The arrival of October marked the seventh consecutive month of pricing declines, as the global cannabis industry continues its 2019 meltdown.
Some thought October might end the disastrous run, while others pointed to the "October Effect" as one of the factors that would lead to another poor month.
According to Wikipedia, the October effect is a perceived market anomaly that stocks tend to decline during the month of October. The October effect is considered mainly to be a psychological expectation rather than an actual phenomenon, as most statistics go against the theory. However, in the cannabis stock world, the October effect was in full force.
As can be seen above, the world's largest ETF—The Horizons Marijuana Life Sciences ETF—continued its downward spiral, declining another 12.54% for the month of October. With over $1.3 billion funds under management, the ETF peaked on March 22nd this year at CAD$23.30 per share and has since last over 55%, closing the month at CAD$10.46.
According to New Cannabis Ventures, the Global Cannabis Stock Index also ended the month 11.2% down. The index, which saw a 57.4% gain in the first quarter of this year, ended the month 26.1% down year to date.
The Canadian Licensed Producer Index faired even worse this month, down a whopping 18.2%. The Index closed the month at a new 52-week low and is now 31.6% down year to date. Without a doubt, one of the reasons for such a massive decline in October could be attributed to HEXO's recently Q4 earnings report.
HEXO released its Q4 2019 results and they were alarming, to say the least. First off, the company reported net-revenues of CAD$15.4M (in line with its pre-release, but almost 40% lower than its original guidance) and was only up a modest CAD$2.4M over the prior quarter. The primary reason given for this horrific miss was the fact that Quebec has been so slow in its rollout of provincially run retail stores.
The Canadian recreational market has been very slow to get out of the blocks, and HEXO was Quebec's largest supplier. The company also announced it was cutting over 200 jobs in an effort to contain costs, and this was clear to see, given cash operating costs in the period increased by over 200%, and adjusted EBITDA losses more than tripled quarter-on-quarter. The company had originally given guidance over CAD$400m in net revenue for FY2020 and have now significantly cut this.
This sent a very clear message to investors.
Canada is going to take a lot longer to get rocking than initially thought, and many of the LP's are going to show plateauing revenue numbers for the immediate future. Although we have been saying this for some time now, the fact remains that many retail investors only comprehend these things when new quantitative earnings data is released…and the bad news…is that there is a lot more earnings data coming in November!
Although the US Operator Index declined for the seventh straight month, it outperformed the broader market, declining 6.1% for the month, with the index now 38.6% down year to date. The big losers in the month were MedMen and Plus Products. MedMen has had a shocker 2019, and October saw them terminate the PharmaCann merger and then renegotiate the terms of their financing agreement with Gotham Green Partners.
So what can we expect in the coming month?
The biggest issue we see is the lack of any clear "green swan" catalyst. Cornerstone Investments recently analysed the global industry and suggested that the last two rallies (August 2018 and October 2019) both occurred as a result of Constellation Brands' investments in Canopy Growth. They also showed, however, that both rallies were followed by heavy selloffs that lasted for months at a time.
This current selloff—the worst for almost three years now—is most probably not going to be reversed by any one event (except perhaps the Federal legalisation of cannabis in the US, which is certainly not set to occur this year) and investors should not be expecting a V-shaped rebound. If anything, we feel the recovery will be more of a U-shape and will take time, as investor sentiment and confidence slowly comes back into fashion.
We expect the stagnant growth rate in Canada to continue. Brick and mortar retail growth has been very slow, and based on the struggles at Zenabis and TGOD—along with HEXO laying off workers and closing a facility—the argument for oversupply seems to be gaining momentum.
There has been much written in the past couple of weeks concerning the oversupply of cannabis coming much faster than originally expected. Indeed, with Aphria getting their Diamond facility approved by Health Canada for cultivation, this brings their capacity up to 255K kg per annum. Add this to Canopy's 650K and Aurora's 570K kg per annum, and overlay this against Canada's total estimated demand of around 600K kg per annum, and the picture starts to become a little clearer.
The Canadian cannabis market still remains dominated by the black market one year into legalisation (this is relevant when one considers that HEXO was also the first LP to introduce low-price products in a move to counter the black market). However, given the current supply and demand picture in Canada, we think the legal market will be overwhelmed by the huge wave of upcoming supply.
We continue to maintain that the US offers investors the best opportunity for significant gains and returns in the short term. Although the companies have been moving forward teasingly in terms of their fundamentals, the US has not been immune to the capital crunch that is currently taking hold of the Canadian market.
While MedMen may have terminated their merger with PharmaCann, during the month both Cresco Labs and Curaleaf cleared HSR review hurdles, which we believe should give investors confidence that much of the sector's pending M&A are unlikely to be challenged by the DOJ on antitrust considerations. We believe these deals will go through, but will be on fundamentally different terms (which we saw this week in the restructuring of the Curaleaf deal).
In addition, we believe that there will be key catalysts in the near term that could really drive investor sentiment and market movements. These include the progression of the SAFE Banking Act to the US Senate, the STATES Act, and the completion of the above-mentioned mergers.
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