Making the Grade

Find Value Plays in the Cannabis Industry

Emotions are often the enemy of logic and rational thinking.

Investors tend to get hyper-focused on the short term because the long term is too abstract for many of us to digest.

But this inefficiency is something I’ve long taken advantage of as an investor and trader.

Over the past month, we’ve seen the Canadian Marijuana Index suffer a steep retreat…

Line Graph - Canadian Marijuana Index's one-month performance

The 21-company index has lost more than 8% of its value since March 19.

Of course, some of those constituents have bled out a lot more than that.

Now, as we’ve covered here in our weekly Beyond the Bong analysis, the main villain is earnings.

This has been the pushpin that’s burst the bubble for a number of the sector’s highfliers.

We’ve seen shares of CannTrust (NYSE: CTST), Cronos Group (Nasdaq: CRON) and Tilray (Nasdaq: TLRY) tumble on their earnings reports.

Investors had high hopes for these reports, as they included the first full quarter of Canadian adult-use sales.

But even though the revenue growth is there, the fly in the ointment is widening losses.

As the kickoff for Canadian legalization grew closer, companies had to ramp up production. Especially as the industry fought – and failed – to stave off a shortage.

Because of these herculean efforts, costs increased exponentially. And losses skyrocketed.

It’s the same tune we’ve listened to on repeat this earnings season. And in response, shares of Canadian licensed producers (LPs) have been hammered.

That’s why, for this week’s “Making the Grade,” my team and I decided to look at which cannabis stocks were showing the highest margin compression. This means gross margin in the most recent quarter was smaller than it was in the previous quarter.

Here are the 10 cannabis large caps showing the highest margin compression…

Bar Chart - 10 Large Cap Cannabis Stocks Showing the Highest Margin Compression

Let’s start with Tilray…

Despite an initial pop, shares of Tilray fell nearly 5% on fourth quarter earnings. Revenue jumped more than 200%. But the company’s loss ballooned from $0.10 per share to $0.82 per share. It had to purchase third-party supply to meet demand.

Meanwhile, CannTrust shares fell nearly 20% as the company’s loss increased from CA$6.25 million to CA$25.5 million.

We can see from the chart, though, that it’s not just LPs experiencing compression.

American multistate operators Green Thumb Industries (OTC: GTBIF), MariMed (OTC: MRMD) and MedMen Enterprises (OTC: MMNFF) are also on there.

On top of that, we have CBD stars Charlotte’s Web Holdings (OTC: CWBHF) and Green Growth Brands (OTC: GGBXF).

So this isn’t just a Canadian phenomenon at the moment.

Though, the company at the top of the list, Aphria (NYSE: APHA), hasn’t reported earnings yet. The Canadian wholesale LP will report third quarter earnings on April 15. Shares have weathered the storm over the past month, gaining roughly 4%.

Now, expectations are for revenue to increase nearly 1,000% year over year. But all eyes are going to be on earnings per share (EPS).

We know EPS is projected to get cut in half to CA$0.03. Anything worse than that could be problematic.

Here’s the deal… short-term margin compression doesn’t really worry me. Especially if there’s a catalyst on the horizon.

I know from years covering the alcohol and beer industry that there are quarters where companies always miss EPS. And that’s a weakness to take advantage of.

For example, with beer, the first quarter is the slowest time of the year. But brewers ramp up advertising spending and production during that time in preparation for the start of “beer drinking season,” which begins Memorial Day weekend.

So brewers will traditionally miss first quarter EPS. And shares will sell off.

Smart investors buy that dip.

Canadian cannabis producers had a major catalyst last year – adult-use legalization nationwide. They ramped up production in preparation for that, which drove up costs.

At the same time, when legalization began, the lowest-margin product – dried flower – was the biggest seller. This compressed margins.

Shares may be selling off. But to me, this is when we’ll find real value plays.

Here’s to high returns,

Matthew