Marijuana stock CannTrust Holdings (NYSE:CTST) has revealed it's been growing pot in unlicensed rooms, calling into question its future as a cannabis leader. The discouraging news follows a string of disappointing disclosures at the company, including worse-than-expected financial results and a downward revision to its future cannabis production.

Can CannTrust restore confidence with regulators and investors, making it a bargain pot stock worth buying? In this episode of The Motley Fool's Industry Focus: Healthcare, analyst Shannon Jones is joined by Todd Campbell to explain what's going on, and outline what could happen next.

Also, Jones and Campbell dive into the reasons why Gilead Sciences' (NASDAQ:GILD) CEO just inked a multibillion-dollar deal with Galapagos NV (NASDAQ:GLPG) to develop drugs together. Can this deal pan out for investors in both companies?

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

This video was recorded on July 24, 2019.

Editor's note: At one point Todd Campbell misspoke; he should have said "GLPG1690, which is in phase 3 for idiopathic pulmonary fibrosis."

Shannon Jones: Welcome to Industry Focus, the show that dives into a different sector of the stock market every single day. Today is Wednesday, July the 24th, and we're talking healthcare. I'm your host, Shannon Jones. I am joined via Skype by healthcare guru Todd Campbell. Todd, how are you doing?

Todd Campbell: I'm doing really good! I hope everybody out there listening is enjoying their summer so far, getting ready for their August travel plans and the like. Are you going anywhere, Shannon, for vacation?

Jones: I'm headed to California here very soon. Going to actually have some time on Huntington Beach. I've been out to [Los Angeles], never to Huntington Beach. I'm excited about some downtime and just, honestly, sitting on a beach with a book. [laughs]

Campbell: [laughs] Sounds like a great way to spend some time this summer! I've actually never been out that way. Maybe some listeners can chime in and give you some tips on places to eat.

Jones: Yes! And Todd, you're headed out to Germany soon.

Campbell: I am. In two or three weeks, I'm going to disappear for 10 days and see what Munich is all about. I'm really looking forward to visiting Munich and Prague and maybe getting down to Innsbruck.

Jones: Yes, beautiful area! Look forward to hearing about your travels when you get back. Hopefully nothing too crazy will happen in the biotech space. As for today's show, we've got some news both from biotech and from the cannabis industry. July's been a busy month for marijuana around the globe.

Todd, let's kick things off with biotech, specifically Gilead Sciences and Galapagos. Back on July the 14th, Gilead Sciences, ticker GILD, and clinical-stage biotech Galapagos announced they were deepening their partnership in a $5 billion deal. CEO Daniel O'Day, Todd, has been on the job only since the spring; he's already announced about a half-dozen partnerships. He's really making his mark already. This particular deal, though, is structured a little bit atypical[ly], but gives a lot of optionality for Gilead, and gives Galapagos a good infusion of some cash.

Campbell: Yeah, big bucks, big bucks -- no question there. Gilead Sciences, we've talked a lot about on the show before; what's Gilead going to do next? It's sitting on bazillions -- is that a technical term? Bazillions of dollars?

Jones: At least bazillions.

Campbell: [laughs] It can deploy that to get itself kick-started and start generating revenue and earnings growth for investors again. Everybody's been sitting on the edge of the seat to see what Daniel O'Day, who came over from Roche, would do once he got comfortable in that C-suite seat. Now we're starting to get a feel for what his vision may be for Gilead Sciences in the future.

To me, it seems like this deal is a good indicator that we're not going to get maybe a huge megadeal where they buy 100% of a company, like what they did a couple of years ago with Kite, when they bought that for $11.9 billion. Instead, what they'll do is they'll cut these deals -- I was trying to think of a way to...this is such a complicated deal, there's a lot of moving pieces to it. When you boil it all down, maybe a good way to think of it is that Gilead Sciences bought roughly 75% of Galapagos' future revenue potential. That's because it's handing over a bunch of money to have the option to get the rights to basically everything in Galapagos' pipeline, from here and over the next 10 years. Galapagos, for its part, will sit back and collect royalties of between 20% to 25% on anything that gets approved from here, with some exceptions. It's a complex deal! No question.

Jones: It's very complex. From a high level, it's a $5 billion deal. But when you break that down, Gilead right now is making a $3.95 billion investment in up-front cash, plus an additional $1.1 billion equity investment in the company. The way that you summarized it is probably the easiest way to say it. But even further, this is essentially giving Gilead ownership of about 22% of Belgium-based Galapagos. But with the warrants, this stake could go up to 29.9%, with the promise that Gilead won't try to take them over or try to increase their ownership stake over the next 10 years. Gilead also got two Galapagos board seats as well.

