“Searching for companies is like looking for grubs under rocks: if you turn over 10 rocks you’ll likely find one grub; if you turn over 20 rocks you’ll find two.”
— Peter Lynch
CannTrust is the second pure play cannabis grower we are looking at. This company is already making a profit; at least on the books. This article dives a little deeper into the accounting aspects and something investors should be aware of. On the surface CannnTrust appears to be making a profit, but are they?
CannTrust has a nice range of products. From CBD vegan capsules and drops, to dried cannabis and accessories. They are in the process of expanding their Niagra facility doubling their production. They are also positioning for legalized marijuana.
Products soon to be on the market include BrewBudz a CBD and THC coffee as well as several cannabis beverages. Their recent partnership with Breakthru Beverages is also a positive for growth. With that said we should always break a potential investment down starting with the team and financials.
Unlike The Green Organic Dutchman (TGODF), CannTrust does not have a powerhouse team. This does matter and the reason we are investing into TGODF first. Reputation and connections are everything, and TGODF has all the above.
CannTrust is an interesting cannabis stock. It is one of the only pure play growers that actually “Shows” a profit. “Alledgedly”. Though the board and management are not as experienced as TGODF, if their quarterlies are right, the “margins” are huge. I mean, they simply defy mathematics.
Revenue vs Margin:
To confirm they are actually making money let’s dive briefly into the latest quarterly report. Keep in mind this is a Canadian company and such everything is reported in Canadian dollars. Also I am not an accountant so feel free to correct a misstatement.
Revenue has more than doubled for the Six months ending June 30th 2017 compared to 2018 from 7.57 million to 16.89 million. Yet revenue was less than the profits made.
Revenue for Six months ended June 30th was 16,890,086, yet gross profit was 32,444,485. This is a red flag and why it is important to read the statements not take it for granted.
In simple terms, this would be like selling $100 in girl scout cookies and claiming you had $200 in profits. Not economically possible unless there is some odd accounting practices.
So how does this happen?
In valuating their current inventory as current assets, they used “Fair Market Value” (FMV). Normally inventories are valued at cost or market value which ever is lower.
However commodities like corn, soybeans and others, valuation of inventory at fair at FMV is reasonable. These are transparent markets where if you have 10,000 bushels of corn in silo we can base value on the futures market.
Since Cannabis is not traded openly, we are taking the boards word for the actual value. This is why reputation matters. This is also understandable for the final product, but for seeds and plants not harvested, it is a little much of a stretch.
The FMV of biological assets included in inventory is considered revenue. Most GAAP practices consider inventory an “asset” not “revenue”. This is assuming the assets are being sold in the future and counting it as revenue in the current quarter. Commodities like corn are often pre sold on the futures market, so this type of accounting is rational. Corn farmers normally lock in futures contract at planting time so even though it is in inventory it is already sold. Not exactly this simple but a brief example. Cannabis companies are not the same there is no cannabis futures market, yet the use the same standard of reporting.
Not the end of the world, but if you are reviewing financials this is something to look for. This is also why the reputation of the board members matters.
“It takes twenty years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.”
— Warren Buffett
In short because Canadian companies follow the International Financial Reporting Standards (IFRS) vs the common US GAAP according to the Financial Accounting Standard Board, cannabis companies are required to recognize the Fair Market Value (FMV) of their biological assets less costs. This comes before selling them and even before they are planted. This is stretching what traditional farmers do.
The would be no different then you having a lemon tree farm, and claiming the new trees you planted, which are 2 years from being productive, are counted as revenue. You have sold nothing, and it is not even matured yet, but it is included as revenue. In effect your lemonade stand made money before the trees have produced the first lemon. Worse yet you are counting the lemon seeds that have not even been planted yet.
As the space grows accounting regulations will need to be adjusted to fit this space. There are some parallels with traditional farmers, but a farmer is not considering the final price of a loaf of bread as revenue for wheat that has not been harvested yet.
Tracking Biological Assets:
How they estimate this is in note 7 Inventory and Biological Assets. I will not break it down here, but this is something that we need to pay attention to. If you track your quarterlies in spreadsheets, I would add number of grams of biological assets each separately.
This is important as they mention a 10% decrease in selling prices can significantly affect the bottom line. In addition a 10% decrease in yield would also have a decrease in FMV.
