KeyStone’s Stock Talk Show, Episode 225.
We have a great show for you this week. In our YSOT segment, Aaron answers a listener question on High Liner Foods Incorporated (HLF:TSX), a leading North American processor and marketer of value added frozen seafood. While the stock offers a strong 4.3% dividend, we continue to have some reservations on the stock and Aaron let’s you know what the business would have to do to become a buy. I will answer a question on Lightspeed Commerce Inc. (LSPD:TSX), which offers a unified POS and payments platform. Having reviewed and passed on the stock multiple times in the past with it trading at significantly higher prices a viewer asks us if it finally offers value after announcing it will break even this year. With US Cannabis stocks jumping last week, Brett explores the news that sent the sector soaring after 2 years of tough times and whether it is sustainable or more of a dead cat bounce for US Cannabis stocks. Last but not least, Brennan revists a segment he put together back in May on Canadian Banks beginning to extend mortgage amortization periods and where they are today after reporting their Q3 numbers last week.
Let’s get to the show – we welcome my cohost, Mr. Aaron Dunn and as always, the killer B’s, Brett, and Brennan.
We got a few questions on why Cannabis stocks jumped higher almost across the board last week. Let me tell you why.
Positive News Item: a recommendation by the Department of Health and Human Services (HHS) to the Drug Enforcement Agency (DEA) that cannabis be reclassified to a Schedule III controlled substance.
- The recommendation follows a Food and Drug Administration (FDA) review on an ask by President Biden last October that the agencies review how cannabis is scheduled.
- Cannabis is currently classified as a Schedule I substance under the Controlled Substances Act (CSA), deeming it to have no medical use and a high potential for abuse.
- Schedule III substances show less potential for abuse (vs. Schedule I and II), have an accepted medical use in the US, and are considered to have moderate to low potential for physical and psychological dependence.
From an Investment Perspective: Reclassifying cannabis to Schedule III (or higher) would eliminate the 280E tax burden that currently applies to cannabis operators.
Section 280E of the IRS tax code prohibits marijuana businesses from taking traditional business deductions or tax credits because the plant is listed as a Schedule 1 drug under the federal Controlled Substances Act.
Reclassifying Cannabis in the US to Schedule III would increase cash flow – many of the larget Multi-State-Operators would see savings of $100 million plus, so it is significant.
So why the jump in the stocks?
The potential for better cash flow. Considering the extreme bearish sentiment and short positioning in the Cannabis segment, the initial move in the stocks is likely significant short covering. Remember, this announcement is just a first step.
More steps lie ahead before a final outcome. The DEA or US Drug Enforcement Agency will now complete its own review. The key risks are the DEA deciding to leave cannabis as Schedule I or opting to reclassify to Schedule II, under which 280e would still apply. It is interesting to note that the HHS’ or the Department of Health and Human Services recommendations are binding as to scientific and medical matters – which would suggests Cannabis likely will not remain a Schedule 1 drug. But the timeline could easily stretch through the 2024 presidential elections, given the political nature of such a ruling.
Conclusion – the announcement is a positive for the sector which has faced extreme bearish sentimiment given the poor and slow moving legislative environment. But, the timeline and ultimate conclusion is still uncertain. There are also other concerns with the segment including too many players and the resulting competition weakening margins. While the potential for a move to Schedule III is good news, for larger investors to move forward, the sector is still likely to need more certainty.
Lightspeed Commerce Inc. (LSPD:TSX)
Market Cap: $3.38 Billion
Company Description: Based in Montreal, Canada, Lightspeed is a cloud vendor of omnichannel point-of-sale software to retail and hospitality customers. Its software is used by >160,000 midmarket customers in North America, Europe and Australia.
Quarter 1 Fiscal 2024 Highlights
- Total revenue of $209.1 million, an increase of 20%.
- Subscription revenue of $78.7 million, an increase of 7%.
- Net loss of ($48.7) million as compared to a net loss of ($100.8) million – so while the company still loses money, I guess we can say it is losing less.
- Adjusted EBITDA loss of ($7.0) million, versus an Adjusted EBITDA3 loss of ($15.6) million in the same period of the previous year.
