Cabot SX Cannabis Issue: September 28, 2022

Sentiment remains extremely negative towards the cannabis sector and the overall stock market.

You can look at this situation and get depressed. Or you can see it as an opportunity to buy cheaper shares for the long term. Being a contrarian, I prefer to do the latter. I think both cannabis stocks and the broad market are buyable right now.

Don’t expect it to be easy to buy stocks now, though. As the old market adage tells us, “buying right never feels good.”

In fact, one of the ways you know you might be making a good entry is that you have to talk yourself into it because you feel a lot of fear, uncertainty and doubt (FUD). Conversely, your worst purchases in the stock market are often the ones you make flippantly, without thinking very much (and often on margin). I know that’s the case for me.

Extreme sentiment measures are rarely a good pinpoint timing gauge. You can easily buy in this environment only to see stocks continue to fall. (The fix here is to plan purchases in several swipes, not all at once.) But over time, buying at negative sentiment extremes works out.

We are now at a negative sentiment extreme for the market.

*The Investors Intelligence Bull Bear Ratio sank below one last week, falling to 0.96. A reading below one is historically a good buy signal.

*The most recent American Association of Individual Investors sentiment poll showed 17.7% bulls and 60.9% bears. When this spread averages negative-10 or more over four weeks, it is a buy signal. That’s the case now. Over the past 35 years, the percentage of bears surpassed 60% just four times. One-year stock returns after those four events were +22.4%, +31.5%, +7.4%, +56.9%, notes Jason Goepfert at SentimenTrader.

Negative Cannabis Sector Sentiment

I don’t have a handy measure that weighs cannabis sector sentiment. But anecdotally, it seems extremely bleak.

*Not even cannabis sell-side analysts can muster much bullishness in the current environment. This is notable, because sell-side analysts in the research arms of investment banks traditionally have a natural bullish bias. Many of them are now cautious.

*Cannabis stocks are quite cheap. Our portfolio of six names has an average book value of one. It has a price to sales ratio (PSR) of just 1.8, despite 30% sales growth. For context, low-margin, low-growth supermarkets are often priced at a similar PSR.

*The sector has been annihilated. The New Cannabis Ventures Global Cannabis Stock Index is down 76% in the trailing 12 months.

The key takeaway: This is a good time to buy stocks in general, including cannabis names. If you own cannabis stocks and you are depressed about the 56% declines for the group year to date, try not to sell. It is probably too late. If you are new to the sector or you otherwise have capital to deploy, I think it makes sense to venture in or average down.

At the very least, everyone should have some cannabis exposure as a play on the inevitable pop once politicians show signs of legislative progress. Those efforts are not over yet. This will happen sooner or later. The only question is timing. (More on this below.)

What Could Go Right for Cannabis Stocks

Sure, there are a lot of reasons to be negative on cannabis stocks. The sector faces challenges like price declines because of oversupply, slowing sales growth, uneven enforcement against illicit sales, and regulatory uncertainty.

But there are also potentially positive catalysts in the mix. They won’t make the stocks jump next week. Investing is usually about buying with a two-to-five-year time horizon, and that’s the case here. However, even near-term gains are possible. The sector could rip again on headline news of revived efforts to pass favorable legislation at the federal level. Some sector experts think that could happen again this year (see below).

Here are six catalysts that could move the stocks higher over the next year.

1. Improvement in oversupply

While inflation is hot in most sectors, it’s just the opposite in cannabis, thanks to oversupply. If the government wanted to lower the Consumer Price Index, all it would have to do is add cannabis to this headline inflation gauge. U.S. wholesale prices have been falling by over 30% year over year, a trend that started last September. The volume-weighted average spot price of cannabis in the U.S. for the week ended September 9 was $1,010 per pound, down 30.7% year over year, notes Cannabis Benchmarks.

