The North American cannabis market has seen a surge of growth and optimism in 2023, thanks to the favorable political and legal environment. In the past, state-by-state legalization of either the recreational or medical marijuana was the catalyst for new opportunities in the cannabis sector. While this is making many people jump on cannabis stocks, there are still many that are waving warning flags.
In 2023, the Biden Administration has also taken steps to decriminalize marijuana at the federal level, requesting the Drug Enforcement Administration to review moving cannabis from a Schedule I to Schedule III under the Controlled Substances Act. This would in effect imply the federal government is acknowledging marijuana has medical uses, which could in turn catapult investment in the nascent industry. However, not all cannabis stocks are poised to benefit from these tailwinds. Some of them are facing serious challenges that could undermine their performance and profitability in the near or medium term. Here are three cannabis stocks that are waving massive red flags in September 2023.
Tilray Brands (TLRY)
Tilray Brands (NASDAQ:TLRY) is one of the largest cannabis producers and distributors in the world, with operations in Canada, Europe, Latin America and Australia. However, the company has been struggling to revitalize growth and achieve profitability in recent years. In their fiscal year 2023 (ended May 31), Tilray reported a slight YoY revenue decline by 0.20%, from $628.4 million to $627.1 million. The production, distribution, and sale of cannabis accounted for a substantial 38% of fiscal year 2023 revenue, and this reporting segment struggled due to higher competition in Canada, Tilray’s largest cannabis end-market.
Tilray’s main problem is its high-cost structure, which erodes its margins and makes it difficult to compete with lower-cost rivals. Tilray’s cannabis gross margin was only 28%, well below the industry average of 45% to 55%. Tilray needs to optimize costs and improve margins, or else it could continue to lose money and market share. The company shares have already fallen 8.2% YTD, and investors desiring exposure to this new market should beware.
Aurora Cannabis (ACB)
Aurora Cannabis (NASDAQ:ACB) is another leading cannabis producer and distributor, with a strong presence in Canada and international markets. Unfortunately, the company has been facing similar challenges similar to Tilray, including high operating costs, low margins, and negative cash flow. In the third quarter of 2023, Aurora generated CA$81.6 million in total net revenue but also reported CA$61.4 million in cost of sales, which would bring non-adjusted gross margins around 22.6%.
Aurora has made strides to reduce costs and improve profitability for years but so far had mixed results. In 2020, Aurora sold off some of its assets, such as its stake in Alcanna, a liquor retailer. Moreover, in July 2023, the cannabis producer closed the sale of its greenhouse facility in Medicine Hat, Alberta. However, these M&A (mergers amd acquisitions) moves have also reduced Aurora’s production capacity and revenue potential, making it harder for the company to achieve economies of scale and gain market share. Last year, the company also pursued a costly equity sale that had the potential to significantly dilute the stakes of existing shareholders. Thus, without sound fundamentals and unresolved costs issues, it is difficult to recommend ACB shares for the foreseeable future.
Canopy Growth (CGC)
My final entry is not so different from those above. Canopy Growth (NASDAQ:CGC) in one of the largest cannabis companies in Canada and has a growing presence in the U.S. and other markets. However, the company’s top-line growth in recent fiscal years and quarters has been either on the decline or just anemic. In fiscal year 2023 (ended March 31), Canopy Growth reported a 21% YoY decline in net revenue driven by higher competition and price compression in the Canadian market. Unfortunately, growth has yet to rebound in the company’s fiscal year 2024. In particular, Canada-based cannabis revenue declined 26% YoY in the first quarter, while total net revenues increased by only 2% YoY.
Another headwind for Canopy Growth is its high valuation. The cannabis brand’s price-to-earnings and enterprise value-to-EBITDA ratios are absurdly high due to the fact Canopy is not generating sufficient profit. A lack of profit and growth make the stock vulnerable to a correction if earnings or growth prospects continue disappoint investors. It appears we are entering a market that could become critical of these high-multiple companies especially as interest rates are deemed to stay higher for longer. Investors are better off proceeding with caution.
On the date of publication, Tyrik Torres did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.