- As at June 30, 2023, Lightspeed has a great balance sheet with $780.3 million in cash and cash equivalents.
Valuations: The company trades at over 20 times EV/adj. EBITDA its FY 2025 estimates – Its trailing price-to-sales is 3.25. There is no PE trailing as the company loses money and we do not expect accounting EPS to be positive in FY 2024 or FY 2025.
Lightspeed has stated that it remains on track for Adjusted EBITDA break even or better in fiscal 2024. Revenue of approximately $875 million – $900 million – this is close to 22% growth. We do appreciate that Lightspeed has shown remarkable growth via acquisition and to a degree organically since 2016 when it posted just $30.7 million in annual revenue to up to $900 million expected in the current fiscal year – remarkable growth in revenues. The company raised capital at an opportune time and boasts a huge cash balance of $780.3 million with limited debt. We have answered questions on this Podcast when the stock traded in the $140 range, a $100, $80, $60, $40, and down to the $20 range today – Our issue with the business as is a lack of profitability. Operationally, the company lost $27 million back in 2016 and despite massive revenue growth lost roughly $243 million over the past 12 months. The losses are decreasing this year on an adjusted basis and management is looking to break even on an EBITDA basis or better in the current year – again, this is not positive accounting earnings, just on an adjusted basis. With losses shrinking, solid revenue growth, and a strong client base the business is moving in the right direction, but still has a long road ahead of it to meet our criteria.
Cannabis Industry / MSOS
Over the last week, we’ve seen the Cannabis industry stocks pop in price. Using as a proxy for the industry AdvisorShares Pure US Cannabis ETF, the largest pure-play Cannabis ETF symbol MSOS on the NYSE. At close on August 29th the ETF was trading at $4.85 and is now trading intraday at roughly $7.85 a 62% increase in a week. Mind you that results in only a 14% increase year to date after the massive increase.
So why has the industry suddenly become so revitalized? The answer is simple expectations have changed due to a senior US Department of Health and Human Services calling on the DEA to ease restrictions on marijuana from Schedule I to Schedule III, Schedule I being the designation for the most dangerous substances. However, the DEA has final authority for any changes to the scheduling, and the change is merely an increase in potential at this point.
A change in the scheduling would likely allow for easier avenues of research, easier access to banking, and less taxation. As well this does not mean marijuana would be in the same state in the US as it is in Canada it would still be federally illegal that would require it to be descheduled, but some are seeing it as a step toward deregulation.
So, how would this impact equity investors? We would see less taxation as companies are not allowed to use credits and deductions on income from sales of schedule I and II drugs, a clear economic benefit with expected savings of $100 million plus for many multi state operators. On the operational side, better access to banking would likely reduce expenses as currently only certain banks have any services offered to Cannabis players, increasing costs. However, the rescheduling still falls short of a recreation demand increase like we saw in Canada years ago. In reality, it just reduces the toxicity of the current operating environment for the industry, but that does not make an industry.
Looking deeper at the MSOS ETF, first off you may notice they primarily hold equity swaps this is due to Federal and Custodial Bank restrictions limiting direct investment in the equity. As the ETF invests in swaps it has a large amount of cash as collateral, if you are looking at the holdings you can effectively ignore the cash position.
The ETF holds 25 companies at this time with its top five holdings are Green Thumb Industries, Curaleaf, Trulieve Cannabis, Verano, and TerrAscend. Representing 77% of the total assets held by the ETF.
Looking historically, Green Thumb Industries is the only holding currently profitable with Trulieve previously having profitability for the top 5 holdings.
As a whole, the industry is still in the speculative phase having the valuations bank on the expectations of future earnings, but that does not mean they will ever become profitable or have positive cash flows.
We can really use Canada as a proxy for full recreational legalization in the US. I will remind our listeners that the potential rescheduling is still far off federal recreational usage. Cannabis is a commodity, it is ultimately a crop with minimal differentiation in its core product. Being a commodity it causes a race to the bottom in pricing due to the goal of producing as much supply as possible, causing margins to be too thin for sustained profitability.