At some point this price deflation will change. Here’s why. Given concerns about recession, lenders have become a lot more risk averse. That makes it harder for less capitalized, marginal players to survive. Slowing growth also puts pressure on companies. So, many will go out of business. Or they will get bought out, a trend that picked up in August which saw several deals. This will reduce supply growth.

“We expect more acquisitions in the next six to 12 months,” says CIBC analyst John Zamparo. “Ongoing cash burn combined with an inability to access capital could mean smaller targets become more willing to accept takeout offers. We also expect further restructurings and insolvencies to address overcapacity in both cultivation and retail.”

If our portfolio’s companies buy targets, which is likely because they are the financially stronger companies in the group, they will probably get good deals and benefit.

Here is another sign oversupply is easing: Retail inventory levels for dried flower have been consistently declining from the peak earlier this year, notes Stifel cannabis sector analyst Andrew Carter.

1. Progress again soon on the U.S. legislative front

The Secure and Fair Enforcement Act, known as the SAFE Banking Act, could get passed before the end of January, says Jason Wilson, who follows the cannabis sector closely at the exchange traded fund (ETF) ETF Managers Group (ETFMG). It manages the ETFMG Alternative Harvest ETF (MJ). This law would boost cannabis stocks, since it would give operators better access to banking.

Conventional wisdom holds that nothing happens in Washington, D.C. during lame duck sessions after elections. But I’ve spent a lot of time talking with Wilson over the past several months, and he knows the cannabis sector quite well. So, he is worth listening to. He’s not alone, in this view. “We continue to believe that SAFE Banking has a real chance of passing in 2022, most likely in the lame duck session after November’s midterms,” says CIBC’s Zamparo. Note that the bill does not actually have to pass for cannabis stocks to catch a bid. Believable speculation about progress would do the trick.

A recent poll by the Independent Community Bankers Association found that 65% of voters support giving cannabis companies access to banks. They cited potential crime reduction, among other reasons. The poll result “provides cover for Republicans on the SAFE banking act,” notes Cowen cannabis analyst Vivien Azer. She’s nevertheless skeptical about progress this year, as I am because of the lame duck status for Congress after the elections. But well informed experts disagree with me on this and they might be right.

1. Progress on the state front

Several states have votes on cannabis legalization coming up in the November midterm elections, including Arkansas, Maryland, Missouri, and South Dakota. Though these are smaller states with smaller markets, many of them send Republican Senators to Washington, D.C.

Republicans often oppose cannabis reform, so approval of legalization by voters might change their thinking. “State-level legalization by no means causes senators to support reform nationally, but it certainly helps send the message to lawmakers about what it is citizens prefer,” says CIBC’s Zamparo.

1. Progress in Europe

Legalization in Europe gets less attention in the U.S. But it would be big for the sector, given the size of the European Union economy. We could see progress soon. Wilson, at ETFMG, thinks Germany will advance a draft legalization bill by the end of the year, and he thinks German legalization in 2023 is possible. That could produce a domino effect in the rest of Europe.

1. Reasonably strong growth continues

The white-hot growth days for cannabis are over. But growth is still pretty good, and most (if not all) of the slowdown has probably already been priced into the stocks.

Here’s the context: The $25 billion U.S. legal cannabis market expanded at a torrid 90% compound annual growth rate (CAGR) over the last five years, including over 30% growth in 2021. But that’s changed because of cannabis price deflation, weak consumer sentiment, and challenging comparisons to strong pandemic cannabis sales.

Cowen’s Azer now expects U.S. cannabis sales to grow at a 12% CAGR to hit $45.6 billion in 2027. That’s still very good growth. And keep in mind the following: Her projection assumes no federal legalization. Lower prices attract more price-sensitive consumers to the legal market, which helps cannabis companies. States that legalize then post impressive growth. And the growth decline is “more than priced into the stocks,” says Azer, given that valuations have declined 83% since February, 2021. “We continue to remain constructive on the U.S. cannabis industry,” she adds.

