Replies to post #7740 on Trulieve Cannabis Corp (TCNNF)

[FUNMAN]

Don't Bet On A Marijuana Turnaround In 2020
Dec. 30, 2019 11:09 AM ET

Harvest ETF (MJ), Includes: APHA, TCNNF

At least Trulieve rates in the writers "book".

By: Ian Bezek
Ian's Insider Corner


Summary

Cannabis stocks had a terrible 2019.

Even after losing more than half their value in 2019, however, the median cannabis stock is still expensive.

If you want to play in the space, try to find one or two decent names to own - the sector as a whole should continue grinding lower next year.

Looking for a helping hand in the market? Members of Ian's Insider Corner get exclusive ideas and guidance to navigate any climate. Get started today »

Cannabis stocks had a terrible 2019. The benchmark ETFMG Alternative Harvest ETF (MJ) lost more than half its value from its high back in March and has now taken out all chart support from prior years as well:

If you want to see the chart, read the article here:
https://seekingalpha.com/article/4314531-dont-bet-on-marijuana-turnaround-in-2020

It could have been even worse if not for the diversification benefits of the ETF structure - many individual marijuana stocks were down 70%, 80%, or even more on the year.

Still Way Too Many Marijuana Companies

For a speculative bubble to be deflated, you need to have crushed optimism completely. And with cannabis, we just aren't there yet. As the table below shows, there are still a ton of companies in the industry with robust market caps. By and large, they're still losing tons of money and have anemic balance sheets. This does not have the makings of a bottom, inflection point, or whatever else you might call it for the sector:

If you want to see the chart, read the article here:
https://seekingalpha.com/article/4314531-dont-bet-on-marijuana-turnaround-in-2020

Do note that I confirmed with the table's creator that the financials shown here are in their local currencies. That is to say that the U.S. listings are in U.S. Dollars while the Canadian tickers are in Canadian dollars. So some of the calculations aren't quite apples to apples comparisons.

Regardless, this spreadsheet from Caetus offers a ton of insightful data. For starters, consider that even after this miserable year for pot stocks, there are still 44 listings with a market cap of at least C$150 million ($115 million).

Incredibly, of these 44 companies, just six reported positive EBITDA over the past year. And only four have positive net income. It's difficult to make the case that an industry has bottomed when you still have dozens of highly-valued companies, nearly none of which turn a profit. Further industry consolidation and bankruptcies seem inevitable.

The usual strategy for a struggling industry of buying the largest companies and waiting for the turn still seems risky at this point, as well. Of the 15 largest market cap cannabis companies out there, only two sell for less than 10x Enterprise Value/Sales. That's insane. Trulieve (OTCPK:TCNNF) and Aphria (APHA) aren't exactly bargains at 6x and 5x EV/sales respectively, but at least they're in the right neighborhood for a highly volatile growth firm. The others are still in the stratosphere.

You can buy plenty of fantastic software companies in the same EV/Sales range as these leading cannabis companies. Unlike the marijuana firms, the SaaS companies tend to have economics of scale, rising profit margins, and huge addressable markets. If you're going to take a flyer on a speculative sector, the valuations for the marijuana companies still look unattractive even on that basis.

You can't really make a deep value case for the marijuana sector either. As there are virtually no profitable companies, you can't argue for cheap stocks that way. Somehow, things look even worse if you turn to cash flow instead of profitability metrics such as EBITDA. Based on free cash flow, not a single marijuana company is generating cash yet.

And the other fascinating thing from the above table is that the median cash/market cap ratio for these marijuana companies was just 11%. This means that a large chunk of these firms, even after seeing their stock prices drop 50-75%, still have barely any cash as a proportion of their market cap. You hear this narrative that the marijuana companies cashed up when equity prices were far higher and are now well-positioned to ride out the downturn. And that may be true of a few companies, but it's really not accurate for the industry as a whole. Much of the capital that was raised has already been spent on growth capex that is uneconomic in the current industry environment. Plenty more cash has been burned to fund ongoing money-losing operations.

The usual Ben Graham-style deep value investments had tons of cash or other hard assets on their balance sheets to balance out poor operating business models or other risk factors. In the case of cannabis, as a sector, you're not getting much of anything in terms of treasury balances or tangible book value to back up the market caps.

If you selectively pick individual marijuana stock investments, you can perhaps find better options. But the marijuana ETFs such as MJ are a composite basket of the stocks you see in the table above. Given the overall huge valuation ratios and lack of balance sheet strength of the average component within the sector, returns for industry ETFs will continue to be lackluster at best.

Supply & Demand Won't Be Fixed In 2020
We've established that marijuana stocks still aren't anywhere close to fair value based on their current outlooks. But won't growth in demand quickly catch up and bail out the currently-oversupplied industry? No, no it won't. Here's the latest data from Health Canada:

If you want to see the chart, read the article here:
https://seekingalpha.com/article/4314531-dont-bet-on-marijuana-turnaround-in-2020

As you can see, in September, total inventories of dried cannabis declined for the first time month over month. Alas, sales also went down too, so that's not reassuring. Also, inventory of CBD oil continues to build, even while the dried product finally paused its buildup of further oversupply. In any case, supply vastly outstrips demand, with there being more than two years of inventory already based on current demand levels.

A big issue has been that the black market remains "vibrant". According to a CBC report, the majority of Canadian marijuana consumers buy from the black market. And in some cases, they do so unwittingly. The CBC quoted Mike Serr, the head of the Canadian Association of Chiefs of Police who said:

"The public don't know that when they're going online, typically the first three or four sites that will come up online will be illegal sites to purchase cannabis," said Serr. "We're working nationally to try to find some solutions."

Given the high levels of taxation on legal marijuana, it's not surprising that the black market has remained particularly robust. Eventually, the government will probably figure out some way to get things under control, but it won't be an overnight solution. And it should serve as an object lesson of the risks as more American states bring their legal markets online. Bulls are modeling exponential ramps in demand once new markets come into place, but Canada's problematic roll-out should cause folks to lower their initial expectations.

At the end of the day, it takes years to bring a new industry into being, and most of the early entrants to a fledgling industry flame out. Be it railroads, cars, computer companies or whatnot, the vast majority of early firms do not go on to great success. With around four dozen marijuana firms retaining $100 million+ market caps (and a good number more private firms continuing to compete in the space) it's simply too early to try to go bottom-fishing on the sector as a whole. Sure, pick a marijuana stock or two that you think has reasonable fundamentals and a sharp management team if you wish.

But steer clear of the sector ETFs such as MJ. The value just isn't there yet. I know it's a popular turnaround trade idea for 2020, but the odds aren't good that it will actually turn out well. Look at ETF.com's breakdown of the quality factors for MJ - on five of the sector factors it scores very badly:

Want to buy a basket of expensive stocks with no momentum whatsoever, of the lowest quality possible, and which sport exceptionally high volatility? Then grab a marijuana ETF. Otherwise, this probably isn't the right sector for you.

Perhaps the sector pops in the short-run on a squeeze or news around individual markets coming online. Over the medium-term, however, I expect the MJ ETF and other baskets of cannabis stocks to continue to slide.