The next decade looks very promising for the North American cannabis industry. With tens of billions of dollars in black-market marijuana sales conducted annually, we know the demand for pot products is there. As more U.S. states legalize marijuana, and the legal Canadian pot industry matures, there's definitely potential for investors to see the green.
But it's also important to recognize that not every company in a high-growth space can be a winner. Thus far, it's a lesson that investors of Canadian licensed producers know all too well.
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Canadian pot stocks have lost their buzz
Canada was expected to be the global blueprint for adult-use weed legalization. However, it's completely fouled up its chance to be a cannabis leader.
Part of the blame lies with federal and provincial regulators, which have done a poor job of setting up the Canadian pot industry for success. Health Canada was particularly slow in reviewing and approving cultivation, processing, and sales licenses, and also delayed the launch of higher-margin derivative products (e.g., edibles, vapes, topicals, concentrates, and beverages) by two months.
At the provincial level, we witnessed Canada's most-populous province (Ontario) stick with an ineffective lottery system for assigning retail licenses through 2019. By the one-year anniversary of adult-use legalization (Oct. 17, 2019), only 24 dispensaries were open in a province that could reasonably house 1,000 retail locations. Ontario has since abandoned its lottery system in favor of a traditional application vetting process, but the damage has been done.
Licensed producers (LPs) also deserve their fair share of the blame, with many expanding capacity far above and beyond what would be necessary to satisfy Canadian consumers, when taking into account how many LPs were competing against each other.
It's for all these reasons that Canadian marijuana stocks have been an utter disaster.
But it can always get worse.
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Reverse-split mania hits Wall Street
In May, the most popular pot stock among millennials, Aurora Cannabis (ACB -3.80%), was forced to enact a 1-for-12 reverse split to avoid being delisted from the New York Stock Exchange (NYSE). Aurora's share price had been middling under $1 for months, and the NYSE requires a minimum share price of at least $1 for continued listing. A reverse split was an easy way for the company to remedy its insufficient share price.
However, reverse splits are often viewed negatively by the investment community. Consolidating stock to boost a company's share price is almost always done to avoid delisting. And the primary reason a publicly traded stock would facing delisting is due to poor operating performance. That's most definitely been the case with Aurora Cannabis, which reported a whopping net loss of $3.3 billion Canadian in fiscal 2020. This net loss includes over CA$2.8 billion in writedowns tied to overpriced acquisitions, closed facilities, and cannabis oversupply.
But Aurora's not alone.
Last week, Quebec-based LP HEXO (HEXO -4.56%) proposed a 1-for-8 reverse split that would help the company avoid delisting from the NYSE. If approved by its shareholders and regulators, it would take effect in mid-December and lift HEXO's share price close to $5 (based on a $0.6075 closing price on Oct. 30).
If Aurora's more than 50% loss since reverse-splitting its shares in May are any indication, HEXO's stock could be facing some rough times ahead.
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A reverse split doesn't resolve HEXO's pressing issues
The problems for HEXO extend well beyond its persistently low share price.
To begin with, the company grossly overpaid for the Newstrike Brands acquisition, which was completed in May 2019. HEXO was counting on the Newstrike's Niagara facility to push peak annual output potential to at least 150,000 kilos of cannabis. But given the numerous issues the domestic market is contending with, the Niagara facility was an expense that HEXO simply couldn't lug around. Roughly 13 months after the CA$263 million deal was completed, and a couple of months after shuttering the Niagara grow farm, HEXO sold the Niagara facility for a mere CA$10.25 million. This prompted big writedowns and a huge loss in fiscal 2020.
Another issue for HEXO (as well as most LPs) is that it's being forced to go toe-to-toe with the black market. Even with Canadian regulators assigning a relatively low tax rate on legal pot purchases, LPs have struggled to complete with low-cost illicit weed. As a result, companies like HEXO have had to introduce value brands to attract cannabis consumers. While building customer rapport is great, the margins associated with value cannabis are terrible. Without a significant uptick in derivative sales, HEXO looks to be years away from turning the corner to profitability.
Making matters worse, HEXO is also facing a cash crunch. The company has been regularly selling its common stock to raise capital because it can't stop losing money and burning through its cash on hand. Between July 31, 2019 and July 31, 2020, HEXO share count nearly doubled from 257 million to 482.5 million. This type of share-based dilution absolutely crushes long-term investors.
In other words, don't be shocked if HEXO's share price continues to get pummeled after enacting a reverse split.