I think holistically, a very complicated deal that continues to allow Galapagos to remain independent. I think that's what Daniel O'Day, coming from his Roche background, really values, is: to have these business units that can operate on their own, really drive innovation. As you and I have talked about a lot on the show, Todd, oftentimes, those big, megamerger deals in biotech never pan out. The synergies never happen, and more importantly, there's a lot of culture clashes that happen when you start to mix up teams and start to share resources. I can see this is very much a deal right out of the Roche playbook.

Campbell: Right. Smaller companies are nimbler, they can act faster on advances in science, they can commit more of the money that they raise directly to R&D [research and development] rather than overhead. And, think about it this way: Galapagos shareholders are certainly more willing to have the capital that Galapagos has go into R&D, where shareholders of Gilead Sciences may be more interested in seeing their earnings climb, their dividend payouts increase. That creates a natural conflict between the R&D team and, say, the CFO, who's trying to allocate the money across the organization to keep everybody happy.

One of the things investors who are new to the Gilead and Galapagos story may be asking themselves is: Why was Gilead interested in this company in the first place? It stretches back to 2015. That was at the point where AbbVie, which is a Gilead nemesis, if you will, in hepatitis C, walked away from filgotinib, a selective JAK1 inhibitor that the two were developing as a potential successor to AbbVie's best-selling Humira. As many of you probably already know, [Humira] racks up about $20 billion in annual sales treating autoimmune disorders such as rheumatoid arthritis. When AbbVie walked away, Gilead Sciences saw that as a great opportunity to get into what is a multibillion-dollar market opportunity. So they went out and they said, "OK, tell you what, we'll give you $300 million up front to license the rights to filgotinib. We'll help you develop it through phase 2 and phase 3 trials. We'll also give you over $400 million to buy a 12% to 13% ownership stake."

Those trials, and the development of filgotinib, have been very successful. In phase 2, filgotinib showed that it could reduce or increase response rates to patients with rheumatoid arthritis. Those were backed up recently with the result of positive phase 3 trials, which again showed that it matches up very favorably to methotrexate, and potentially on a safety front, matches up well against Humira. Now, the two companies are planning on filing filgotinib for FDA [Food and Drug Administration] and EU approval before the end of this year -- theoretically clearing the way for this drug to make it to market about 10 months after the FDA accepts that application, let's say late in 2020. So, this seemed like a really good time for Gilead Sciences maybe to solidify its relationship with Galapagos, which has proven through filgotinib that it knows a thing or two about developing drugs that can make their way through trials.

Jones: Todd, this $5 billion deal is just not about filgotinib. It is really about strengthening Gilead's pipeline for the long term. As I mentioned, you've got a lot of optionality with this particular deal. A lot of them are still pretty early-stage, though. Filgotinib is the one that gets all the attention -- certainly, as you mentioned, has had some good results in clinical trials. But essentially, Gilead's getting access to six drugs in development, plus 20 other early-stage programs. It's pretty remarkable: This one deal is effectively doubling their pipeline in one fell swoop, Todd.

Campbell: Right, and giving Galapagos a ton of financial flexibility in the process, and the potential to have it even be a bigger deal. Two of the drugs that they also have the options on now are: GLPG1690, which is an osteoarthritis drug that's in phase 2; if that ends up getting approved, they can collect hundreds of millions of dollars' worth of milestones on that. [Editor's note: GLPG1690, the drug Todd was discussing here, is actually in phase 3 for idiopathic pulmonary fibrosis; the phase 2 osteoarthritis drug is GLPG1972.] They've got another drug that's also further back in trials that they can collect another $200 million on, plus hundreds of millions in regulatory and commercial milestones.

And then you mentioned the 20 programs that Galapagos has in even earlier stages. If any of those eventually make their way down the pike, Gilead Sciences can option into those and pay $150 million per program to get rights to that. This is a potential cash cow that could stretch out for years for Galapagos, and reward Gilead investors with a stable production of new pipeline candidates.

Jones: And it lessens their reliance on the HIV franchise, which we've talked about quite a bit, and of course the ongoing concerns about the hepatitis franchise as well. This also gives Gilead a foothold in Europe, which they previously have not had to this degree, and puts them right in the court of the immunology space, which I think is important for a company that is trying to figure out where its growth is going to come from.

All in all, I like the deal. I do like the optionality. I think for a lot of investors, you're still wondering: Is there going to be this big transformative deal? I really don't think so. I think you're going to see a lot of these smaller plays designed to beef up that pipeline long-term.

Campbell: Yeah. And I think actually, if you're an investor and you're looking at these two, Gilead Sciences is still trading at a pretty decent discount based on where it was a few years ago. Galapagos is hitting new highs on the deal. I actually think that the deal might be a bigger win for Gilead, and may give investors yet another reason to go out and consider finally putting that in their portfolios, if they don't have it already.

