How to Tell if a Cannabis Stock is Good or Bad
The basic principles underlying a successful investment strategy haven’t changed for centuries. Don’t put all your eggs in one basket (diversification), don’t let your emotions guide your decisions (market timing), a penny saved is worth two in the bush (the time value of money), always get a prenup no matter what (common sense), and never ask the barber if you need a haircut (don’t trust financial advisers) – these are all timeless principles, each of which business school professors have turned into an entire series of classes. Investing shouldn’t be that difficult. Nor should we be relegated to a man wearing a Ferragamo tie – who rode the subway into work – telling us where he thinks we ought to invest our money.
People often email us asking which cannabis stock they should invest $50 in, or which cannabis stocks are “good” or “bad.” We use this opportunity to point out what a giant convoluted mess the “cannabis industry” is in right now, especially when it comes to vetting all the selections there are for retail investors. There are so many acquisitions happening it’s impossible to keep up, everyone is lighting cash on fire, and the gubment is getting a bit antsy. (The FBI is now seeking tips on marijuana corruption.) These are all risks that need to be considered when thinking about investing in cannabis stocks. In our recent article on The Biggest Cannabis “Multi-State Operator” Stocks, we talked about eight companies that are operating dispensaries in multiple states in ‘Murica today, while listing their shares in Canada because cannabis is still illegal in the United States at the federal level. These are the eight companies in order of size by market cap:
Since you can’t transport cannabis across state lines, these MSOs are usually vertically-integrated which allows them to control costs very closely. It also creates huge problems when trying to manage the operation across so many states since the rules and regulations differ dramatically for each state. In short, being able to tell how one cannabis stock compares to any other cannabis stock right now is a nightmare.
Today, we’re going to talk about some metrics you might want to use when trying to determine if a cannabis stock is good or bad. As an example, we’ll look at an MSO called Colombia Care – one of the largest fully integrated operators in the global medical cannabis industry. They also happen to be the smallest MSO in the list of eight that we procured from a Curaleaf investor deck.
Is This Cannabis Stock Good or Bad?
The story starts in April of 2019 when Colombia Care performed a reverse merger to begin trading on a Canadian stock exchange called Neo. (Not all companies decide to list on the “Cannabis Securities Exchange.”) They’re now a publicly traded firm that discloses all the necessary information we need to make some observations about whether or not they’re good or bad. So, where do we start when trying to assess the merits of any given cannabis stock – or any stock for that matter? This differs between industries. For the cannabis industry, the simplest things to look is how much product is being sold and is that number growing every quarter? We call this revenue growth, and it’s particularly important in today’s race to grab as much territory as possible before the dust settles. Nobody bats an eye if a drug development firm has zero revenues but when it comes to selling cannabis, that’s just not going to fly.
All those people who thought running a dispensary would be the ultimate career choice are now realizing just how hard it is to compete in a saturated market with cannabis stores on every corner. Those who exit the business will not be in the best position when it comes to negotiating for the sale of their license(s) to another party. Larger MSOs can then step in and pick up the scraps. As these new dispensaries come online, more revenues are generated. As acquisitions happen – even at ridiculous valuations – more revenues are generated. Therefore, a great metric to look at for any MSO is revenue growth.
Just remember that the rate of growth often decreases as a company scales. This is the same reason why you should never pay heed to a company that says “revenues this year were up 400%,” and then doesn’t tell you what number they started with. Pointless. Fortunately, Columbia does spell out their growth in numbers.
“We are pleased to deliver revenue growth of over 100% year-over-year and over 50% sequentially,” said the CEO of Colombia last quarter. That’s the sort of revenue growth that investors in a disruptive market expect to see sustained over time. If the marijuana industry is growing to reach 17 quadzillion dollars by 2025, then all these companies should be growing their revenue at a rate that at least matches industry growth. If the growth isn’t there, that’s a big red flag, and you shouldn’t waste your time trying to understand why. It’s probably a bad stock.
The next thing we might want to understand is what they’re selling and where.
Take a Look in SEDAR, Eh
Many new investors may not know about mandatory regulatory filings. Long story short, companies that are publicly listed need to file documents to regulatory authorities at designated times. These documents contain mandatory disclosures like accounting numbers, pending lawsuits, relationships with other companies, and non-mandatory disclosures like revenue segmentations or the names of key customers or suppliers. Basically, to find out what’s really going on under the hood of any publicly traded company, you need to dig through financial repositories like Canada’s SEDAR where all publicly traded Canadian companies submit their filings. This is where you might find red flags that make you think, “bad stock.” Alternatively, you may find other tidbits of information that provide additional insights.
For example, we looked at Columbia Care’s latest financial filing and learned that for the first six months of this year ending June 30, 2019, the company produced 2,408,107 grams of dried cannabis. That’s always a good metric to look at, but bear in mind that’s a minuscule amount – around 2% – of their estimated full capacity of 125,000,000 grams. We figured out their total operating capacity from this gem of a chart buried in Columbia’s investor deck, and surrounded by more buzzwords than you can shake a stick at.
