CannTrust (TSX: TRST) scandal parallels Ascent Industries situation (CSE: ASNT)
As the CannTrust Holdings (TSX: TRST) (NYSE: CTST) scandal continues, the parallels with the situation with Ascent Industries (CSE: ASNT halted) become eerier and eerier. Even the nicknames are similar. As the stock price fell dramatically, pundits begin referring to Ascent as Descent. Similarly, as investors suffer a sense of betrayal, CannTrust is becoming known as Can’tTrust.
I think there are lessons to be learned by what happened with Ascent and what is happening and might happen with CannTrust. Fortunately, I can match my thinking and actions with respect to Ascent because it was included in the initial Cannabis Report Model Portfolio that is published by Investors Hub and although the stock traded between a low of CAN $.085 and a high of CAN $.98 per share, I was able to sell out the position at a handsome profit for the portfolio.
The chart above shows the trading in Ascent Industries (CSE: ASNT). There are numbers 1, 2 and 3 on the chart in 2018 that reference the paragraphs below.
1. I started the Cannabis Report Model Portfolio on August 10, 2018 and ASNT was included in the initial portfolio. The starting position was 15,300 shares at a cost of $.49 per share for a value of $7,572. At 7.6% of the portfolio, ASNT was the second smallest of seven positions because it was a smaller company and I often start with smaller holdings and increase or decrease the position as things develop. I had visited their property as well as a large greenhouse they purchased and a third facility under construction. I interviewed management and liked the potential because the focus was on international sales. The long and the short of it is ASNT was an interesting company doing good things. The shares performed well in the short run and all seemed well.
A similar picture can be drawn for TRST. The company was a darling of Bay Street and Wall Street and their shares had performed well generally and both medical and adult customers loved their products.
2. On September 27, 2018, ASNT disclosed, “…Health Canada has informed (Agrima Botanicals that held ASNT’s licenses) that it did not meet all of its record keeping and other compliance requirements during a Health Canada inspection….” It turned out ASNT was selling cannabis out the back door to illegal dispensaries. This is very similar to CannTrust’s initial disclosure that “…some of its cannabis-growing practices at its facility in Pelham, Ontario were found to be non-compliant with certain Health Canada regulations.” It turns out TRST was secretly and illegally growing cannabis in five unapproved rooms at a twelve room facility and selling the cannabis to dispensaries and exporting some to Denmark. As I said last week, TRST’s statement “…is the equivalent of saying some of Bonnie and Clyde’s banking practices were non-compliant with certain laws.” TRST was involved in the illegal growing of cannabis, plain and simple.
The day after ASNT’s disclosure, I sold 67% of the ASNT holding or 10,300 shares out of the total of 15,300 shares at $.71 per share. I said at the time, “An unscheduled inspection by Health Canada revealed some shortcomings in ASNT’s accounting resulting in the suspension of certain licenses. The company is actively working to resolve the problems….These issues with Health Canada always take longer to resolve than expected and the issue will be a cloud over ASNT and the stock until it is fixed. I am retaining a position in the stock because I am confident the issue will be resolved and I very much like the direction the company was headed before hitting this bump in the road.”
I believe a similar comment applies to TRST today. Investors who are buying or holding TRST shares in the belief that the worst is over will be proven wrong, in my opinion. This fiasco could drag on even longer than the ASNT problem and I believe the worst is yet to come.
3. On November 9, 2018, I sold the balance of 5,000 shares of Ascent at $.45 per share. I explained “To boost our cash position, we will close out the small remaining balance in ASNT. We still like the company and will reconsider it when their issue with Health Canada is resolved.” Although the final sale of the ASNT position took place slightly below cost, the overall investment was very profitable for the portfolio. Of course the issues with Health Canada were never resolved.
I don’t know exactly how the TRST case will end up but I think there are some lessons to be learned from ASNT and conclusions we can reach.
In my opinion the transgressions of ASNT and TRST are quite similar on a scale of the degree of seriousness. One could even argue that TRST’s issues are more serious.
I understand one employee below the senior executive level at TRST has been let go. ASNT also initially fired some lower level employees. But senior management at ASNT lost their positions relatively quickly and I think the same may happen with TRST. Growing thousands of illegal plants for six months in five rooms behind a wall build to hide the activity a scam one person can engineer. It’s not a case of whether management knew or were involved even though I find it hard to believe they didn’t know. One person cannot plant five rooms and build a wall to hide it without several other people, maybe everyone finding out. Thousands of plants have to be sourced, brought into the growing facility, planted, allowed to vegetate, then put into the flowering cycle with lighting, temperature control and fertilizer. Then they have to be harvested and dried, processed and packaged. You cannot sell or harder still, export illegally grown product before the official company records reveal something is happening. But if senior management didn’t know, they should have known and for that reason alone, I don’t think they will be allowed to stay.
Information in the case of ASNT seeped out slowly. There was also a process that was followed. Health Canada stated the intention to revoke ASNT’s licenses and gave management the opportunity to explain why their licenses shouldn’t be revoked. Deadlines were set and extended and the process dragged on creating uncertainty which is one of the things investors hate the most. I find it somewhat ominous that Health Canada chose last week to issue a notice that ASNT’s licenses held through Agrima were, in fact, revoked. Was it just coincidence or was it a warning? It has taken ten months to reach that point and for much of the time ASNT’s stock has been halted from trading and it remains suspended from trading today. Therefore, I think it is a mistake to conclude we have heard the worst of the TRST case. There is a saying in investment circles that applies here, “Bad news is like a cockroach. If you find one there are many more that haven’t been found. Yet.”
