Over the next decade, you'd struggle to find an industry with greater growth potential than cannabis. Depending on your preferred Wall Street source, the global marijuana industry could grow from nearly $11 billion in sales in 2018 to between $50 billion and $200 billion in a decade's time. Growth like this doesn't come along very often, which is a big reason why pot stocks have been so popular with Wall Street and investors.
However, investing in the cannabis industry hasn't always been a green experience. On more than one occasion since October, investors have contended with unpleasant scandals, whether they be accounting snafus or insider conflicts of interest following acquisitions. But nothing is quite on par with the blatant fraud that appears to have occurred at licensed Canadian cannabis operator CannTrust Holdings (NYSE: CTST).
Image source: Getty Images.
The CannTrust scandal comes to its first logical conclusion
A little over three weeks ago, CannTrust announced that it had been growing marijuana in five unlicensed rooms at its Niagara campus in Pelham, Ontario, between October 2018 and March 2019 (the rooms became licensed in April 2019). As a result of this admission following a Health Canada inspection, the regulatory agency put a hold on 5,200 kilos of inventory, with CannTrust also choosing to voluntarily hold an additional 7,500 kilos at its much smaller Vaughan, Ontario, facility. Unfortunately, this isn't the worst of it, according to various reports that have emerged in recent weeks.
Just days after CannTrust announced its misstep, The Globe and Mail reported, via a company whistleblower, that the company used fake walls to conceal cannabis plants that were growing behind them when sending photographs to Health Canada. If accurate, this implies clear intent to subvert marijuana growing regulations by deceiving the regulatory agency.
Furthermore, this past week various media outlets reported that senior executives were aware of the illegal growing activity in these rooms via email, but allowed the growing to proceed. As a result, CannTrust announced on Friday that CEO Peter Aceto was terminated with cause, and that company chair Eric Paul was asked to resign by the board and complied.
Robert Marcovitch, who was heading the special committee investigating the wrongdoing at CannTrust, was appointed as the interim CEO, although he'll now step down from the special committee since he's taking on an active role in guiding the company forward.
Suffice it to say, things are a mess. But the big question is: Now what?
Image source: Getty Images.
Blatantly subverting Canadian growing laws could certainly explain the company's nearly 60% loss in value over a span of three weeks. But don't discount the cement blocks weighing down the company's stock that are the direct result of not knowing what comes next.
At this point, CannTrust's special committee and Health Canada are gathering information, with a ruling from Health Canada expected very soon. There are three possible outcomes, in my view.
First, CannTrust could effectively walk away with a slap on the wrist. Assuming the unlicensed cannabis that's being held by Health Canada tests appropriately (in terms of quality), CannTrust could walk away with a 1 million Canadian dollar fine, and might lose some or all of its inventory being held (the noted 12,700 kilos). This would be an extremely positive outcome for the company, given that the held cannabis would represent only a fraction of the 200,000 kilos to 300,000 kilo it's capable of producing each year, when at peak capacity.
A second scenario could see CannTrust temporarily lose its license. In doing so, Health Canada would be asserting that illegal grow sites will be dealt with harshly, which may not be the message it sends if CannTrust is simply fined and loses its inventoried cannabis.
A final scenario is that CannTrust could have its growing license completely revoked. Should this happen, CannTrust would presumably have two options. It could put the for-sale sign on its front lawn and hope to land a suitor that has appropriate cultivation licensing and is in good standing with Health Canada. The other option would be to wait things out and reapply for its cultivation licenses. The latter pathway could potentially take more than a year, depending on how quickly Health Canada cycles through its existing backlog of cultivation, processing, and sales applications.
Image source: Getty Images.
Buyout or remain independent?
Once we know the punishment, then we can move on to the next big unknown: Will CannTrust remain an independent company, or will it be acquired for a fire-sale price point? Remember, we are talking about a company that could produce as much as 300,000 kilos a year of cannabis, making it potentially the third-largest grower in Canada.
Assuming a worst-case scenario, chances are good that CannTrust wouldn't have trouble finding a suitor. For starters, it would be a target because of its plans to grow 100,000 kilos to 200,000 kilos of cannabis outdoors each year, much of which would be used for derivative production. Derivative products, such as vapes, edibles, topicals, and infused beverages, generate much juicier margins than traditional dried flower.
CannTrust also has its hydroponic-focused Niagara campus, which is the source of its woes at the moment. Assuming the company's cost estimates and yields are trustworthy, Niagara, when combined with Vaughan, can yield 100,000 kilos a year from roughly 900,000 square feet of cultivation space, or about 110 grams per square foot. With access to cheap sources of electricity and water, its growing costs should be relatively low.
Most valuable of all, CannTrust is also one of just four pot stocks to have a wholesale supply agreement with every Canadian province, and it has outlets to sell cannabis in foreign markets. Take the veil of this scandal away and CannTrust looks perfectly set up to thrive domestically and abroad, which is why a buyer could emerge once Health Canada lays out its punishment.
If the company is given one of the lesser two punishments, things aren't as clear. CannTrust's management would almost certainly prefer to remain independent, but it could struggle to do so given how hard it is to regain the trust of investors. Take a gander at Aphria (NYSE: APHA), which had longtime CEO Vic Neufeld step down earlier this year after it was uncovered that Neufeld and a few other execs at Aphria had conflicts of interest regarding the company's Latin American purchases. In the grand scheme of things, what Aphria did versus what CannTrust has apparently done is no comparison. Yet, Aphria's stock has languished the entire year because regaining lost trust is extremely difficult to do. You can only imagine how long it could be before investors place any faith in what management has to say.
Long story short, expect ongoing changes at CannTrust, with added clarity once we get an official ruling from Health Canada on the company's punishment.
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