Jones: Great point, Todd! Let's turn our attention to the cannabis space now. CannTrust Holdings, ticker CTST, or, probably, I should say, Cann'tTrust Holdings at this point. News just came out prior to the opening bell on Monday, July the 8th, that CannTrust, one of the major Canadian licensed producers, grew cannabis in unlicensed rooms at one of its facilities -- a huge no-no, particularly given the company's focus on growing medical-grade cannabis for patients. Shares absolutely tanked, down almost 60% on the news. But really, Todd, this particular story is a long list in the line of woes that CannTrust has had this year.

Campbell: This is disappointing. It's a good reminder to investors, including myself -- I happen to be a shareholder of CannTrust -- that you need to diversify when you go into particular industries. Don't bet everything on one small-cap company; spread it out.

This is where the "go fast" mentality of entrepreneurs in fast-growing markets like this can work against you, if the practices and processes aren't in place, the corporate governance isn't in place, to make sure that everybody's doing things by the book. We've talked about it on the show, you read about it online: There's a shortage of marijuana in Canada following the legalization of recreational use last fall. That's prompted all of these Canadian cannabis companies to invest tremendous amounts of money in expanding their capacity to grow marijuana. The rule in Canada is, though, that you need to have a license first before you can cultivate it. The disclosure that they were growing in these five rooms, which you mentioned, is in a string of bad news this year for this stock, is obviously very disheartening, because it shows that management maybe cut some corners toward that goal of becoming one of the largest Canadian producers.

We'll get to the implications of what could happen from here in a second. But to run down the list of "bad news" that this company has delivered to investors this year:

  • Back in March, they reported quarterly results that were shy of industry-watchers' expectations. Their fourth-quarter revenue had clocked in around 16.2 million Canadian dollars. That was up a lot, 132% year over year, but people were looking for CA$20 million in sales; [they] fell shy of that.
  • Then, in April, they announced: "We're going to issue more shares to solidify our balance sheet and give us plenty of money to execute on our growth strategy." The problem is, there wasn't a lot of appetite among investors for that deal. As a result, the deal actually closed at a price that was 15% below the stock's closing price the day before. That's not a good sign.
  • And then in May, they reported the most recent quarter's results, and that showed very little sequential revenue growth. Now, we know the Canadian recreational market has been struggling, flattening out in the first quarter, so that's not too surprising, but still not necessarily something that you would want to see. You'd rather see this company generating strong quarter-over-quarter growth.
  • Then, in July, before they even told investors that they had gotten caught for growing in these five unlicensed rooms, they disclosed that their previous plans to grow up to 75,000 kilograms of marijuana in a new acreage they had purchased may not pan out; there may actually be zero to 75,000 kilos, because they had yet to receive licensing for that space.

So, you've got this string of bad news that has just punished investors. And now, the stock is trading at a market cap of about $380 million, which, considering the market caps of some of the competitors and peers that have similar capacity, is downright tiny.

Jones: Yeah, extremely. As you mentioned, a lot of the issues that have plagued CannTrust this year aren't specific to CannTrust. There is the supply shortage related to regulatory and packaging constraints throughout the supply chain. But I'm going to go out on a limb here and say, with CannTrust growing cannabis in unlicensed rooms -- I don't think they are the only player in this space that has done that.

Here's why I say that. I think when legalization happened in October of 2018, you had a lot of licensed producers -- well, they weren't licensed at the time, but they were preparing for that, but they did not want to actually start building out anything until they knew it was a sure deal. As a result of that, now it's been an all-out sprint to try to get these facilities up and running as quickly as possible so that they can gain market share. The problem with that is Health Canada and their massive backlog on these licenses, while these companies are waiting to grow and to sell and to process, and do all of the things that they need to do to actually start generating revenue. When you're looking at the backlog -- at one point, it was up to 800 applications in Health Canada's backlog; that was earlier this year. I don't know where it's at right now, but 800 is a lot. Cultivation licenses themselves take months. Sales licenses take about a year. If you're a grower, that means you could be waiting up to two years to get all of your licensing in play. You have to remember there are so many producers that are trying to get online right now, that are trying just to get into a spot to start generating revenue; I don't think CannTrust is the only one. I think they're the only one that's been caught so far.

If you remember, this was actually reported because an employee was disgruntled and whistle-blew on this particular company. So, I don't think that they're the only ones. That is by no means to condone what they did. I think there's a lot of regulatory hiccups. But CannTrust: Even news this morning came out, Todd, that the executives knew seven months before Health Canada found out about this. So, if anything, I have a lot less confidence in the management team. I think you're going to have to see a shake-up there. But again, I think this is one of many stories that we'll probably see as the regulators and the producers try to get on the same page.

