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Which pot stocks will survive? Measuring cannabis bankruptcy risk

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Picking winners and losers is a well-worn theme for cannabis investors looking to place bets on companies building strong brands, turning a regular profit, and capturing meaningful chunks of the market. 

With the global economy withering under the COVID-19 pandemic, the odds of a wave of bankruptcies wiping out underperforming cannabis firms swept up in the 2018 hype around recreational legalization are on the rise. 

“Even prior to COVID-19, we expected industry exits,” CIBC analyst John Zamparo wrote in a research note last week. “The pandemic will likely serve as an accelerant.”

He recently slashed his 2020 retail sales estimate to $2.5 billion, from his prior forecast of $3.4 billion.

Cracks were widening in the sector prior to the novel coronavirus becoming a full-fledged global pandemic. Early 2020 was marked by major layoffs, lacklustre financial results, and executive departures. 

Adding to the virus-related headwinds, licenced producers continue to grapple with limited financing options, unforgiving capital markets and resilient illicit sales. In late March, embattled Canadian cannabis producer CannTrust Holdings (TRST.TO)(CTST) and James E. Wagner Cultivation (JWCA.V) both filed for bankruptcy protection.

Cannabis spending briefly surged at the onset of COVID-19 in Canada as stay-at-home orders spurred panic-buying. However, the virus forced physical retail stores, the most popular sales channel, to close their doors and pivot to online.

The ongoing pandemic will also delay the pace of new store openings in the underserved Ontario market, leaving Canada’s most populous province with about 50 locations in the near-term, compared to the hundreds of shops in smaller neighbouring provinces. 

“The catalyst for the Canadian marketplace in 2020 was already predetermined: the launch of hundreds of stores in Ontario was set to unlock the industry’s potential. COVID-19 has now brought about serious doubt as to when that might occur,” Zamparo wrote. 

With new storm clouds gathering over the battered sector, Yahoo Finance Canada turned to a method of determining bankruptcy risk developed in the 1960s. 

New York University Stern School of Business professor emeritus Edward Altman’s Z-score weighs five ratios using data from financial filings to predict the probability that a firm will go bust within two years. It’s not a measure of when a firm will file for legal bankruptcy, but rather how closely it resembles other firms that have done so. 

The formula takes into account metrics for profitability, debt, and liquidity. The results are by no means definitive, and cannot account for factors not represented in the data, such as new sources of funding that could keep a company alive. 

In this case, the scores capture a snapshot of cannabis companies as they reported their most recent quarterly results. Much of the data reflects periods prior to the economic shock of COVID-19.  

According to Altman, scores of 1.8 or below indicate a risk of bankruptcy, and scores over three suggest a sounder footing. For reference, Goldman Sachs recently assigned energy drink-maker Monster Beverage (MNST) and Facebook (FB) Z-scores of 22.7 and 11.8, respectively.

Here’s how 10 Canadian cannabis companies ranked:

MediPharm Labs (LABS.TO): 9.03

Cronos Group (CRON.TO)(CRON): 6.01

The Valens Company (VLNS.TO): 4.35

Organigram (OGI.TO)(OGI): 2.75

Canopy Growth (WEED.TO)(CGC): 2.17

Aphria (APHA.TO)(APHA): 1.44

Aurora Cannabis (ACB.TO)(ACB): 1.12

Tilray (TLRY): 0.09

HEXO (HEXO.TO)(HEXO): -0.22

Sundial Growers (SNDL): -1.26

Data for this story was compiled using Sentieo.

Jeff Lagerquist is a senior reporter at Yahoo Finance Canada. Follow him on Twitter @jefflagerquist.

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