The taxes are high, this is already seen in the US states where it is legal on the state level where an additional sales tax of 6% to 37% with 10-20% being the sweet spot for most states. Also, there is always the potential in the case of federal legalization addition taxes being levied on the federal level.
So as a whole, the industry is still regulatory high risk in the US and will continue to be but just not as risky as it currently is. The industry will be commoditized and will be subject to high taxes, which are both negative aspects of an equity investment case on top of the fact any tangible market demand shift is years out.
We’re once again seeing the same headline-driven share price increase once interest fades so will the share prices once again, while the underlying companies will continue to burn cash for years to come. There may be an outlier or two in the future who do become sustainably profitable but it is too early to tell, and if you were to invest in an ETF like MSOS to hedge your bets you take on a large amount of losers with the potential of one winner lower or completely removing any upside from that winner. The industry is still far off being viable for a buy-and-hold investment or really anything more than event-based trading.
Canadian Banks and Mortgages
We did a segment back in May on Canadian Banks beginning to extend mortgage amortization periods on outstanding mortgages to help ease the pain of some Canadian’s facing higher interest rates and ongoing inflationary pressures.
So now that the banks have reported their Q3 results, I thought that I would go over some common themes we saw with the bank’s results and see what their MORTGAGES BY REMAINING AMORTIZATION looks like now.
Looking at the results, several of the banks failed to meet analyst expectations and only RBC outperformed.
Some of the common themes which they reported:
- Growth in GIC funding as investors flock to higher interest-bearing securities.
- There were comments that there was a bit of a slowdown in Dealmaking & Mortgages as consumers are more cautious with elevated rates… and a few cited fierce competition for Mortgage spreads.
- A couple of banks discussed reducing headcount, specifically RBC, as well as TD. And for TD they indicated that they had large one-time costs due to the failed Acquisition of First Horizon Corp.
- Lastly every bank reported Higher Provisions for Credit losses. And just to keep in mind, these aren’t actual credit losses that the banks are experiencing, but just that the banks are placing aside more provisions for potential losses in the future.
And just to show some earnings estimates, analysts have been downgrading their EPS estimates as banks are facing a tougher macro-environment.
Now moving to the bank’s MORTGAGES BY REMAINING AMORTIZATION… just as a reminder, in 2021 there were basically no Mortgages with an amortization period of greater than 35 years… now almost a 3rd of mortgages in Canada are over 30-year amortizations.
And TD now has 48% of its mortgages with a great than 25 year amortization – as we saw an uptick in 25-30 year mortgages and a slight move downward in mortgages greater than 35 years.
A similar story with CIBC, 47% of mortgages have an amortization period greater than 25 years which was pushed up by growth in 25-30 year mortgages offset by a slight decline in mortgages greater than 35 years.
Lastly with RBC, 43% of their mortgages have an amortization of greater than 25 years. And again there was a slight increase in 25-30 year mortgages with a slight decrease in mortgages over 35 years.
The Financial Consumer Agency of Canada (FCAC) – said two-thirds of mortgage holders in Canada are having trouble meeting their financial commitments.
In July the FCAC provided new guidelines for banks on how to deal with “at-risk-consumers” dealing with financial stress. With the aim of standardizing how lenders implement policies and procedures. Some of these items include:
- Waiving prepayment penalties.
- Waiving internal fees and costs
- Not charging interest on interest
- And of course, extending Amortization periods.
Now Banks and other lenders will sometimes offer various forms of relief for consumers struggling in these scenarios – so it is not a new thing – but again the FCAC’s new guidelines seek to standardize the approach but do not prescribe direct action that institutions should take.
The standalone monthly Seasonal Adjusted Annual Rate of total housing starts for all areas in Canada in July was down 10% from June, (which was the strongest month so far this year). But despite the monthly drop, total housing starts for all areas in Canada was 7.4% above the 5-year average.
And lastly, I just wanted to finish on the affordability of housing in Canada. Where the median resident in both Toronto & Vancouver are paying above 80% of their median income on their mortgage payment. It remains at approx.. 60% across the country with Montreal and Calgary coming in at much better levels of around 40%.