Market Offers an Opportunity to Reposition Cannabis Investments

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The cannabis sector experienced something we haven’t seen in quite a while Friday, rallying sharply despite weakness in the broad stock market. In fact, the New Cannabis Ventures Global Cannabis Stock Index bounced 14.3% from the all-time low set on Wednesday as the S&P 500 fell almost 4%. For the full week, cannabis stocks declined 8.5%, far less than the 15% drop in the S&P 500.

Extreme Pessimism

For perspective, cannabis stocks have performed quite poorly. Even with the bounce, they are down 54.1% in 2020 thus far, and this follows declines of 34.1% last year and 54.9% in 2018. Our survey in last week’s newsletter, not surprisingly, revealed extreme pessimism among respondents, with over 70% expecting the decline to persist at least over the balance of the month:

The index had closed at 21.18 on the Friday before our newsletter went out, but we kept the survey open until Monday evening, when the index closed at 18.99 and note that it closed at 19.38 on Friday.

More Gains Ahead or Just a Bounce?

Is this the beginning of a new bull market in cannabis stocks, which have declined 82% from the peak exactly a year ago, or is this a chance to sell? We think it is a bit early to call a bottom and have seen many other apparent bottoms prove not to be, but we hope the plunge and partial recovery does signify the end of the decline that began in early 2018. We would attribute the bounce to two factors. First, there was likely some short-covering. Second, and perhaps more importantly, news reports of surging demand for cannabis along with all states that are restricting business activities not forcing dispensaries to close likely attracted some buyers.

Of course, the short-term spike in sales, as described by Akerna as an increase of 19.2% on March 18th from March 11th, isn’t sustainable, but we do think that when some sense of normalcy returns, there are likely to be two big takeaways for cannabis investors. First, we have come a long way in recent years such that state governments categorize cannabis as “essential”. This reinforces the state-legal proliferation thesis. Second, the pandemic isn’t likely to end quickly, which leads to two positive implications. First, cannabis legalization could be seen as more important to states looking for tax revenue and job growth. Second, cannabis companies may see more demand as consumers cope with increased anxiety, trouble sleeping and other conditions that are being exacerbated by this crisis.

Rather than suggest to our readers to be buyers or sellers in general, we will share this perspective: This is a great time to consider repositioning. Last week, we warned that many companies will be forced to raise capital on egregious terms, diluting existing shareholders. Some companies, though, are better positioned to weather the current environment than others. Some of the biggest bounces are taking place in some of the companies less likely to avoid dilution, and we think it could make sense to use the rally to reduce exposure to them and to increase it to companies that are in a better position. At our premium service, 420 Investor, we have been discussing this theme extensively as we also reposition our model portfolios.

A New Threat to Investors Emerges

This week, something that caught our attention should alarm investors in small cannabis companies, the “take-under” of Indus Holdings. This is a story most readers probably aren’t following, so let us summarize. A week ago, the California cultivator and processor, which has its own brands but also provides turnkey services to other companies, had a market cap of just $7 million (and today as well) at a price of just $0.21 (C$0.30). The company, which generated $10.1 million revenue in Q3 and $26.2 million year-to-date, had used $31.3 million to fund its operations through the first three quarters of the year and had ended the quarter with just $2.7 million in unrestricted cash, leaving it in dire need of additional investment, which it found through an outside investment group.

The pending Geronimo Capital investment into Indus consists of up to $14.5 million in a convertible note with a conversion price of $0.20, approximately where the stock had closed previously. Doing the math, this would convert to over 72 million shares for a company that currently has just 32.5 million shares and no debt. Though there will be no shareholder vote apparently, this is a change-in-control, with existing shareholders owning potentially just 31% of the recapitalized company. Since the investment is debt, it is possible that the new investors could end up with the entire company should the financial condition deteriorate and the company seek creditor protection.

Indus went public with a $40 million capital raise at $11.60, so this next round is a bit of a down-round at $0.20, down almost 98%. The balance sheet of the company showed assets, nearly all tangible, as $85.8 million, with liabilities of $44.1 million. The company agreed to give control to outside investors (as well as some insiders that are participating) at a valuation that represented approximately 16% of tangible book value. Annualizing the Q3 revenue, the valuation represented 16% of one-year sales as well. The alternative to selling out at such a low price may have been worse, as the company may not have been able to continue as a going concern.

Focus on Earnings

We caution our readers to be particularly careful with companies that aren’t on a path to profitability and that lack access to capital, as we expect many other small cannabis companies could be taken over at terms that aren’t favorable or risk extinction, as we discussed in last week’s newsletter. This environment elevates the risks to investors in these types of companies in general but especially in our industry, where capital is even more constrained. On the other hand, several companies that are either close to or at profitability or that are adequately capitalized have declined with the market-wide sell off, and this could be an opportunity for investors who want to participate in the growth ahead.

You’re reading a copy of this week’s edition of the New Cannabis Ventures newsletter, which provides thought-provoking commentary on the industry from a financial and business perspective. We do this at no cost to our expansive readership, which spans greatly from industry executives, family investment offices, competing industries, regulators and retail investors. The newsletter represents an example of the extensive content we provide daily and in real-time on Alan Brochstein’s 420 Investor service, built to help investors navigate the complexities of the cannabis sector.

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Alan & Joel

Exclusive article by Alan Brochstein, CFA
Alan Brochstein, CFA
Based in Houston, Alan leverages his experience as founder of online community 420 Investor, the first and still largest due diligence platform focused on the publicly-traded stocks in the cannabis industry. With his extensive network in the cannabis community, Alan continues to find new ways to connect the industry and facilitate its sustainable growth. At New Cannabis Ventures, he is responsible for content development and strategic alliances. Before shifting his focus to the cannabis industry in early 2013, Alan, who began his career on Wall Street in 1986, worked as an independent research analyst following over two decades in research and portfolio management. A prolific writer, with over 650 articles published since 2007 at Seeking Alpha, where he has 70,000 followers, Alan is a frequent speaker at industry conferences and a frequent source to the media, including the NY Times, the Wall Street Journal, Fox Business, and Bloomberg TV. Contact Alan: Twitter | Facebook | LinkedIn | Email

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