The buzzards are circling while the corpse is still warm. The source is a report from BNN Bloomberg, considered a reliable source. Apparently two cannabis firms have been approached by investment bankers to solicit interest in buying TRST assets. [Note: buyers are not interested in buying the TRST corporate entity because any liabilities attach to it. In the ASNT case, for example, the Canadian assets have been sold but not the company] BNN Bloomberg also reported one cannabis producer has approached Health Canada to determine if they would be open to a third party running TRST’s operations to correct the problems. A report by the deepdive.ca speculated this might have been RavenQuest Biomed. In any event, ASNT sold off its Canadian assets and received approximately $40 million or approximately $.12 per share. Allowing for expenses, there is around $.10 per share that was also the price of the last trade in the stock before trading was halted.
Speaking of vultures, the lawyers are also attracted to the scent of fresh meat. The problem for TRST is they are listed on the NYSE which makes them fair game for American investors and their lawyers. Because of TRST’s higher status, it is quite likely that institutions such as pension plans and mutual funds owned TRST shares. This was not the case with ASNT that was much smaller and not as well known. Professional fund managers have a fiduciary responsibility to act in the best interest of their investor/shareholders. In addition, TRST has approximately $150 million in cash that will have the ambulance chasers drooling. So whereas legal issues have not been a major problem for ASNT as yet, I suspect it is going to be a major problem for TRST in both the U.S. and Canada. Not only that, it could be a problem for senior management if someone is able to prove negligence caused financial losses. Finally, as some of the product was exported, TRST could also have international legal issues.
What might TRST be worth if their assets are sold off? Here is a Tweet that was also included in deepdive.ca’s report. I have no comment on Mr. Willis’ figure of CAN $.64 per share except to say because of the increase in cannabis share prices based on the expectation of rapid long term growth, the shares of most and perhaps all cannabis companies are trading substantially above their breakup value. In other words, although Willis’ estimate is a large discount from the market price, that does not mean it is inaccurate. In fact, it makes sense that it is a surprisingly small number.
Another factor that could cause problems for TRST is a complaint from a shareholder that the enforcement team of the Ontario Securities Commission is now investigating. The question is whether the fact TRST was violating regulations and not disclosing the fact to investors placed investors at risk. I would also raise a couple of other issues. First, it some of the reports implied TRST did not make immediate disclosure of the Health Canada problems. Second, a company as well known and highly regarded as TRST would have spoken to many investment analysts, investment bankers, investors, lenders and the media over that period of six months. Without question, the message from TRST would have been positive with the intention of attracting investor interest. My guess would be that some and perhaps many of the people engaged in this activity on behalf of TRST did not know about illegal activity. I am not a lawyer so I only ask - if someone knew or should have known, isn’t that a problem?
ASNT was a relatively small Licensed Producer operating in British Columbia and listed on the Canadian Stock Exchange. TRST is a relatively large Licensed Producer operating in Ontario and listed on the Toronto and New York Stock Exchanges. The potential collateral damage from TRST is much greater and more serious. It will taint the industry in a way that ASNT could never have done. Not only that, I believe the TRST scandal has extended the correction in cannabis stocks that is currently reaching records for duration according to my data. In other words, you don’t have to own CannTrust to be negatively impacted by their actions.
Conclusion: There are lessons to be learned from the Ascent scandal that applies to TRST. I think Health Canada needs to open its eyes to the needs of investors. We can’t go through a long, drawn out process with scarce information as was the case with Ascent. For the more influential CannTrust, that would be a disaster that could extend the bear market much longer than it already has. Nine months ago, seeing far fewer cockroaches than we already see with TRST motivated me to sell Ascent Industries from the Model Portfolio and that strategy locked in a profit and proved to be a money saving decision. But TRST’s reach extends far beyond its own shareholders. There are large institutional investors who own TRST stock and that wasn’t the case with ASNT. There are also the 72,000 medical customers who have been cut off from their medication with no warning. This is not an illegal insecticide contamination case where damaged and possibly dangerous goods reach consumers. TRST has some of the most popular brands available and that is critical, especially for medical patients and a lot of that has been confiscated by Health Canada. I think something should be done to ensure medical patients have their prescriptions filled for as long as possible.
In this case, we need a white knight to rescue TRST while at the same time, I think legal and regulatory action needs to be taken against senior management and anyone else involved in this scandal.
If you are a current shareholder, I wouldn’t jump up and down at the prospect of being taken over by a friendly, credible suitor. The price they will pay may not be a large premium to current prices. It may, in fact, be a discount to the current market. ASNT’s Canadian assets were sold for around CAD $40 million compared to a peak market cap that probably reached $250 million.
At this point in the process, I think the risks still outweigh the returns for TRST shareholders and I don’t think buying at current levels is a good idea. In the early stages of the ASNT fiasco, management was convinced they could work things out with Health Canada and that was the party line that was fed to shareholders and the public. But that isn’t what happened and if we are to learn from that experience, I cannot justify or rationalize buying TRST shares at this time and, for the reasons given, I would be selling. It was the best thing to do with Ascent and I suggest it will be a good approach to TRST.