If you're looking to invest in the cannabis industry, you have to be prepared to take on some significant risks. The industry's been struggling during the past year, and a turnaround is not necessarily imminent. This year is already setting up to be a challenging one for many pot stocks, and investors should be careful not to be lured in by low prices. Here are four signs that the industry is still extremely risky and why a turnaround isn't likely just yet:
1. Lack of M&A activity
When things were going well for the industry, all the talk was about mergers and acquisitions (M&A). Aurora Cannabis (ACB -6.81%) was busy scooping up many of its rivals, buying MedReleaf Corp for $2.5 billion and CanniMed Therapeutics for $852 million, both in 2018. There was also excitement about a partnership with soft drink giant Coca-Cola (KO 0.31%).
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Nowadays, however, not only is there scarce M&A activity, but companies are also backing away from deals, even small ones, that already exist. Just this year, Harvest Health & Recreation (HRVSF) halted plans for an $850 million purchase of Verano Holdings; Cresco Labs (CRLBF -5.34%) abandoned a $282.5 million purchase of Tryke; and Planet 13 (PLNH.F -2.66%) even gave up on a $10 million acquisition that would have seen it expand into California.
It's the era of anti-M&A activity in the industry and a sign that companies just don't have the money or aren't willing to invest it into growth. Neither of those factors are particularly attractive for investors.
2. Growth is stalling
It used to be easy for cannabis companies to generate revenue growth. The industry was still in its early stages, so as markets opened up, prior-year periods were easy to beat with minimal revenue. But that's changed, and the bar to be beaten isn't so low anymore.
OrganiGram Holdings (OGI -3.63%) is a great example of that. When the company released its second-quarter earnings on April 14, sales were down from the previous year. Revenue of 23.2 million Canadian dollars declined by 14% from CA$26.9 million a year earlier. In April 2019, however, the company looked like a rock star, with its sales up nearly 700% from the CA$3.4 million in revenue it had earned in 2018 -- back when recreational pot wasn't yet legal in Canada.
Growth isn't a given anymore in the industry, and many companies were struggling to expand even before the pandemic. Now, with COVID-19 putting millions of people out of work, generating sales growth will be an even bigger challenge for the industry. And that can make posting a profit even more problematic.
3. Profits aren't consistent and are usually boosted by nonoperating items
For most cannabis companies, profits are a rarity. Sometimes investors will see a pot producer record a profit thanks to investment gains, fair value adjustments, or nonoperating income -- but usually not as the result of day-to-day operations. Going back to OrganiGram, the company was profitable a couple of years ago. In Q2 2018, it netted a modest profit of CA$1.2 million, and it even had an operating gain of CA$2.3 million. But that wouldn't have been the case without a CA$4.4 million fair value change that boosted its gross margin.
In each of its past five quarterly results, OrganiGram's finished in the red as expenses have risen even when revenue hasn't. Industry giant Curaleaf Holdings (CURLF -5.94%) reported a loss of $67 million in 2019, which was even deeper than the $56 million loss it incurred in the previous year. The lack of profitability in the industry is a big concern for investors, as it could lead to more cost-cutting and prevent companies from taking on growth initiatives. It could even exacerbate the industry's biggest problem: lack of cash.
4. Cash is scarce
There's a concern that cannabis companies will run out of money this year. Investment bank Ello Capital projected in February that some companies only have a few months of liquidity left. Ello Capital estimated that Aurora was in one of the worst positions in the industry and that it had just a couple of months' worth of cash available to= tap into.
Cannabis companies can obviously still raise money through debt and equity, but either one of those options will likely spell trouble for their respective share prices. Using OrganiGram as an example again, it is no exception to cash problems. In the past six months, the company has used CA$25 million in cash -- which is more than half the CA$41.1 million in cash it had on hand as of Feb. 29. On April 22, the pot producer announced an at-the-market equity program under which it could issue as much as CA$49 million in common shares to help boost its cash balance.
Shares of OrganiGram have tumbled 24% since then, while pot stocks have generally shown a lot more stability:
Should investors avoid the industry altogether?
If you're a risk-averse investor or investing with retirement money (or any money that you can't afford, for that matter), then buying cannabis stocks may not be the right strategy for you. There are safe ways to invest in cannabis, but you still need to be diligent in analyzing a stock in the industry to ensure you're comfortable with all of the risks involved. Otherwise, you could face significant losses. Although pot stocks have been crashing, there's no guarantee that they've reached the bottom just yet.
