Earlier in the year, we discussed the dangers of buying into the hype around TAM (Total Addressable Market) in valuing speculative businesses. We did this in the context of a red hot IPO of a company called Beyond Meat. Since reaching its high of roughly $225/share in mid to late July, the stock is down 34% to $148/share or so at this writing. Yet, amazingly, it still trades at 22x next year’s estimated sales (which may turn out to be optimistic). While we are optimistic that there appears to be a significant market for alternative protein sources in the diets of many around the world, we also think future assumptions about the actual business fundamentals will prove to be way off base relative to how they are valued today. For proof, look no further than Lyft, Uber and WeWork.
But I digress. My point really isn’t to debate short-term stock performance, the viability of alternative meat business model and the path and timing of adoption, but rather to point out that investing in these nascent businesses that seek to change the world may be a treacherous hype-fueled ride.
That brings us to the cannabis business. What in the world is going on?!? Where is all the optimism that sent these stocks racing higher fully detached from economic reality? Remember some of the promises:
- CBD products could do virtually anything and cure virtually any ill – enter CBD-infused shampoos, toothpastes, lotions and soaps (even CBD supplements for both your dog and cat to help with “separation anxiety”);
- The cannabis market was so huge that it would prove to be a “once in a generation opportunity”; for starters those in the industry portended to take over a possible massive share and hollow out the liquor and beer businesses;
- Cannabis itself had virtually no health consequences to individuals or society; and
- There was massive momentum for national legalization – it was just a matter of time;
- and many other TAM-type claims.
Taking a look at the stock charts for some poster-children of the cannabis industry—Tilray (TLRY), a manufacturer and MedMen (MMNFF), a retailer—tell what we view is an obvious story:
Source: Yahoo Finance, as of September 24, 2019
Source: Yahoo Finance, as of September 23, 2019.
Oops. While there may be some truth to many of these claims, in our view it was never going to be that easy—turns out that execution is hard and capitalism works. Some of our thoughts about the current state of play:
- Many bought into the opportunity leading to a competitive siege that is costing more and more and pushing out the timing of eventual profitability
- Negative cash flow is suddenly a bad thing (and rightly so);
- And these companies are generating a boat-load relative to their market valuations (TLRY 2019e – negative $231m / MMNFF 2019e – negative $271m according to Bloomberg);
- Even when the “winners” become profitable, we believe the business likely won’t be as attractive as expected;
- With nationwide legalization still hazy, it is still very hard to finance these businesses;
- Vaping health-scare apparently linked to actual deaths is providing a further black eye (at a minimum);
- Lack of standards for CBD levels, quality and efficacy – expect regulatory scrutiny of these claims; and
- Illegal cannabis trade still exists and is substantially weighing on legitimate players.
None of this means that these businesses won’t eventually succeed. But no one really knows how the landscape will evolve. Today, it seems to us that cannabis stocks more accurately reflect the risks of achieving economic success than they did a year ago, which might be better for the industry in the long run. In the meantime, be very wary of the hype.
The views presented herein are those of Validus Growth Investors, LLC (“Validus”) as of September 2019 and are provided for informational purposes only. There is no guarantee that any historical trend illustrated above will be repeated in the future, and there is no way to predict precisely when such a trend might begin. The information is based on the economic and market conditions as of this date. The information is not intended as a discussion of the merits of a particular offering and should not assume that any discussion or information provided herein serves as the receipt of, or as a substitute for personalized investment advice from Validus or any other investment professional.
This material is provided for informational purposes only and does not constitute a solicitation. The material is not intended to be relied upon as a forecast, research or investment advice and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any forecasts made will come to pass.