The cannabis industry is in trouble. Not only is there lots of competition, but growth can be expensive, especially given the challenging conditions and regulations in today's market.

Transporting marijuana across state lines is not legal and with share prices cratering and many cannabis companies burning through cash, it's not easy for a cannabis producer in the U.S. to grow, even though the opportunities may be there. In Canada, a slow retail rollout and high prices are posing big challenges. The cannabis industry needs something to help turn things around.

Are bankruptcies the answer?

One of the sobering realities for the industry is that many companies may not survive 2020. Cash flow is a growing problem and it's especially problematic for U.S. companies that don't have access to bank accounts or traditional loans.

Many cannabis producers are not generating free cash flow, or even enough to cover their operating expenditures. They also face the risk of criminals targeting their cash-based businesses. With burglaries continuing to threaten dispensaries, it makes a bad situation even worse for American cannabis companies.

Person holding their head in their hands as stock price falls.

Image source: Getty Images.

The positive aspect of companies going out of business and shutting down their operations is that it gives remaining companies the opportunity to gain more market share and acquire assets at cheap prices. If done well, a company that makes these moves could attract investors and boost its share price. There's also the possibility for further consolidation in the industry, especially as valuations keep dropping.

But the bad news for U.S. companies is that because cannabis is not federally legal, bankruptcy and Chapter 11 protection from creditors is not available. The situations vary for cash-strapped cannabis companies depending on the state they're based in, but the end result remains the same: Some companies simply won't be able to continue operating as they do today. 

Cash crunch is evident

Investors don't need to look far, or even at financial statements, to know the industry is having cash flow problems. Sundial Growers announced in January it was laying off 10% of its staff, and MedMen Enterprises has cut more than 40% of its headcount over the past few months.

In October, HEXO (HEXO) announced it would lay off 200 people from its workforce. Meanwhile, Aurora Cannabis said in November it was halting construction at a facility in order to conserve cash.

These are significant moves by major cannabis companies that suggest they're experiencing serious problems. In a high-growth industry, investors would typically expect to see more jobs and expansions happening, but that hasn't been the case. Companies are doing what they can to stay lean and cut costs as much as they can.

In some cases, cash flow problems aren't at all subtle. In January, MediPharm's wholly-owned subsidiary filed a lawsuit against HEXO for unpaid bills totaling 9.8 million Canadian dollars. MediPharm alleges HEXO hasn't been making payments since October, with invoices outstanding for November, December, and January. It's a touchy situation to go through the courts, but HEXO makes up more than 10% of MediPharm's total sales, which means the issue is more pressing. MediPharm said it "will likely impact near-term results."

What can investors do to protect themselves?

Investors need to look for the warning signs of a business that may be in trouble. Whether it's layoffs, lawsuits that allege they aren't paying their bills, or anything that indicates things aren't going as planned, investors should pay attention and assess why a company is doing what it's doing.

HEXO's stock price began crashing in October when the company pulled its guidance for fiscal 2020, which happened shortly after the company's CFO resigned. Since then, the stock has been in a free fall and is now down 70%, drastically underperforming the cannabis sector, which is down 45% over the same period, measured by the Horizons Marijuana Life Sciences ETF. While retracting guidance alone isn't a sign that cash flow is a problem, when the company is also laying off staff, it starts to paint a very negative picture.

In addition to developments, investors should be paying close attention to a company's statement of cash flow to see whether it is cash flow positive. Over the past 12 months, HEXO has burned through CA$142 million from its operating activities.

While that doesn't mean HEXO can't turn things around, cash flow problems certainly elevate a stock's risk level. That's something investors should consider very carefully when making a decision to buy a pot stock. And if certain cannabis companies start gobbling up defunct companies' assets and market shares, perhaps their stocks are worth a second look.