CIBC’s Zamparo recently trimmed his 2023 Canadian sales projection to $5.2 billion from $5.5 billion. He thinks 2022 sales will come in at $4.6 billion, which suggests 13% sales growth next year. Again, not 30%, but not bad.

1. Risk-on investment psychology returns

I’m sticking with my case in my September 14 update that headline Consumer Price Index inflation will soon start to show obvious signs of easing, given the sharp declines in upstream inflation indicators like commodity and energy prices. Gasoline has come down a lot and even rents are declining on a sequential monthly basis, according to CoStar, which tracks the real estate market.

Declines in headline inflation will ease fears about the Fed creating a recession and bring a return to risk-on investing. That will help perceived risky groups like cannabis. It will also boost consumer and corporate sentiment. This will boost spending by both, and help avert recession, or make any recession a mild one. Most recessions caused by Fed rate hikes are triggered by a credit-related debacle caused by excessive and irresponsible lending and borrowing. There do not seem to be any vulnerabilities on this front at the moment.

New Names

Because of the prospects for progress on recreational use legalization in Germany and the rest of Europe, I’d like to increase our international exposure. I’m introducing two new names to our Sector Xpress Cannabis Advisor portfolio this month which do this. I’m putting $15,000 into each, which will make them roughly 7% positions. This will bring our cash position down to about 19.6%.

Tilray Brands (TLRY)The product of a 2021 merger with Aphria, Tilray is a cannabis and consumer packaged goods company with one of the biggest global geographic footprints in the industry. It is a large recreational and medicinal cannabis supplier in Canada. Tilray also supplies medical cannabis in 20 countries on five continents through its subsidiaries and agreements with pharmaceutical distributors. It sells CBD products in the United States.

Tilray has been making significant investments in its operations in Europe. It has a medicinal marijuana distribution network in Germany, where it has 20% market share. It has production facilities in Portugal and Germany.

Tilray recently met with German political leaders to try to help advance legalization of recreational use there. In the meeting, Germany’s Drug Commissioner Burkhard Blienert reiterated the German government’s plan to present a first draft of its legalization bill in the coming months. That would be a catalyst for the stock. Tilray recently got approval from the Italian Ministry of Health to import and distribute medical cannabis.

Tilray sells hemp food products through its Fresh Hemp Foods division, and it has a craft alcohol business called SW Brewing, the 10th largest craft brewery in the United States.

Second-quarter sales grew 14% to $163 million, but the company reports losses and negative cash flow.

The cannabis market is crowded in Canada so Tilray faces a lot of pressure to develop consumer brands that can lead to pricing power. CEO Irwin Simon founded The Hain Celestial Group, a natural food company, so Tilray has a plausible shot at getting this done.

In July, Tilray formed a strategic alliance with the cannabis company Hexo (HEXO). This could bring substantial cost savings over the next two years. Tilray also holds convertible debt and warrants in MedMen Enterprises, a U.S.-based dispensary with over 25 stores in six states, including California, Illinois and Florida. This gives Tilray exposure to the U.S. market. Conversion of the debt and warrants could eventually bring a significant outright ownership stake, if that ever becomes legal.

One risk here is that Tilray fails to produce positive free cash flow, so a dilutive capital raise is possible. On the other hand, the company projects it will turn cash flow positive by August next year. Next, Tilray is the kind of “industry flagbearer” that could see a big boost on SAFE banking progress, notes CIBC’s Zamparo. And the exposure to potential legalization in Germany and other parts of Europe, where legalization may soon advance, is a plus.

ETFMG Alternative Harvest ETF (MJ)We’ve avoided cannabis ETFs, but I think it’s time to change that to broaden diversification and international exposure. For this purpose, I’m adding the ETFMG Alternative Harvest ETF. Among the cannabis ETFs, it has outsized foreign exposure, by design.

This means ETFMG Alternative Harvest could benefit more than other marijuana ETFs if we see progress on legalization in Germany, which could happen in the form of draft legislation by the end of the year, and decriminalization of recreational use in 2023.

