Pot sector bankruptcies are coming, says Mackie Research

Is the pot sector about to see a big change?

Cannabis 2.0 may turn out to be a boon for the faltering legal marijuana industry but many of Canada’s pot companies are now in trouble when it comes to funding their operations, says Mackie Research Capital analyst Greg McLeish, who released an industry update to clients on Wednesday.

McLeish says while some companies still have strong balance sheets others will need to get creative in order to fund their longer-term plans.

It’s been a rough year for cannabis, one that started out promising as pot stocks drove higher in anticipation of soaring revenues and production expansion in tandem with the birth of a new market sector both across the country and around the world. That scenario quickly flipped as the reality of a slow rollout of cannabis stores and a challenging regulatory environment found its way onto the quarterly financials of Canada’s licensed producers.

Companies like Canopy Growth (Canopy Growth Stock Quote, Chart, News TSX:WEED), Cronos Group (Cronos Group Stock Quote, Chart, News TSX:CRON) and Tilray (Tilray Stock Quote, Chart, News NASDAQ:TLRY) started reporting drops in sales and inventory write-offs as a supply bottleneck spread over the industry, causing investors to flee the space and capital to dry up, leaving some companies little choice but to rein in expansion efforts and start scrambling to pay the bills.

In his report, ‘Cash is King,’ McLeish reviewed the financials of 52 publicly-traded Canadian cannabis companies, looking at quantitative and qualitative metrics to assess the financial strengths of their positions.

In the end, the analyst said a disastrous retail rollout combined with, to date, a lack of good quality consumer products to not only keep the black market thriving but to put numerous companies in precarious positions.

“Since much of the available funding from investors was snapped up last year amidst the excitement and optimistic valuations of the new industry, competition for capital is expected to intensify amongst LPs,” McLeish wrote.

“Now, companies looking for cash will be competing with companies positioning themselves in the US in anticipation of cross-border legalization. The combined effect of this draw on capital and lack of investor willingness to build out new operations in Canada could jeopardize growth for some companies. This could make it extremely difficult for companies to deliver on-plan unless they have already accumulated sufficient cash-on-hand,” he said.

McLeish found that of the 52 companies, 20 are in a positive net cash position while 32 have net debt. Based on cash flow burn, 13 of the 52 have less than six months of cash left, a number that increases to 25 companies if cash flow burn and capital expenditures are considered together. In total, those 25 companies have a combined market capitalization of $7.5 billion.

What’s worse, the convertible debentures employed by many companies to raise capital are essentially a “ticking time bomb,” McLeish said. Of the 52 companies, 28 have outstanding converts (with a total face value of about $2.9 billion) and 27 of them have debentures that are out of the money. A further ten companies have converts that are out of the money and mature in less than a year.

McLeish said while many companies will have to get creative in order to address their convertible debenture liabilities, possibly by scaling back operations, issuing additional securities, repricing the existing converts, issuing new convertible debentures or attempting to finance with equity.

Although such measures end up being dilutive and the situations they imply are non-ideal, McLeish said that many cannabis companies will end up thriving in the newly-born cannabis industry — while others will perish.

“We still consider the cannabis industry to be in its initial stages of growth and the eventual industry leaders will be able to overcome the initial challenges facing the industry,” McLeish said.

“In the meantime, there will be winners and there will be losers (ie. bankruptcies). These early challenges will result in industry consolidation and many companies will never see a complete recovery in their valuations,” he said.