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Nov. 25, 2019, 7:48 a.m. EST

Cannabis stocks end 3-day rally as weak fundamentals come back in focus

MKM analyst says profitability expectations for Canadian LPs remain unrealistically high

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By Ciara Linnane, MarketWatch


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Cannabis stocks ended their three-day winning streak on Friday, as the euphoria sparked by a House vote in favor of a bill that would lift the U.S. federal ban eased and investors refocused on the sector’s weak fundamentals.

The bill, introduced by House Judiciary Committee Chairman Jerrold Nadler, a New York Democrat, passed Wednesday by a 24-10 vote. It includes provisions to expunge past criminal records and introduce a 5% cannabis sales tax.

But with the Senate unlikely to take it up any time soon, the initial burst of excitement that brought investors back to the beaten-down sector faded. At the same time, the buying sparked by reports that Canada’s most populous province, Ontario, is looking at moves that would speed up the pace of store openings also slowed.

“While obviously supportive, neither are likely to materially impact near term and we expect the space to remain pressured as perceptions of a liquidity crisis persist,” Jefferies analyst Owen Bennett wrote in a note.

Read now: All the excuses cannabis companies are making for an ugly crop of earnings

MKM analyst Bill Kirk wrote Friday that expectations for the sector remain too high after a series of disappointing quarterly reports. The five biggest Canadian licensed producers in MKM’s coverage are forecast on average to grow sales by 82%, but adjusted operating expenses are projected to rise just 8%.

“We think massive revenue growth with hardly any absolute cost growth is very unlikely,” Kirk wrote in a note to clients. “Yes, there will be P&L leverage as a percent of sales, but absolute costs are going to grow. In this context, we believe Canopy and Aurora profitability expectations will be the hardest to achieve.”

Kirk reiterated his expectation that, over time, flower and extraction production will become commoditized and profitability will decrease, similarly to how other agricultural products perform. U.S. producers have seen the same trend in the first years of their operation, with most still unprofitable after three years.

Read now: Cannabis stocks litter the list of most expensive bearish bets

“We are already beginning to see the cracks in Canada: Pricing is down, gaps [between the pricng of sanctioned and illicit product] aren’t closing, and consumption per federal license is contracting. To us, this means the future does not have a near-term path to profitability, and consensus expectations are unrealistic.”

Part of the three-day rally was short-squeeze driven, according to Bennett.

“Some may see the upside and think the sector may have bottomed out. We don’t think so,” he said. He noted that prices are only back to the levels they sat at about 10 days ago and that the move is based more on the positive headlines than a real shift in sentiment.

The analyst said his preferred names in the sector are Aphria Inc. and OrganiGram Holdings Inc. as examples of companies with some hope of near-term profitability, healthy cash levels, evidence of execution and brands that are selling. Both are rated buy at Jefferies.

On Friday, shares of Aphria /zigman2/quotes/207425803/composite APHA +7.63%   /zigman2/quotes/205566616/delayed CA:APHA +7.56%  were down 6.5% and of Organigram /zigman2/quotes/209289540/lastsale OGI +3.86%   /zigman2/quotes/202287350/delayed CA:OGI -0.44%  were down 7.9%.

Aurora Cannabis Inc. /zigman2/quotes/210559470/composite ACB +7.82%   /zigman2/quotes/203734337/delayed CA:ACB +7.79%  shares fell 12% after it became the latest company to be hit with a securities class action. Rosen Law Firm said late Thursday it has filed a suit on behalf of shareholders alleging the company made false or misleading statements or failed to disclose that revenue would fall in its first quarter and that it would halt construction on some of its facilities.

/zigman2/quotes/207425803/composite
US : U.S.: NYSE
$ 5.08
+0.36 +7.63%
Volume: 5.66M
Dec. 9, 2019 6:30p
P/E Ratio
N/A
Dividend Yield
N/A
Market Cap
$1.28 billion
Rev. per Employee
$147,410
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/zigman2/quotes/205566616/delayed
CA : Canada: Toronto
$ 6.69
+0.47 +7.56%
Volume: 3.51M
Dec. 9, 2019 4:00p
P/E Ratio
N/A
Dividend Yield
N/A
Market Cap
$1.68 billion
Rev. per Employee
$190,843
loading...
/zigman2/quotes/209289540/lastsale
US : U.S.: Nasdaq
$ 2.69
+0.10 +3.86%
Volume: 3.68M
Dec. 9, 2019 4:00p
P/E Ratio
N/A
Dividend Yield
N/A
Market Cap
$420.29 million
Rev. per Employee
$49,972
loading...
/zigman2/quotes/202287350/delayed
CA : Canada: TSX Venture
$ 6.85
-0.03 -0.44%
Volume: 392,662
Aug. 21, 2019 3:00p
P/E Ratio
31.08
Dividend Yield
N/A
Market Cap
$1.07 billion
Rev. per Employee
$64,794
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/zigman2/quotes/210559470/composite
US : U.S.: NYSE
$ 2.62
+0.19 +7.82%
Volume: 37.68M
Dec. 9, 2019 6:30p
P/E Ratio
N/A
Dividend Yield
N/A
Market Cap
$2.75 billion
Rev. per Employee
$94,401
loading...
/zigman2/quotes/203734337/delayed
CA : Canada: Toronto
$ 3.46
+0.25 +7.79%
Volume: 10.83M
Dec. 9, 2019 4:00p
P/E Ratio
N/A
Dividend Yield
N/A
Market Cap
$3.63 billion
Rev. per Employee
$123,163
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