What’s behind the stock correction in cannabis?

This has been a roller-coaster year for cannabis stocks, a signal that investors are assessing the opportunity more critically than they have before.

A strong start, with New Cannabis Ventures’ Global Cannabis Stock Index (GCSI) rising 64.7% – albeit with volatility – through March 21, gave way to a decline of 32% through July 25.

But even with this decline, the GCSI is up 12% for the year.

Here are some key events/drivers that we believe are material to this correction:

1. Short-seller report released by Quintessential Capital Management that described Aphria as a “shell game with a cannabis business on the side.”

Effectively, Quintessential’s report accused Aphria of failing to have proper governance procedures in place to protect investors and shareholders from management insider dealing. This report caused Aphria’s stock to fall substantially and eventually led to the announcement that a co-founder and the CEO of Aphria would transition out of their roles.

2. Lawsuit by MedMen Enterprises’ former CFO alleging the company and its executives engaged in numerous unethical and illegal activities and breached their fiduciary duty to shareholders.

This was another accusation related to alleged failures in governance. While the stock slid after the announcement of this lawsuit, shares again traded upwards within just a couple of weeks.

3. CannTrust was found to be cultivating cannabis in illegal grow rooms – and its executives were aware of the violation months before it was uncovered by regulators.

The illegal activity led to the seizure of thousands of kilograms of cannabis products and drove down CannTrust shares roughly 75% in a few months.

Not only is CannTrust’s licensure at risk, but more than a dozen class-action lawsuits have been filed, and more penalties could be coming, including:

  • A delisting of the company’s stock from the New York Stock Exchange.
  • Sanctions from the U.S. Securities and Exchange Commission.
  • International penalties due to the export of illegal product.
  • Fines.
  • Possible jail time.

4. Rapid rise of valuations and expectations coupled with slower increases in fundamental performance have raised profitability concerns.

Investors renewed their focus on fundamental performance – not only revenue growth but also trends toward operational and net profitability – when Canada launched its national adult-use cannabis market.

While the Canadian cannabis industry has generally benefited from the addition of adult-use legalization, various factors -including regulatory impediments and delays in market launches – have impacted operators’ performances.

Even the largest cannabis companies were not immune to these operational issues:

  • Canopy Growth Corp., one of the largest cannabis firms in the world, unexpectedly reported reduced revenues from its recreational cannabis sales in Canada. This, combined with Canopy’s increasing losses that flowed up into investor Constellation Brands’ financials, led to the removal of co-founder Bruce Linton from his position as Canopy’s co-CEO.
  • Aurora Cannabis was downgraded by Bank of America Merrill Lynch due to concerns over its perpetual cash burn and the likelihood it has to pay back large tranches of debt in the coming year, perhaps necessitating additional external capital. That could lead to shareholder dilution (if raised through equity or convertible instruments) or adding more to cash burn (if raised via debt with coupon payments).
  • Eaze, one of the largest cannabis delivery platforms, reduced its previous forecasts for the number of transactions expected through its platform in 2020. Previously, Eaze raised capital touting a 2020 goal of more than $1 billion worth of cannabis flowing through its infrastructure; it reduced that expectation to less than $500 million.
  • Eaze’s cash burn also came into focus. MarketWatch reported the company was burning roughly $1 million per month in 2017 and that has since roughly tripled.

5. U.S. regulators have introduced new concerns to cannabis investors.

The U.S. Department of Justice (DOJ) has begun investigating certain transactions on antitrust grounds. Most notable was Cresco Labs’ announcement that the DOJ was requesting further information about its planned acquisition of Origin House.

While Cresco said it did not expect the DOJ’s request to interfere with the completion of the acquisition, it was one of the first times antitrust issues were raised in the cannabis industry.

The U.S. Food and Drug Administration (FDA) also has been more involved, given its purview over numerous consumer products.

Following prompts from various stakeholders, the FDA held hearings related to the new hemp space. Investors piled into the industry hoping to capitalize on new food and wellness products, but the FDA requires further evidence of these products’ safety before allowing their widespread use.

Because plant-derived cannabinoids have been illegal for decades, they have not been determined to be safe or approved by the FDA (though certain cannabis-based drugs have been approved).

The agency has even sent warning letters to several companies – most recently Curaleaf Holdings, one of the largest cannabis companies in the world – that are selling CBD products and making claims alluding to specific health benefits.

Given the FDA’s stance, several states have enacted their own laws for hemp-derived products, with some banning CBD in food or drink and others requiring that these products be sold within existing cannabis supply chains.

6. Threat of write-downs beginning to enter investors’ minds.

Cannabis companies have been on significant acquisition sprees to fuel their stock prices and growth outlook. However, many of those acquisitions added large sums of goodwill to the acquirers’ balance sheets that must be periodically reviewed for impairment.

If a company comes to believe it will not be able to capture sufficient value from the assets to justify the goodwill, it is required to reduce goodwill to better reflect the new outlook.

One company in particular, Tilt Holdings, announced a write-down of its assets of about $500 million one month after completing a four-way merger. The company cited a reduced “outlook on the medical cannabis industry in Canada as a result of the legalized recreational market.”

Individually, each of these factors would be unlikely to significantly impact investor sentiment as the overall cannabis industry continues to expand internationally with healthy long-term growth prospects.

However, each event had a marginal impact, leading eventually to a shift that has caused the recent correction in the cannabis capital markets.

This does not necessarily signify a change in whether investors believe in the overall prospects of cannabis.

Rather, this correction signals a change in how investors are analyzing the space, a shift that is vital for a healthy, sustainable relationship between operators and investors.

We expect to see a resurgence in the cannabis capital markets once a balance is reached between market valuations, company governance and performance as well as investor expectations.

Harrison Phillips is vice president of Viridian Capital Advisors.