Last year was a challenging year for most cannabis companies, with shareholders becoming fed up with the continued losses that many industry giants were reporting. While some held out hope that 2020 would mark a turnaround for the sector, this COVID-19 bear market is the last thing the industry needed.
During the past month alone, many prominent pot stocks have reported major losses. Aurora Cannabis (ACB -7.38%) has officially fallen into the penny stock range, losing over half its market cap since late February. Canopy Growth (CGC -2.49%) saw a similar decline over the same period, with most other cannabis companies following suit. In comparison, the Dow Jones Industrial Average has lost around one-third of its value.
If COVID-19 continues to spread -- which it seems like it will -- should investors get out of the cannabis market altogether? Here are a few reasons why you might want to stay away from this sector until things stabilize a little.
A lack of profitability
Profitability is something that pot stocks have historically struggled with. While investors were willing to overlook quarterly losses while growth prospects seemed promising, companies can only postpone making a profit for so long before alarm bells start going off. If these companies struggled to make a profit when times were good, what's their financial position going to be like during this bear market?
This is even more true for markets that are cyclical rather than defensive. Cyclical industries are those that are sensitive to the ups and downs of the economy, and typically have products or services that people can do without during tough times. On the other hand, defensive industries tend to do well regardless of the business cycle, with goods or services that remain in demand no matter what.
Although there is some demand for medical marijuana, cannabis isn't really a defensive sector. If this bear market continues and people end up losing their jobs, they will be spending less money on nonessentials, which includes recreational marijuana purchases.
This is bad news for cannabis companies, but especially for those that are still reporting losses. Unfortunately, many stocks fall under this category, including two of the biggest names in the industry. Aurora Cannabis reported an adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) loss of 39.7 million Canadian dollars in its most recent fiscal first-quarter 2020 financial results. Net revenue has also decreased, coming in at CA$70.8 million in comparison to last year's CA$94.6 million.
It's a similar situation with Canopy Growth, which reported a CA$124.2 million net loss for its fiscal 2020 third quarter. Canopy also announced it would be closing its 23 corporate-owned retail locations amid the COVID-19 pandemic, something that's likely to further impact sales, and by extension, its bottom line.
Cash is king
Having some cash on hand can help a business shore up any short-term losses as it adjusts to a period of reduced income. Unfortunately, many cannabis companies are short on cash as well.
Aurora is one of the most egregious examples. The company has only CA$152.5 million in cash and cash equivalents on hand. Aurora will undoubtedly need to raise further financing in the future, but the company already has plenty of debt. With CA$1.1 billion in total liabilities on its balance sheet, it's hard to see how Aurora will stop digging itself into a hole if this bear market continues to get worse.
Canopy is a little bit different since it's one of the few pot stocks with an impressive cash position. While its CA$2.3 billion in cash and short-term assets looks fantastic, it's burning through this cash pile at a rapid rate. Last quarter, Canopy had CA$2.7 billion in cash and short-term assets, a CA$400 million decline in just three months. Canopy is already in the red, and while it has enough cash to last for a while, it needs to slow down its cash burn now that a recession could be on the horizon. Considering that cannabis sales will likely decline due to the COVID-19 pandemic, it's hard to see how Canopy will turn things around.
Overpaying for acquisitions
For much of 2018 and 2019, cannabis companies were on a buying spree, paying hefty premiums in the process while hoping that revenue growth would continue to stay strong. These premiums are reported on a company's balance sheet as a type of intangible asset known as goodwill.
While not necessarily a problem in small amounts, goodwill continued to accumulate as businesses continued to buy out smaller firms. In today's market, however, it's becoming harder and harder for companies to justify these large goodwill figures to auditors.
What's worrying, however, is that many cannabis companies have goodwill figures that are larger than their current market capitalizations. In turn, many businesses have either already faced significant goodwill writedowns, or are at risk of facing writedowns in the future.
Both Aurora and Canopy have already faced major goodwill adjustments, but that doesn't mean they won't face further adjustments in the future. The two companies still have plenty of goodwill remaining even after these initial writedowns -- around CA$2.2 billion and CA$1.3 billion, respectively -- and if the markets continue to sour, further adjustments might still be necessary. This could erase hundreds of millions or even billions of dollars from their balance sheets and further push down their stock prices.
What should you do?
Some of the best buying opportunities can be found when there's a bear market and investors are fearful. However, you still have to make sure that you're buying a business that's healthy. Most cannabis stocks on the market have a lot of problems, and a bear market is going to make these issues even more apparent for all to see.
However, there are always a few exceptions. Aphria is one of the few large-cap pot stocks to be profitable, have cash on hand, and have relatively little in terms of goodwill. But even Aphria has seen its stock price decline substantially over the past month, and it will probably be a while before it recovers.
In general, however, pot stocks underperformed significantly in 2019, and it seems likely that they will continue to do so in 2020. Except for a handful of companies, investors should be very careful about putting money into this market right now.