That first chart shows you the growing footprint Columbia has in each state which tells us they haven’t put all their eggs in one basket though they’re overweight Florida a bit. The second chart tells us their maximum output (assumes 65 grams per square foot with 5.2 cycles grow cycles per year). Based on the licences owned by Columbia Care, their upper limit of production at full capacity is 125,000,000 grams of dried flower a year. Assuming they sell these flowers at $10 a gram, that gives us $1.25 billion a year in revenues. Sounds like an absolutely incredible opportunity, but the surface is only just being scratched with Columbia Care bringing in Q2-2019 revenues of just $19.3 million – about $77 million a year all things being equal. And where is all this revenue coming from? Unless the company tells us, it’s nearly impossible to figure out. In that same presentation, Colombia shows how dramatically different product mix and transaction size can be between states.
Unless these MSOs provide state-level granularity around costs and revenues – and we haven’t seen any doing that – then we really can’t tell what’s working or what’s not working for each state they’re operating in. What Columbia Care tells us in their latest investor deck is that the company operates five dispensaries in New York – the most of any state at the moment – and that’s where they’re optimizing their approach which will then be replicated in other states.
In 2017, Columbia Care began offering home delivery services with an average basket size of $355. That ought to go over well with all the people surfing the Silver Tsunami in Florida.
So far, we’ve placed the importance of revenue growth above all else. Sometimes, this can take the form of “subsidized growth” where a company will spend $10.50 to acquire a customer with an average lifetime value of $10.00. This sort of “organic revenue growth” is not sustainable but it’s often used to quickly capture market share. In other words, don’t expect high-growth companies to be focused on profitability right now. Creating a vertically integrated presence in a state takes time and loads of capital. (In Alaska for example, you need to lease the property eight months before you can actually begin growing on it.) What we want to understand next is where that capital is coming from.
Simply put, a company that hasn’t achieved profitability yet can get more cash through two avenues – taking out loans or selling equity in the business. When the latter happens, everyone’s piece of the pie gets smaller. We call that “dilution.”
The way to track dilution for any company is to look at the number of outstanding shares from the end of one period and then compare it to another period. If that number keeps increasing, then the share price will keep decreasing – all things being equal. Here’s why:
The market cap of a company is $100 million (1,000 shares X $100 per share). If the company sells another 1,000 shares to a new investor, the price of their shares falls to $50 in order to maintain the same market cap – $100 million (2,000 shares X $50 per share).
In the case of Colombia Care, we can look at their latest financial filings and see how the number of shares has changed from June 30th, 2018 to June 30th, 2019.
In the above example, we can see that the number of shares has increased sharply in just a years’ time. When the company issues 49,109,489 shares in a single year – an increase of about 30% – that’s what we refer to as dilution.
Sometimes businesses can offer shares in exchange for services, but most the time they need cash to operate. Last quarter, Colombia may have brought in record revenues of $19.3 million but they also lost $33.6 million during the same time frame. That’s also referred to as “burn rate.”
If you have $1 billion sitting in your company bank account and you’re losing $50 million a quarter, then you can last 20 quarters or about 5 years before you need to either achieve profitability or raise more money. In the startup world, they call this your “runway.” In the case of Columbia Care, they have about $125 million in cash on their books.
If they continue to burn $33.6 million a quarter, that gives them 3.7 more quarters before needing to raise more money. That means next summer, they’ll either need to give away some form of equity in exchange for cash or they’ll need to issue some debt. (Columbia Care had almost no debt on the books as of June 30th, 2019.) When the music stops and everyone stops throwing capital at the burgeoning cannabis industry, it’s important that companies have the runway they need to achieve profitability before running out of money trying.
So, is Columbia Care a “good stock” or a “bad stock?’ What we might conclude is that they’re not a “bad stock,” but the real takeaway for investors is that cannabis as a theme is very tricky. That’s because consolidation is happening very quickly, there are significant regulatory risks present, and there are a multitude of new investors buying these stocks, sight unseen, and creating high levels of volatility causing new investors to panic. And so it continues, as one big vicious volatile cycle.
It’s impossible to see where the revenues are coming from for these multi-state operators because the operating environments behave so differently. Each state will differ in how much of the product mix is CBD, how much flower is grown and sold in owned dispensaries or third party dispensaries, and how much product from other producers is being sold in owned dispensaries. All we can do is pay attention to simple top-line metrics like revenue growth, burn rate, and dilution, while ignoring the volatility. Just don’t put all your eggs in one basket.
Do you want to trade cannabis stocks on the Canadian stock exchanges? Do what we did and open an account with Zacks Trade. You also get $1 trades for U.S. stocks and options for one year after opening your account. Open an account with Zacks Trade and start trading Canadian cannabis stocks now.