Tilray: Down 89%, But Still Far From A Bargain

Summary:

• Cannabis stocks remain highly exposed to the Canadian market; Tilray, long Canada’s top producer, is especially so.
• Tilray, along with many of its peers, are working to shift focus from Canada to more lucrative international markets.
• Tilray has established itself on three continents, and is now Germany’s biggest cannabis player.
• Efforts to penetrate the prized US market, however, have proven slow and challenging thus far.
• While Tilray’s stock has fallen 89% from its all-time high, it remains far from a bargain.

If you’re legally producing and selling cannabis in a regulated market, but somehow can’t make any money from it, then it is likely that one of the following is going on:

1. You’re bad at operating a cannabis business;

2. You’re operating your cannabis business in a bad market; or

3. Both of the above.

In Canada, where the biggest operators have spent years posting net loss after net loss, the answer very often turns out to be (3).

Canada plays host to a multitude of money-losing cannabis businesses, many of them publicly traded. Despite their less-than-ideal economics, Canadian cannabis companies continue to attract investment dollars. This is because they often appear to be the only option available to investors who want exposure to cannabis. However, investors would actually be better served looking elsewhere for opportunities.

Through various combinations of over-concentration in one of the world’s lowest-margin cannabis markets, high taxes and onerous regulatory burdens, Canada’s top cannabis players look virtually uninvestable right now. To understand why, it may be helpful to take a look under the hood of one of the biggest names in Canadian cannabis: Tilray Brands, Inc. (NASDAQ:TLRY) (TSX:TLRY:CA).

Let’s discuss.

Trials and Tribulations

During its second fiscal quarter ended Nov. 30, Tilray fell short of analysts’ expectations on both top and bottom lines. The company reported net revenue of $144.1 million, down 7.1% from the same period last year, and 7.24% below the consensus estimate. This translated to GAAP net loss of $69.5 million, or -$0.11 per share, a miss of just over 11%. Cash burn also accelerated even as revenue growth stalled out. Net cash fell by $300.4 million, leaving $433.5 million in cash and marketable securities at quarter-end.

Apart from its less-than-stellar GAAP performance, Tilray also reported a number of non-GAAP metrics. After considerable adjustments, Tilray’s official non-GAAP operating cash flow and non-GAAP free cash flow came in at $29.2 million and $25.4 million, respectively. Management also highlighted that the second quarter marked the company’s 15th consecutive quarter of positive adjusted EBITDA.

But non-GAAP adjustments can only get you so far. After all, reporting positive free cash flow cannot change the fact that net cash fell precipitously over the three-month period.

Canadian Crucible

Much of the blame for Tilray’s lackluster results can be laid at the feet of the Canadian cannabis market. The truth is, the Canadian cannabis market has some serious issues. Among the most serious is the extreme market saturation that has resulted from Canadian producers inundating the domestic market with cannabis in an effort to secure greater market share. But bigger is not always better, and, in the case of Canada’s cannabis market at least, increased market share has consistently failed to produce positive economies of scale for industry leaders.

Tilray has been the largest cannabis producer in Canada for years, and it continued that streak in the second quarter. The company spent years pursuing a “growth at all costs” strategy, as did many of its peers, such as Canopy Growth (NASDAQ:CGC). Unfortunately, this strategy failed to yield the intended effect. Instead, it has produced remarkably terrible outcomes for even the biggest operators, including Tilray, a fact attested by its second-quarter results.

Making matters worse for Tilray and its peers are the high taxes and onerous regulations set by Canada’s federal government, which add burdensome costs to legal producers not shared by illicit operations. As a result, already overstretched legal producers struggle to compete with black market producers on price. Legalization has thus far failed utterly to rein in the black market. According to an estimate last month by Canopy Growth’s CEO, the black market currently accounts for as much as 40% of Canada’s cannabis market.

