When CEOs offer insights into their industries, it behooves investors to listen. During Sundial Growers' (SNDL 4.89%) May 16 earnings call, CEO Zach George quipped that "[Sundial is] in an enviable position as we witness a reckoning taking hold in the Canadian cannabis market," and that "continued aggressive cash consumption by our peers, reduced access to capital, and waning investor risk appetite is likely to accelerate sector rationalization as the industry slowly moves toward the formation of an oligopoly."
Bold predictions like those are actionable for investors, and there's more than one reason to believe that change is actually afoot in the cannabis industry. Here's why George's comments will likely prove to be prescient.
The reckoning isn't exactly new
The first thing to notice is that in the last 12 months, many cannabis stocks have fallen considerably, as shown below:
If that doesn't look like a reckoning, not much does. But declining share prices don't shed much light on why investors are souring on cannabis stocks. For that, it's necessary to consider the Federal Reserve's ongoing campaign to raise the interest rates at which companies can borrow money.
As the cost of borrowing rises, smaller growth-stage businesses -- like most cannabis companies -- become riskier as they need to grow more per borrowed dollar to justify the interest fees. So, when Sundial's CEO mentioned that investors have less desire to buy risky stocks, the rising interest rates are a big reason.
Higher borrowing costs also make the cost of borrowing so high that some enterprises can't afford it at all, which the CEO also alluded to. And that's not even getting into the difficulties many companies in the industry have with getting traditional financial institutions to lend to them due to cannabis being illegal at the federal level in the U.S.
The next piece of the reckoning is that many public marijuana businesses are running down their cash reserves at a time when large infusions of cash are harder and harder to come by.
Take a look at this chart:
Of those businesses, only Curaleaf has any positive quarterly free cash flow (FCF) to speak of. In other words, a lot of players might be out of money in the near future, and that could make them ripe for acquisition -- or vulnerable to bankruptcy.
Consolidation is already occurring
Per George's forecast, as more marijuana businesses become desperate for cash to keep the lights on, they'll increasingly be forced to seek investment from, merge with, or be bought out by larger competitors. So far, the industry's most significant consolidation occurred when Tilray Brands merged with Aphria in the middle of last year to make what was, at the time, the largest single cannabis business by revenue.
Since that period, Sundial has been a prolific acquirer, as shown by its recently closed purchase of the Canadian liquor chain Alcanna, which also held a 63% equity stake in another company called Nova Cannabis.
But even the industry's less impressive contenders, like Aurora Cannabis, are on an acquisition spree. In early May, it finalized its purchase of TerraFarma for CAD$38 million in cash and stock. One takeaway from this trend is that as the larger publicly traded businesses continue to consolidate, their brand portfolios will consolidate, too. And that could easily lead to redundancy or self-competition, neither of which would be desirable.
At the core of the consolidation wave is one of the industry's most persistent bugbears: profitability. Few companies have an ironclad profit margin yet, and very few are consistently profitable at all. Given the ongoing reckoning, it's highly likely the enduringly profitable marijuana businesses are going to be the beneficiaries, whereas the unprofitable ones will be devoured or forced into niche markets or even bankruptcy.
In sum, Zach George is completely correct about where the industry is going in the next year or so. For investors, there's no single correct move to take advantage of the looming shakeout, but a good rule of thumb will be to only purchase shares of companies that are cash-rich, low in debt, profitable, and, preferably, growing revenue and earnings. Even then, it'll probably be a bit of a bumpy ride.