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1 Major Problem for the Cannabis Industry

By David Jagielski – Apr 4, 2020 at 10:50AM

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It makes many pot stocks high-risk investments to hold on to amid the coronavirus pandemic.

Another earnings season is just weeks away, where much of the focus will be on sales and profits and how they may change amid the coronavirus pandemic. However, for cannabis companies, there's something much more important -- liquidity. A big problem for many cannabis companies today is that they don't have access to a lot of it, and they aren't generating positive cash flow, either. A lack of liquidity makes for a potentially dire situation for the industry, and here's why.

Raising cash is more challenging now than ever before

Previously, if a cannabis company needed to raise cash to grow its business, it would just issue more shares. But that's no longer an attractive solution given that many pot stocks have lost more than 70% of their value in the past 12 months. The Horizons Marijuana Life Sciences Index ETF (HMLSF -8.37%) is down more than 75%, and it holds some of the top pot stocks in North America. Smaller companies are in even worse shape as investors look for safer investments to hold on to.

If share prices are down, that means a company needs to issue more shares to raise the same level of cash than it would have had to if it issued the shares earlier. And a flood of shares onto the open market is a quick way to send the stock even further down in price, as the number of sellers will heavily outweigh the number of people looking to buy a stock.

100 dollar bills.

Image source: Getty Images.

The only other option then becomes obtaining a line of credit or loan, which can be costly and full of conditions and covenants to maintain. And with the coronavirus pandemic stalling many economies around the world, now's not exactly a time when lenders will be lining up to take risks on already risky cannabis companies. For companies that don't have liquidity, it's important to ensure they're generating positive cash flow. That's why a company's statement of cash flow may be the most important place to start looking when thinking about investing in a pot stock.

It doesn't leave companies with many options

Investors don't want to invest in a company that has no money, nor do lenders want to lend money to someone who doesn't have the financial means to pay them back. There's not a whole lot left for a company to do once it runs out of cash and available credit outside of selling whatever assets that it can. That's why investors are seeing companies start to be a bit more aggressive in their cost-reduction strategies. In February, cannabis producer Tilray (TLRY) announced it would be reducing its staff by 10%. The company said the move was to help drive growth and to put itself in a better position to be able to post a profit in the future.

However, it'll improve the company's cash flow as well. On March 2, Tilray released its year-end results. In them, investors saw that the company spent $258.1 million in cash throughout the year to fund its day-to-day operating activities. And this is before any growth or investing activities it would spend on to try to expand its business. Yet that amount of cash burn was already more than the cash and cash equivalent Tilray had on its books as of Dec. 31, 2019 -- $96.8 million. Tilray finished the previous year with a cash balance of $487.3 million. It's no surprise that in February, investment bank Ello Capital estimated that Tilray had less than four months of liquidity left to keep its operations running.

The wrinkle, however, is that the coronavirus is causing all sorts of problems for the world's economies, and that's likely going to change the outlook that cannabis producers have for the industry as well. Tilray and other pot stocks may have to reevaluate once again and decide if they need to make even deeper cuts to their expenses.

What does this mean for investors?

A company's balance sheet and statement of cash flow may be a good starting point for cannabis investors today. It can be a quick way to see how much cash a company has on hand, as well as if it's burning through the cash it has or not, and at what rate. In Tilray's case, it would have sent off alarm bells by doing so. In the company's most recent quarter, Tilray used up $90.8 million for its day-to-day activities during just the last three months of 2019.

At that rate, Tilray could easily burn through the remaining cash it has on hand within six months -- unless, of course, the company raises more money. But burning through so much cash means a company will stay in that cycle and continually look to find ways to raise money.

Investing in companies that can support themselves through their day-to-day operations is a way that investors can minimize their risk whether it's in cannabis or in any other sector. That's why investors should steer clear of Tilray and other cannabis stocks that are burning through large sums of cash.

David Jagielski has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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