Tilray clearly understands that the Canadian market is unsustainable in its current form, despite its efforts to establish a sustainably profitable business in the country. As CEO Miguel Martin explained to employees last year:

“Simply put, our business is bigger than what we need, and we must position ourselves to better secure our path to profitability and ultimately be successful in this industry in the long term.”

This conclusion has informed Tilray’s accelerating effort to expand its presence in other countries, while also rationalizing its Canadian operations. But this can be much easier said than done.

Growing Nowhere Fast

Like so many other Canadian cannabis operators, Tilray has made efforts in recent years to reach other, more lucrative cannabis markets. It has already established footholds in numerous foreign markets, and now boasts a presence on three continents. Last year saw Tilray turn its eye toward Germany in particular. Already the biggest cannabis producer in Europe’s richest country, Tilray’s German pivot has garnered about 20% of total market share. Yet while Europe, Australia, and other far flung lands undoubtedly offer intriguing opportunities for expansion, the real prize for Canadian cannabis operators lies just south of the border.

Tilray has made some efforts to position itself for the US opportunity, including moving its corporate headquarters to New York and standing up some limited operations. However, it still has little more than a toe-hold in the market. As Seeking Alpha’s Pacifica Yield observed in an article last month, Tilray and its Canadian peers continue to face considerable barriers to market entry:

“The Canadian cannabis market remains structurally opposed to long-term shareholder value creation due to its burdensome regulations and a black market that has remained sticky. Want to make money investing in cannabis? Pivot your operations to the US. However, this has been complicated due to cannabis still being illegal under US federal law. Hence, Tilray and Canopy Growth are still largely excluded from the expansive US cannabis market which is set to reach more than $34 billion by 2025, around 5x larger than the forecasted size of the Canadian cannabis market in the same year.”

The US cannabis market is the world’s most valuable, by far, but also the most fragmented. Thanks to continued federal prohibition and wide variance among the legal regimes of the various states, each state cannabis market is more or less autarkic in character. Every state’s cannabis market is different thanks to a myriad of factors, including wide differences of regulations, licensing restrictions, ownership requirements, etc. This has made certain state markets extremely attractive compared to others. Some states have even managed to replicate Canada’s mistakes; Oklahoma, for example, has seen its nascent cannabis industry implode due to oversupply.

For Tilray, success in the US market will be essential to support the growth trajectory expected by investors. Whether it can actually do it successfully remains to be seen.

Investor’s Eye View

Tilray’s stock closed at $2.61 per share on March 17th, down 5% year to date, and down nearly 98% from its all-time high. With a market capitalization of $1.61 billion, Tilray’s valuation is certainly less wildly optimistic than it was in the halcyon days of 2018. But it is still far from cheap, given the current state of its operations. Tilray is still highly reliant on periodic capital raises to fund its existing operations. While its ongoing efforts to cut costs and reach more lucrative markets may bear fruit one day, that day is well into the future. Right now, Tilray is a cannabis operator with an uncertain future. Until it is priced accordingly, I would not bet the farm on this name.

More generally, it is my view that investors would be wise to give a wide berth, not just to Tilray, but to pretty much any cannabis stock, especially those that trade on Canadian exchanges where securities rules and disclosure requirements are substantially weaker than those in the US. Unfortunately, far too many investors still insist on conflating the idea of “investing in the cannabis industry” with “opportunities to invest in cannabis stocks”. But they are not the same—not in the slightest, in fact. While pot stocks have been a bust for many investors over the past couple years, and are likely to remain so, there are other options. Indeed, the most lucrative opportunities in cannabis can be found in the private space.

Privately held cannabis companies in legal markets around the country are making huge profits, especially in highly controlled markets with structurally limited supply. While such opportunities may be a bit harder to find than a pot stock, they are still plentiful. Investors in states where cannabis is legal should look for local operators who need capital, or entrepreneurs preparing to apply for a license. Usually, the extra reward is more than worth the extra effort.

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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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