Earnings in early months of legal sales suggest the marijuana sector is overpriced

Soaring expectations for Canada’s cannabis industry are being tempered in some quarters after licensed producers reported what for the most part were underwhelming financial results in the first post-legalization period.

Over the past few months, the biggest cannabis companies in the country — Canopy Growth Corp., Tilray Inc., Aurora Cannabis Inc., Aphria Inc., Cronos Group and CannTrust Holdings Inc. — have been reporting earnings reflecting the early months of recreational sales, presenting the first picture of the state of the market across the country. In some cases, the sales figures were microscopic in relation to the valuations the companies are carrying.

Sales and revenues have been absolutely horrible post-legalization Jason Zandberg, a special situations analyst at PI Financial

“Sales and revenues have been absolutely horrible post-legalization,” Jason Zandberg, a special situations analyst at PI Financial, told the Financial Post in a recent interview. “Clearly the market is overpriced and many of these companies have gotten ahead of themselves in valuations.”

According to data from Statistics Canada, just $307 million of legal weed has been sold in the last three months of 2018 for both adult-use and medical consumption post-legalization, versus $1.17 billion in sales from the black market. Legal sales to date are far below many pre-legalization forecasts, including a widely-cited report from Deloitte released in mid-2018 that predicted recreational sales alone could generate up to $4.34 billion in 2019.

This week, cannabis industry research firm BDS Analytics also cut its forecast on the expected growth of Canada’s pot market, reducing its target and extending the time frame it will take to get there.

The firm now expects the Canadian cannabis industry to grow to US$5.2 billion by 2024, whereas in January it had forecast that the industry would be worth US$5.9 billion by 2022.

“About 2 years ago, we put out revised numbers for the first year of rec sales and we said it would be $2.5 billion,” Zandberg said. “At the time, we took some flak from investors calling us pessimistic. But if you look at the numbers now, we’re on track to do less than a billion dollars in the first year of recreational sales.”

Part of the reason why cannabis sales have been weaker than expected is because of a nation-wide supply shortage — a combination of Health Canada licensing delays and the struggles many producers are facing to scale-up quickly. While the issues are not entirely unexpected for an industry in its infancy, the disconnect between earnings and valuation was apparent in the recent earnings cycle.

Cronos Group, for example, a cannabis cultivator listed on both the Toronto Stock Exchange and the NASDAQ, received a $2.4 billion investment earlier this year from tobacco giant Altria Group and had a market capitalization of approximately $8 billion as recently as last month.

But in the fourth quarter of 2018, which ended Dec. 31, 2019, it brought in revenue of just $5.6 million while operating expenses tripled from the previous quarter to $29.4 million.

Two analysts covering Cronos — Matt Bottomley from Canaccord Genuity Corp. and Zandberg downgraded their ratings on the company. Bottomley lowered his recommendation to “sell,” citing a “stretched” valuation, especially given Altria’s investment.

“We note that Cronos’ first full quarter of recreational sales fell well behind its large-cap peer group, which reported net revenues that ranged from $21 million to $83 million for the same period,” Bottomley wrote in a note.

“Cronos definitely had their share price rise perhaps too much over the last two to three years. I mean, it is great to have a strong financial backer like Altria, but they are trading a valuations that are just too high. By no means am I disparaging company management, my downgrade is just a reflection of valuation,” said Zandberg.

On a conference call with analysts, Cronos’ chief executive Mike Gorenstein attributed the company’s lower-than-expected revenues to “complications” in the supply chain each time a supply agreement with a province is made.

But in the past two weeks since Cronos’ reported, its share price has tumbled 12 per cent, wiping off approximately half a billion in market value.

CannTrust too, received downgrades from analysts at Cormark Securities Inc., and Eight Capital Inc. due to weaker than expected revenue numbers — unlike Cronos however, none, had a sell rating on the company.

Paul Rosen, Managing Director of Breakwater Venture Capital, a private VC fund that invests in the cannabis industry, said margin compression was a common theme across the industry.

“There are a number of reasons for these low margins. First, the effect of the excise tax, which the LPs are trying to absorb. Then you have increased packaging costs associated with the recreational market, and producers are spending lots of money on getting around marketing prohibitions,” Rosen explained.

Canopy’s third fiscal quarter revenue of $83 million was the highest amongst all the licensed producers in the period from October to December 2018, but its gross margins were substantially lower than what many investors expected, coming in at 22 per cent. The company has a market value of slightly under $20 billion.

Aurora, with a market cap of almost $12 billion, also saw a decent jump in revenue from its previous quarter, with net revenue of $54 million. But it also lost almost $240 million.

Investors seem to have taken notice of the industry’s slow start. Since the earnings season began, the Canadian Marijuana Index which tracks the performance of the Top 20 cannabis companies by market capitalization, has declined by just over 10 per cent.

Rosen, however, remains bullish on the cannabis sector as a whole in the long run, even though he concedes that at some point the excitement and hype that have buoyed the entire industry will have to translate into earnings.

“I don’t care what your business is, but you should not be losing more than a million dollars a day, day after day,” he said.

Zandberg points out that U.S. multi-state operators, most of whom are less established than their Canadian counterparts, are trading at valuation multiples far healthier than the likes of Canopy, Aurora, Cronos and Tilray.

“I think a lot of it is a reflection of lack of financial discipline. When you are a growth industry, the market values what you are going to look like in five years. But when you get to the earnings stage, the market is waiting for you to pump out strong earnings per share,” he added.

But Damas, who has closely followed the cannabis sector for over five years now, believes that focusing on quarterly earnings reports is a “separate issue and backward looking.”

“There are 21.8 million square feet of cannabis greenhouses, all of which will be finished by 2019 or 2020. What we’re seeing right now is kind of like the quiet water before the tsunami hits. Soon, producers will reach peak efficiency and the shortage will be forgotten.”

• Email: vsubramaniam@nationalpost.com | Twitter: VanmalaS