The cannabis industry has been under intense pressure over the past year as regulatory indecisiveness worked its way into expansion plans. At the height of the cannabis market last summer Constellation Brands (NYSE: STZ) invested $4.0 billion in an equity offering of Canopy Growth (NYSE: CGC).
It seemed like the good times were going to continue in October 2018 with the legalization of marijuana in Canada, but lack of available supplies and a transition period resulted in lackluster growth figures and greatly disappointed investors with respect to their expectations. In the 2.5 months following Canadian legalization the Global Cannabis Stock Index published by New Cannabis Ventures plummeted 50%. Cannabis stocks recovered in Q1 after the passage of the Farm Bill on December 20, 2018.
That strength dissipated in April of 2019 and stocks have been on a slow decline until just recently when they nearly retouched the low set in December of 2018. Most valuations last year were driven by sales growth but the lull in the market seems to be a reevaluation of what is important in a cannabis stock.
This article is going to address the key points to look out for in a cannabis company and demonstrate how fundamental stories tend to do better. As the whole cannabis sector is starting to uptick, finding that best of breed stock can help you weather any storm.
Big Money Stocks
Some of the large cannabis stocks backed by conglomerates seem uninterested in profitability and more interested in making sure their strategic needs are being met. Cronos (NASDAQ: CRON) a Canadian marijuana producer received a $1.8 billion investment from Altria Group (NYSE: MO) which is one of the largest tobacco companies in North America. Altria also has a large stake in brewing giant Anheuser-Busch InBev (NYSE: BUD). In total Altria has a 45% stake in CRON and has the option to increase the stake to 55% for an additional $1.06 billion. Even more interesting is that Altria has a chairman and 2 board seats at BUD and the board of CRON is controlled by Altria.
The investments don’t stop there, because BUD also has a research partnership with Tilray (NASDAQ: TLRY), and Molson Coors Brewing Company (NYSE: TAP), competitor to BUD, has a joint venture with The Hydropothecary Corporation for a non-alcoholic cannabis infused beverage.
Massive Multiple Contraction
Many still see huge opportunity in cannabis but the industry itself has gone through a massive correction in its price to sales multiples in just the past 6 months. This means investors are not as ready to pay for sales as they once were. Leading in the contraction are the top players like CGC, TLRY, and CuraLeaf (OTC Pink: CURLF) which nearly halved their multiples. The biggest standout was CRON which went from 255 down to 19. This multiple contraction means that investors will need to see increasing revenue growth quarter over quarter to sustain the stock prices of these companies.
Earnings Starting to Matter
The companies least prone to volatility in the sector were the ones with earnings. Top standout was Charlottes Web Holdings (OTC Pink: CWBHF). This stock has moved higher since the turning point of the Canadian legalization. This move higher was also due in part to growth in its underlying CBD business.
Operational Efficiency and Scalability Attracting Investors
Village Farms International (NASDAQ: VFF) just recently announced its third quarter of profitability. During the announcement it pronounced that it was the first cannabis farm to achieve 1.0 million square feet of cannabis grown in a greenhouse. This scalability and operational efficiency is a key trait. What’s interesting about Village farms is they started out as a greenhouse vegetable producer that slowly started transitioning to cannabis. This operational efficiency strongly contributed to the bottom line and investors were taking notice.
Ideal Company Characteristics
- Compounding Sales Growth
- Smoothly Completing Mergers & Acquisitions
- Vertical Integration
- Scalable Operations & Profitability
CLS Holdings (OTCQB: CLSH), (CLSH.CN) is one company that stands out from the pack and, has been flying under the radar.
CLS Holdings (OTCQB: CLSH) (CLSH.CN) is a best of breed stock that combines all of the best attributes of cannabis stocks into one company.
- They have a strong medical and retail marijuana franchise in both Massachusetts and Nevada.
- With the advent of recreational sales in in Massachusetts they are at an inflection point where sales growth is going to compound higher.
CLSH’s management team has also fully aggregated one acquisition know as Oasis Cannabis. This is one of the top dispensaries n Las Vegas and one glance at the interior retail space will tell the story with its clean professional look.
CLSH Management also has another acquisition in the pipeline to hit in Q1 2020. The next Brockton Acquisition called In Good Health is unique, because the total purchase price is $50 million in cash, notes and equity, but they are getting a company that has the potential to throw off $20 million in EBITDA the first year assuming modest growth. Getting a marijuana company for 2.5X profits is unheard of when the average price to sales is 17X.
They also have a decent balance sheet with $10 million in the bank at FYE 19 and the past quarterly reports have showed a positive trend that looks like they are turning the corner to profitability. They also have plans to grow their operations capacity and have a retail brand known as City Trees which is a specially formulated THC distillate used in vape products, tinctures, and caplets. This product is gaining traction in the market and is distributed in 47 dispensaries. They are vertically integrated and in every way a seed to shelf company. This means there are so many chances for cross promotion, which eventually finds its way to the bottom line.
The cannabis sector clearly looks like it has put in a double bottom on a technical basis so now could be an opportune time to step into the sector and buy value. The next stage of growth could very well be mergers and acquisitions, but it’s unlikely that the top brands backed by conglomerates will be creating mega brands. Those businesses like TLRY, CRON, and CGC will start to work when these large brands start selling and launching CBD or THC infused products. Mergers an acquisition plays could also begin to happen in the space and represent big upside for investors.
The sweet spot in the sectors seems to be a company that can successfully complete acquisitions at fantastic valuations while increasing their revenues and profitability all at once. CLSH is a best of breed stock with all the characteristics an investor is looking for including a great price. By all metrics the stock seems extremely undervalued and ready to run. After the acquisition in 2020 revenues are expected to be $50 million. Using a modest multiple of 5X sales puts a one year price target of $2.00 share on the stock. With so much upside potential and very little downside risk it makes sense to go with the best of breed.
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