally grown inventory, and its sales and cultivation licenses were suspended by Health Canada. By mid-2020 or sooner, CannTrust may also face delisting by the New York Stock Exchange.
While this was, by far, the most egregious breach of investor trust, Aphria (NYSE:APHA) and Namaste Technologies (OTC:NXTTF) also did little to inspire confidence in their leadership teams.
Aphria was accused of fraud in a short-seller report in December 2018, which led an independent committee to investigate the allegations. In early 2019, we learned that while most of the accusations were without merit, conflicts of interest were discovered involving Aphria's purchase of Latin American assets. This led to the departure of longtime CEO Vic Neufeld, and was followed by a writedown of 50 million in Canadian dollars ($38.2 million) on this acquisition.
Similarly, Namaste faced fraud allegations from noted short-seller Citron in October 2018. An independent committee found that now-former CEO Sean Dollinger had sold company assets to a related party without disclosing the sale. Dollnger was fired from his post with cause, but Namaste's share price hasn't recovered.
Building trust will be key for cannabis stocks if they're to have a better 2020.
Aurora Cannabis Inc.
NYSE:ACB
HEXO Corp.
NYSE:HEXO
CTST
CannTrust Holdings Inc
NYSE:CTST
TGODF
The Green Organic Dutchman
OTC:TGODF
NXTTF
Namaste Technologies
OTC:NXTTF
Aphria Inc.
NYSE:APHA
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