Since these are included in the revenue portion this could result in a report of severe losses. This makes the quarterlies hard to track as inventory is removed, reallocated, or sold, vs new biological assets in process. To add to this they had an unrealized loss on changes in FMV of 15,350,984.
Bonds Warrants and Options:
In addition in another round of funding through stock issuance, provide nearly 88 million in money ready to invest.
11,155,000 units were bought at 9.00 per unit for total proceeds of 100,395,000. Keep in mind the company can issue an unlimited amount of shares, thereby diluting current shareholders, but with 88 million on hand, for acquisitions and expansions this is not a likely scenario.
What we are going to watch is their current cash holding. If we start to see this go down significantly there is likely to be another issuance and further dilution for shareholders. This is not good, just ask the shareholders of Bank of America or GE when Buffet bailed them out. Good for Buffet, bad for shareholders.
How Warrants Work:
It is not uncommon for a new company to have outstanding warrants and options. A warrant entitles the holder to buy the underlying stock at a specific price until a specified time. This is similar to stock options.
Warrants are generally attached to bonds as a deal sweetener. You want me to loan you money, I will at a specific % interest rate, and at the expiration I have the right to buy stock outright at $XX.XX per share. This is how Bank of America received funding from Warren Buffet.
During the financial collapse Bank of America’s stock was bleeding. Where there is blood there are sharks, and in stepped Buffet. In 2011 he invested $5 billion in BOA and received 50,000 shares of preferred stock at 6% dividend, with the warrant to buy 700 million more at $7.14 each expiring I believe in 2021.
Like I said previously good for Buffet bad for the current shareholders of BOA as that dividend came out of theirs. In addition they are subject to a dilution of 700 million shares in the future. This is why we say YOU can not invest like Buffet.
None the less CannTrust is raising money for expansion and growth. We want companies investing in growth with good fundamentals and a good product. They are also expanding their product lines to include recreational use, and entry into the beverage market. This is something we need to continue watch and monitor closely.
This is why owning too many stocks is not good. You can not keep up with research required to make good decisions.
Seeing the current warrants were issued at $9, this seems to have priced in the value of what we can expect. We do not have near the insight as bond investment groups who can better value the future worth of a company. If they are happy with warrants at $9, then we can draw a reasonable assumption that the future value is so. However this is a big assumption.
Shareholders could see share dilution of almost 30%, and those exercising their warrants at $1-$5 per share are likely to take profits. June 5th another round of funding was done consisting of 11,155,000 units @$9 per share, including the right to exercise @$12 per share by June 2002.
The level to look at is $18 as the company has the right to accelerate the date if common shares trade above $18.00 for 10 consecutive days. The FMV of the shares issued on exercise of warrants was $8.65 at time of exercise. This is an important level to watch!
Shareholders are exposed to infinite dilution of ownership. In addition the accounting practices are subject to scrutiny and deceptive practices. This is where understanding the financials is required when they report their next quarterly.
This is a speculative investment by all measures and this requires due diligence and emotional balance.
“The game of speculation is the most uniformly fascinating game in the world. But it is not a game for the stupid, mentally lazy, the person of inferior emotional balance, or the get-rich-quick adventurer. They will die poor.” – Jesse Livermore
The weekly inside bar is not in the ideal position we would consider ideal for a position trade. But this is a strong chart. The 8.25 area is where the 0.382 & 0.618 retrace overlaps from the overall bullish swing and the previous swing from early September. Lower support is found at 7.00 or the 0.618 of the overall swing.
Overall the chart is very bullish. With that said as this is still a speculative stock with accounting practices that are deceiving. It is important to get your money out when you can. Not when you have to. This separates successful from the coulda woulda shoulda investor.
Investing in speculative cannabis stocks is risky. This should not be done with discretionary monies. Money that is allocated should be money you can afford and are willing to lose in its entirety. This is not the same as investing in JNJ, PG, KO or other relevant blue chip stocks.
It is your money, and in lieu of buying the hype you should look to understand what you are buying. From the surface CannTrust is a screaming buy, but when digging deeper there are flags a frugal investor must be aware of. You will not find this on a chart, or in a book, this takes time, effort and experience.
Not that CannTrust will not be one of the winners in the space. They are position to be so, or even the potential for a takeover. They have the experience and products we want to see. However for every successful company there will be many more losers; this is what we need to be cautionary about.