“Legalization in Germany could be a tipping for global expansion,” according to cannabis experts at ETFMG. This would put additional pressure on other European Union members to move forward with legalization. It could also encourage reform of the 1961 U.N. Single Convention on Narcotics which prohibits the cultivation and sale of recreational cannabis. “Such a result would be momentous and would open the doors to a global market,” says ETFMG.

Owning this ETF broadens our industry exposure to names not in our portfolio, like Canopy Growth (WEED), SNDL (SNDL), Cronos (CRON), and GrowGeneration (GRWG), among others.

What to Do Now

If you’re a new subscriber, or you’re underinvested in the sector, you should consider buying new additions Tilray Brands (TLRY) and ETFMG Alternative Harvest ETF (MJ) now. These new additions take our cash position down to around 19.6%. Also consider adding any of the other buy-rated names in our portfolio that are down sharply with the sector, meaning Ayr Wellness (AYRWF), Cresco Labs (CRLBF), Curaleaf (CURLF), Green Thumb (GTBIF), OrganiGram (OGI) and Trulieve (TCNNF).

Portfolio

Current Recommendations

Ayr Wellness (AYRWF) is a vertically-integrated multistate operator based in Miami, Florida with 73 dispensaries in eight states (Arizona, Florida, Illinois, Massachusetts, Nevada, New Jersey, Ohio and Pennsylvania). It makes the #2 carbonated THC beverage in the U.S (Levia). It has its products in 475 third-party stores. And it has three adult-use stores coming to the very dense New Jersey market. Second-quarter sales were $110 million, up 21% from the prior year but down less than a percent from the first quarter, while the loss per share was $0.56, the biggest loss of the past two years. The company ended the quarter with $117 million in cash, so viability is not a problem. The problem is that growth is slowing, and profitability now looks farther out than investors previously anticipated. But it’s by far the cheapest name in our portfolio trading at just 0.39 times sales compared to a portfolio average of 1.83. And the company is posting incremental progress. Ayr recently rolled out its Lost in Translation cannabis brand in four more states, and a partner won a cultivation license in Connecticut. BUY

Cresco Labs (CRLBF) reversed its July-August strength to retest its summer lows, mirroring the moves in the broader market. That makes the stock look attractive here. The company is on track to become the biggest cannabis company in the world, once its acquisition of Columbia Care (CCHWF), expected to closed by the end of the year, is complete. Cresco has long prioritized the wholesale market, and thus is currently the #1 seller of branded cannabis products in the U.S., with its products in over 1,100 stores. But retail revenue has been growing faster, and the addition of Columbia should create a balanced powerhouse. Second-quarter revenues were $218 million, up 4% from the year before, while EBITDA was $51 million, or 23% of revenue, up 11% from the previous year. Management expects continued growth as seven more high-population states—New Jersey, New York, Pennsylvania, Ohio, Virginia, Florida and Maryland—transition to legal adult use. Cresco recently expanded its Cresco brand vape and concentrate product in Florida. BUY

Curaleaf (CURLF), based in Massachusetts, was the industry leader in the second quarter, with revenue of $338 million from 22 states and 136 dispensaries and its European operations but will likely be surpassed by Cresco once the Columbia Care acquisition is complete. Still, Curaleaf is the clear leader on the perception front. Its market capitalization of $3.7 billion tells us investors expect a lot from the company—and its price/sales ratio of 2.86 is the second highest of our U.S. operators. Curaleaf will benefit from progress on legalization in Germany and Europe. It has operations in eight European countries as well as Israel. It just completed the acquisition of a majority stake in Germany’s Four Pharma, a licensed producer and distributor of medical cannabis that has more than 10% market share in Germany. Investors also believe the company’s R&D will pay dividends as the industry goes more mainstream. The company recently announced the launch of Plant Precision, a curated collection of edibles and a topical gel that contain minor cannabinoids that are non-psychoactive and do not create the euphoric feeling that THC does. They are designed to target specific wellness categories for the growing numbers of Americans who say they would be more likely to use cannabis as a health solution if it came in small, controlled doses. Curaleaf also has a healthy balance sheet—$90 million at the end of the second quarter. Ongoing market developments in Illinois and New Jersey could be strong catalysts for Curaleaf, says Stifel’s Andrew Carter, who has a buy rating on the stock. Illinois will increase its store footprint by more than 2.5 times. Considerable upside exists in New Jersey as product offerings expand in the second half of this year, he says. BUY