Campbell: Right. CannTrust has created -- the board of directors has created -- a special committee comprised of independent members of the board to investigate this matter. They did send a letter this week responding to Health Canada; Health Canada did say that they received the letter. They have not said, either of them, what's in the letter. Health Canada has not said when it may respond to the letter. So we don't know how this is going to shake out.

It could go one of two ways. One way would be very good for investors; the other could be potentially disastrous to investors. You could have, theoretically, Health Canada say: "Guess what? We're revoking your licenses, effectively meaning you're going to have to go out and fire-sale all your stuff to somebody else." I don't suspect that'll happen, but I suppose it's a possibility.

The other end of that could be that the board gets together and says: "Tell you what, here's our plan to make sure nothing bad ever happens here again. We'll ditch our CEO." I think he has to go. At this point, he has to go. This is like Aphria, and the CEO having to step down there earlier this year. He's got to go. So, you change up the management. You put practices and processes in place. They allow these grow rooms to operate. And then by the end of this year, you've got a company [that's] producing at an annualized rate of 50,000 kilos, and then next year, theoretically, you could have them exit 2020 at 200,000 kilos. With a $380 million market cap, there's theoretically a lot of optionality there.

But again, the big risk and the big unknown: What will Health Canada finally decide to do?

Jones: So true. I think at the very least, you're going to see a hefty fine. You're probably going to see a suspension. I don't know if they'll revoke their licenses.

I guess another follow-up question to that is: With whatever regulatory punishment, will it just impact the one facility where they were growing in these unlicensed rooms? How does this impact their outdoor grow facility? CannTrust was really focused on investing in and building that up ahead of the derivatives market, which is set to open in December of this year. So I think you've got a lot of questions there.

Another question is: What's going to happen to the inventory related to these unlicensed rooms? Right now, they've got 5,200 kilos on hold. The company also voluntarily is withholding 7,500 kilos of dried cannabis, for a total of about 12,500. Considering they only sold 3,000 kilos and produced 9,400 during March, I'm concerned about what's going to happen to this inventory. Assuming that the fines and the other punishments don't necessarily completely knock them offline, even so, that means they're probably going to have to go to the wholesale market, and they really have very little leverage in terms of negotiating power at this point. And even so, that's going to continue to squeeze their margins even further.

As you mentioned, you've got this scenario -- this is a very high-risk, high-reward play -- they get a slap on the wrist and they're able to move forward.

Another scenario I'm going to throw out there is a white knight. I think the sharks are more than likely circling at this point. You've got CannTrust right now, half-completed Niagara campus, 60,000-square-foot Vaughan facility. I talked about their outdoor grow facility that can be used for extraction. A lot of the players are trying to focus on the extraction ahead of derivatives. You've also got...CannTrust right now is one of only four Canadian growers that has supply deals in all 10 provinces in Canada, and they've got a foot in the door in the U.S. They announced just recently a joint hemp-farm venture with Elk Grove in California, just so they can ride the wave of hemp legalization here in the U.S. CannTrust has a ton of assets. I would not be surprised to see someone come in and attempt to take them over, either.

Campbell: They've also got $150 million or so of cash on the books that can help finance whatever deal ends up getting cut, if that's the route they end up going. I don't know if they'll go that route, because I'm not sure shareholders are going to want them to fire-sale. Obviously, I don't think any of these companies are going to come in and offer top dollar if they don't have to. They might. You never know. This could be one of those situations, Shannon -- we always talk about "buy the rumor, sell the news."

Jones: You might be onto something here, Todd. But, yeah, a lot to watch with this story. Regulatory mayhem right now with Health Canada and these producers.

Again, I don't think this will be the last story that we hear of mishaps. This is still an industry very much in its infancy. They're all trying to get on the same page. Volatility is to be expected, if not embraced, if you are investing in the cannabis space right now. It's important not to always have the knee-jerk reaction and sell on every piece of news, or even buy simply because of a rumor that's out there. But it does mean that you have to stay on top of things. And you really have to evaluate the quality of the executive team, the management team, behind a lot of these companies as well.

Campbell: Yeah, and don't expect any good news when they report quarterly results.

Jones: At least for the next few quarters! Even ahead of derivatives in December. We won't see that until 2020. This is going to be a long, hard slog for CannTrust and CannTrust shareholders. We'll be sure to keep everyone up to date on all the latest.

That will do it for this week's Industry Focus: Healthcare show. Thanks so much for tuning in! As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is being mixed by Dan Boyd. For Todd Campbell, I'm Shannon Jones. Thanks for listening and Fool on!