It’s Best to Leave Sundial Stock for the Gamblers

Pot stocks have been on fire in November, thanks to favorable U.S. legal developments and accelerating momentum in Canada’s cannabis market. This rising tide has lifted all boats, even the most downtrodden of cannabis stocks like Sundial (NASDAQ:SNDL) stock. Year-to-date, SNDL stock is down just shy of 80% … but shares are up 320% in November alone, with 90% of that gain coming today.

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Is this breakout in Sundial stock the real deal? Or is it just a head-fake that you should ignore?

I think it’s the latter.

The reality is that while the story and fundamental trends underlying Sundial stock are improving, there are still major liquidity, dilution and demand risks that remain at-large, and ultimately make SNDL stock more of a gamble than an investment.

Here’s a deeper look.

The Case for Sundial (SNDL) Stock

Ostensibly, the bull thesis for Sundial to make a big turnaround seems pretty compelling.

You have a struggling Canadian cannabis producer, that has dropped the ball when it comes to adjusting to changing market demand, is burning cash left and right, and was on the cusp of going bankrupt not too long ago.

But times are changing.

Canada’s cannabis market is turning a corner, thanks to reduced legal restrictions, and for the first time ever in the second quarter of 2020, legal cannabis sales in Canada surpassed black market cannabis sales — marking a changing-of-the-guard wherein Canada’s legal cannabis market should start to come into its own and fully displace the black market.

At the same time, Sundial is executing a series of operational shifts to better align its business to rising legal cannabis demand. These changes include shifting towards producing higher-potency THC product, moving away from wholesale distribution and toward branded product sales, accelerating production of high-demand pre-roll products, expanding distribution for its top-selling Palmetto brand and pouring resources into marketing.

Good changes. They should couple with improving macro conditions and lead to better revenue growth trends in 2021.

Sundial has also streamlined its operations and dramatically reduced its cost structure, to a point where Sundial’s all-in cash cost of production per gram are now on par with industry-average costs (they were, for several quarters, far above industry-average costs). Plus, the company has significantly improved its balance sheet, reducing debt by $100 million CAD so far in 2020 and boosting its cash reserves to record levels.

All in all, Sundial is doing everything right to “unbreak” itself, from shifting the sales strategy, to cutting the cost base, to fortifying the balance sheet.

Going forward, Sundial is positioned for healthier growth.

Big Risks Remain

The key word above is “healthier”. I didn’t say healthy growth. I said healthier growth.

That’s because while, yes, the Sundial story is getting better — much better — it’s still a long ways from being good.

There is roughly $60 million CAD in cash on the balance sheet. Cash burn last quarter was roughly $20 million CAD. Plus, there are principal repayments of debt. So the company basically has enough cash on the balance sheet to last two to three quarters. That’s not long enough. While Sundial’s growth trends will improve in the coming quarters, they won’t improve by enough to make the company cash flow positive anytime soon.

So, by mid-2021, Sundial will likely have to raise more money.

Because of the existing leverage on the balance sheet, that raise will likely be funded through the issuance of new shares. That means more dilution for shareholders, who have already gone through more dilution than is bearable. More dilution, in turn, means a lower share price.

Perhaps more importantly, none of this raising money and diluting shareholders stuff matters unless Sundial can drive a huge sales turnaround in the coming years. Given the aforementioned operational shifts and improving macro conditions, that’s totally possible. But assuming so requires quite a bit of imagination, since net revenues dropped 54% year-over-year last quarter.

All in all, there are still big risks when it comes to SNDL stock.

So long as these risks hang around, betting on a big turnaround in SNDL stock is more of a gamble than an investment.

Valuation Is a Stretch

One of my bigger issues with SNDL stock is that even in the off-chance of a success, the present valuation leaves little room for upside.

That’s because this is a tiny player, in a hyper-competitive cannabis market, with nothing that’s all that unique about its product or marketing, and so profit margins at scale will be fairly slim. All of that basically means that even if Sundial does pull off an incredible business turnaround, the long-term profit growth prospects will remain relatively weak.

Hurting those profit growth prospects is the fact that in order to pull off this turnaround, more dilution is necessary, so the per share potential of profits at scale is small.

Indeed, my modeling says that even if Sundial pulls off its big turnaround, earnings per share won’t get much higher than 5 cents. A 20X multiple on that implies a potential future price target of $1 — in an everything goes right scenario.

Sure, that’s 3X upside potential. But in a stock with as much risk as SNDL stock, I’d want to see bigger upside potential to compensate for the risk.

Bottom Line on SNDL Stock

I get the appeal of SNDL stock. But, at this juncture, this penny stock is best left for gamblers, not investors.

On the date of publication, Luke Lango did not have (either directly or indirectly) any positions in the securities mentioned in this article. 

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