Cannabis Watch: Cannabis stocks mostly higher after major rout but concerns about lack of profit persist

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Cannabis stocks were mostly higher Friday, recovering some of the steep losses suffered in the previous session as concerns about the lack of profits in the sector sparked a massive rerating of risk.

The rout was triggered by a revenue warning from Hexo Corp. HEXO, -4.91% HEXO, -5.32% that served as a reminder to investors that the much-hoped for sales and profit that sent stocks to record highs earlier this year are not materializing.

The news came in a week in which the continued power of the black market was in focus, after Statistics Canada released crowdsourced price data for the black and legal markets and found an average legal price in the third quarter of C$10.23 a gram, almost double the black market average price of C$5.59 a gram.

There was further bad news when a major deal involving retailer MedMen MMNFF, +1.22%  fell through, Aleafia Health ALEAF, +2.07% ALEF, +2.50%  dropped Aphria APHA, +1.30% APHA, +0.00%  as a supplier and Green Organic Dutchman TGODF, +9.52% TGOD, +8.11%  highlighted the difficulty in accessing capital at viable prices. Hexo closed down 23% and sent a swath of stocks down by a double-digit percentage.

“We call this the ‘Sanitation Cycle,” said Korey Bauer, portfolio manager at the Cannabis Growth mutual fund CANNX, -7.46%  from Foothill Management. “This is what happens with a new sector. We’re going through a phase now where the companies that are doing the right things — not overspending, hunkering down — will survive, and the ones that don’t will not.”

The cannabis sector is still mostly driven by retail investors, he said, with little institutional money in play because of the federal ban on cannabis. Retail investors can be more skittish when signs of trouble emerge, such as the lung disease that has sickened more than 1,200 Americans and killed at least 26 that is understood to be caused by vaping, albeit of black market products.

“Illegal vapes are the problem and that should be good for legal companies,” he said.

Investors are disappointed by the rollout of legal cannabis in Canada, which is now coming up on its one-year anniversary. Companies continue to express frustration at how few stores have been approved and opened, forcing consumers to continue to tap the black market.

Read: Aurora Cannabis earnings: When does pot profit actually arrive?

Related: Canopy Growth slides 14% to drag broader cannabis sector lower as earnings disappoint

In case you missed it: Cannabis companies are having a horrible summer as scandals mount and stocks slide

Ontario currently has about 75 stores, and needs 1,400 if it wants to match Colorado’s ratio of stores to 10,000 inhabitants. “Access to the legal market is huge,” said Bauer.

The next phase will likely be defaults which will push some companies into bankruptcy. But that’s a good thing, because right now there are too many companies, too much supply and not enough outlets to sell it, he added.

“There’s a select group of stocks that are now trading at fair value or below relative to where they were six months ago,” he said. “We’re taking advantage of the dislocation, but we think they will make it out, while the rest get left behind. We have moved from caring about revenue to positive EBITDA to just, ‘will you still be in business this time next year?’ incredibly quickly.”

Jefferies downgraded market leader Canopy Growth CGC, -1.72% WEED, -1.14%  and Hexo on Friday, and cut its stock price targets on the sector by an average 50% to reflect the greater risk and volatility in the sector. Analysts Owen Bennett and Ryan Tomkins agreed that the next 12 months will “see strong divergence between those who can execute/move to profit and the rest.”

The analysts upgraded Flowr Corp FLWR, +10.50%  and Organigram OGI, +11.02% and named Aurora Cannabis ACB, +0.00%  , ACB, -0.30%  Green Organic Dutchman and Aphria as top picks in the sector with buy ratings.

Canopy is “the most expensive name across the space (even with recent sell off) and although it continues to have material potential long-term, signs of share pressures in Canada, near term weak GM (gross margin)/profit performance (especially vs. its closest peers), lack of material catalysts, and question marks over how successful beverages will be see us move to underperform.”

GMP analyst Robert Fagan downgraded Hexo to hold from buy and slashed his stock price target to C$4.00 ($3.00) from C$9.50. MKM analyst Bill Kirk stuck with his buy rating on the stock, but lowered his price target to C$7.00 from C$12.00.

Hexo shares were down 4.4%. Canopy fell 0.3% and Valens GroWork VGWCF, -1.38%  was down 1.2%.

But Cronos was up 0.2%, Tilray TLRY, +1.84%  was up 1.8%, Aurora Cannabis was up 1.6% and Aleafia health was up 2.2%. Aphria rose 1.1%, Organigram was up 11.4% and Green Organic Dutchman rallied 10.7%.

The ETFMG Alternative Harvest ETF MJ, +0.59%  was 1.5%, with 28 of its 38 constituent stocks trading higher. The Horizons Marijuana Life Sciences ETF HMMJ, -0.48%  was up 0.5%, with 32 of its 54 components trading higher. Both ETFs are still down sharply on the week and year.

The S&P 500 SPX, +1.73%  and the Dow Jones Industrial Average DJIA, +1.71%  were up 1.5%.

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