Have pot stocks become a good contrarian bet?

Benj Gallander, Ben Stadelmann, and Philip MacKellar
November 3, 2022

Are pot stocks a good contrary bet yet?

My inbox is seeing this type of question pop up more and more these days, but rewind a few years and this line of questioning was unthinkable. Back then, these stocks were all the rage – initial public offerings were hitting the market to much fanfare – and no valuation, business misstep or level of insider selling could undo the hype underpinning the newfangled industry.

The sector’s future seemed so bright that exchange-traded funds launched to cash in, and some Vancouver-based junior miners on the TSX Venture Exchange even rebranded to pump up their share price. Indeed, the story underpinning legalization was full of feel-good vibes and optimism. Justice was being served after decades of criminalization, and the potential uses and end markets for marijuana appeared almost endless.

Fast forward to the present, and the boom has turned to bust. Many pot-linked companies and ETFs have seen their share price smoked by more than 90 per cent from their record highs. Considering the collapse, it is natural for investors to start asking whether the sector would be a good contrary bet. Unfortunately, the answer for now is “no.”

Among other factors, my evaluation process considers revenue trends, profitability, cash flows, balance sheet strength, dilution, insider activity and business prospects. Corporations in the pot sector today fail on nearly every measure. Industry leader Canopy Growth Corp. (WEED), for example, is a case in point. The company’s revenues have been stagnant for two years, and in the latest quarterly, sales were down 19.2 per cent versus the comparable period last year. More importantly, Canopy is losing a stunning amount of money. In the second quarter, sales were $110.1-million, but the net loss was close to $2.1-billion, of which $1.7-billion was related to goodwill and non-cash impairments. This is not the first billion-dollar-plus quarterly net loss either – in fact, in the past two years, Canopy has only generated profit in one quarter. Unfortunately, cash flow metrics look similar and the enterprise is burning money quickly.

The impact of these sales, profit, and cash flow trends have hit the balance sheet. The company’s long-term debt stands at nearly $1.3-billion and the accumulated deficit (i.e., cumulative losses) is staggering, at almost $8.5-billion. Not only has Canopy taken on a lot of debt, but the outstanding shares have increased from 29.9 million in 2014 to 398.5 million in the latest quarter. That is not the type of 13-bagger that investors desire.

Though there may still be mega-bull believers out there who argue the stock is cheap, or say that the smart money is stepping in, there is little evidence for this. While the valuations such as price-to-sales and price-to-book are much better than they were historically, the stock remains expensive. Furthermore, behind the scenes, managers and directors have not purchased a single share in the last year, according to INK Research, but have cumulatively sold $832,583 in stock instead. Executives and board members are fallible like the rest of us, but they are often the best informed about their corporation’s prospects. Therefore, there is a strong argument that they are the smart money. This is not to pick on Canopy, however, as in many ways this stock is in better shape than its peers.

It is hard to see Canopy’s situation improving so long as revenues are stagnant or in decline, net losses continue and cash flows are negative. This means the operation will have to continue divesting business units, cutting costs and tapping credit facilities. If these measures are not enough, Canopy will have to fill the gap by issuing shares, debt or both – assuming the market is interested. There is a distinct possibility the market will not be interested, however, given that Fitch recently downgraded the firm to “CCC-minus,” and S&P downgraded them to “CC.” Even if Canopy and its investment bankers could convince equity investors to pony up, the dilution it could generate would crush existing shareholders, as the stock is already trading near its lowest level in years.

Long story short, pot stocks – like Canopy – are far from making it onto our watch list here at Contra the Heard Investment Newsletter. Though this sector could present investors with near-term trading opportunities, for longer-term owners there is a lot of work to be done before these stocks represent a good contrary bet.

Personally, I will be looking for revenue growth, positive cash flows or profitability, better balance sheet metrics, credit rating upgrades, an end to dilution and insider buying. Without most or arguably even all these features in place, any such investment in this name will be speculative. Nevertheless, those interested in following the sector or Canopy can stay tuned for the organization’s latest earnings, which are due out on Nov. 9.