Cannabis Watch: ‘Don’t smoke the Kool-Aid,’ analyst says in sober note on the cannabis sector

MKM Partners initiated coverage of five Canadian cannabis companies and two U.S. multi-state operators on Friday with a cautious outlook, arguing that the current business model of cultivation will become commoditized and make it difficult for companies to build strong brands.

In a note entitled, “Don’t Smoke the Kool-Aid,” analyst Bill Kirk, an executive director at MKM, said supply will likely exceed consumer spending growth, which will pressure existing business models. Ever since Canada fully legalized cannabis for adult recreational use last October, companies have struggled with losses and Kirk is expecting things to get worse; like other agricultural products, as yields per acre improve, profitability per acre will fall. U.S. growers in states that have legalized are facing the same dilemma.

“In the U.S., cultivators have indicated that their 2018 (roughly year three of most operations) profitability is down considerably,” Kirk wrote. “The vast majority recently said they were break-even or profitable in year one. Now, in year three, the vast majority say they are unprofitable to break-even. We are already beginning to see the cracks in Canada: Pricing is down and consumption per federal license is contracting. To us, this means the future presents a less profitable system than exists today.”

Kirk’s comments come after a rough summer for the cannabis sector, with most stocks down by a double-digit percentage rate in the last three months. The ETFMG Alternative Harvest ETF MJ, -0.47% has fallen about 29% in three months and is now down 6.7% in 2019.

Cannabis Watch: For all of MarketWatch’s coverage of cannabis companies

Stocks have fallen amid a crop of scandals and some weaker-than-expected earnings from Canadian licensed players, that have dampened the hopes for big returns that some investors were expecting.

Kirk assigned sell ratings to Massachusetts-based Curaleaf Holdings Inc. CURLF, +1.01% CURA, +0.00% and Edmonton, Canada-based Aurora Cannabis Inc. ACB, -2.71% ACB, -2.34%, which was already smacked with a sell rating from Stifel analysts earlier this week.

Curaleaf’s valuation is looking stretched given that most of its retail sales are in Florida, where stores are showing declining productivity and where it has weak scores with customers, based on data from Yelp and Leafly, Kirk wrote.

“Recent acquisitions Select and Grassroots help the company diversify away from the problem (we estimate pro-forma net sales from Florida at ~20%),” said the analyst. “However, comparing Curaleaf retail to liquor retail metrics and valuation, Curaleaf would have to open 1,200-5,000 successful dispensaries to justify its shares’ current valuation.”

Kirk assigned the stock a C$5 ($3.8) price target, or half its current price of $10.08.

For Aurora, the issue is profitability, which Kirk expects will generally get worse before it gets better. Aurora’s outsized exposure to medical cannabis relative to peers is another challenge to growth as most medical markets are showing flat to declining medical consumption.

“In this light and with recent industry equity declines, we believe Aurora will have more difficulty refinancing some convertible notes coming due (March 2020),” Kirk wrote. “We prefer companies that do not need funding before reaching profitability. Aurora will need some capital before its able to show positive EBITDA.”

See: Alliance Global starts coverage of 4 cannabis stocks with buy ratings but not all gain

The analyst assigned neutral ratings to market leader Canopy Growth Corp. CGC, -2.96% WEED, -3.78% based in Smith Falls, Ontario, Tilray Inc. TLRY, -3.20% and Cronos Group Inc. CRON, +0.59% CRON, +0.00% He slapped buy ratings on New York-based Acreage Holdings Inc. ACRGF, +6.47% and Montreal, Canada-based Hexo Corp HEXO, +8.60% HEXO, +11.45%

HEXO, +11.45% “We think retailers with a focus on recreational experience, strong real estate, and regulatory license moat or manufacturers focused on heavily processed product will offer the best chance at investor upside,” said the note.

Canopy shares were last down 3.4%, Tilray was up 0.3% and Cronos was up 0.6%. Acreage Holdings stock was up 1.6% and Hexo was up 6%.

Curaleaf was down 4.3% and Aurora was down 1.6%.

The S&P 500 SPX, -0.49% was up 0.2% and the Dow Jones Industrial Average DJIA, -0.59% was up 0.3%.

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