Green Thumb (GTBIF), based in Chicago, is the portfolio’s largest position. Green Thumb was the third-largest cannabis company in the U.S. in the second quarter but will likely fall to fourth after Cresco’s acquisition of Columbia is complete. Yet it has been the most profitable multistate operator of all the big ones, based on its consistent record of profitability over the past eight quarters—a sign of good management. Second-quarter revenues were up 15% from the previous year to $154 million, while earnings per share were $0.10, unchanged from a year ago. Revenue growth was driven mainly by increased retail sales in New Jersey as the legal market opened, increased retail sales in Illinois, 19 new locations opened since last year, and increased traffic in most of the company’s 77 stores. If you already own the stock, hang on tight, otherwise consider buying in the current correction. Ongoing market developments in Illinois and New Jersey could be strong catalysts for Green Thumb Industries, says Stifel’s Andrew Carter, who has a buy rating on the stock. Illinois will increase its store footprint by more than 2.5 times. Considerable upside exists in New Jersey as product offerings expand in the second half of this year. We will learn more when the company announces earnings November 2. BUY

OrganiGram (OGI) is the number three producer of cannabis in Canada, and number one in dried flower, with its flagship brand Edison. And it’s now the fastest-growing company in the portfolio; second-quarter revenue (technically the firm’s fiscal third quarter) was $38.1 million, up 88% from the year before, which was in stark contrast to many Canadian producers, who are still shrinking thanks to falling wholesale prices. And the loss per share was just a penny, unchanged from the preceding quarter. Part of the company’s growth comes from the international market. During the quarter, OrganiGram made two shipments totaling $1.3 million to Australia, and since then it has shipped a further $5.4 million of product to Australia and Israel (and it’s looking seriously at opportunities in the German market). But the major reason for growth was expanding market share in Canada, as investments in automation reduced dependence on manual labor and enabled continued price competitiveness. British American Tobacco (BTI) is a big investor in OrganiGram, owning 19.4% of the company, an endorsement of its potential. BUY

Trulieve (TCNNF), long the biggest seller of marijuana in Florida, where it has a 46% market share and does 70% of its business, has been expanding across the country in the past year (it had seven acquisitions in 2021). The upside of that expansion effort (short term) is that it made Trulieve #1 in the U.S.—a title it will likely cede to Cresco. The downside (again, short term) is that it ruined the company’s record as the “most profitable” multistate operator, as its record of seven consecutive profitable quarters has now been broken by three consecutive quarterly losses. Long term, however, Trulieve has great prospects and has a unique geographic hub system, with Florida the company’s Southeast hub, Pennsylvania its Northeast hub, and Arizona the Southwest hub, all serving the company’s current operations in 11 states. As of June 30, Trulieve had $181 million in cash, and as of August 10, the company had 175 retail outlets in 10 states. Management expects full-year revenue to hit $1.25 to $1.3 billion this year (that projection is down a little) and expects positive free cash flow in 2023. The company has had a busy September, announcing new medical dispensaries in West Virginia, a production license for medical cannabis in Georgia, and the launch of Khalifa Kush medical cannabis products in Florida in partnership with the recording artist Wiz Khalifa. Trulieve will present at three cannabis conferences in September, which could attract investor interest. BUY

The next Cabot SX Cannabis Advisor issue will be published on October 26, 2022.