Guide: CannTrust’s Illegal Cultivation and Health Canada Non-Compliance

The cannabis market can’t seem to catch a break. Last week, industry bellwether Canopy Growth fired their beloved CEO Bruce Linton. Now this week, one of the larger licensed producers, CannTrust (TSX: TRST) was caught illegally growing cannabis by Health Canada regulators.

As expected, the news has weighed heavy on the stock, as of this writing over 30% of CannTrust’s market cap has been erased since the story broke.

The Bottom Line

CannTrust could face serious consequences including revocation of their license, fines, and even destruction of millions in illegally produced cannabis.

If their license to grow cannabis at the Niagara facility is revoked, the company is highly unlikely to have any other significant capacity come online this year.

To put this in perspective, if the 12,700 kg of cannabis they currently have on hold is written off, it would represent a year’s worth of sales based on CannTrust’s 2019Q1 results. Looking at their past quarter’s operational numbers, it would represent a top-line hit of $71 million and corresponding EBITDA losses of $38.5 million. 12,700 kg is 12.7% of total legal demand in Canada today!

Luckily, they closed a public offering in May 2019 that gave them a boost in the form of US$160 million of cash. CannTrust has a war chest to try and weather the storm.

The larger concern, of course, is the loss of their full sales license. If they can hold on to this license, even with a loss of their cultivation license, they could buy white label product ala Tilray and minimize losses until a growing solution is found.

In contrast, losing their sales license would starve the company of cash flow and ultimately lead to a fire sale of their assets. We don’t expect a larger LP to throw them a lifeline when they could wait and acquire only the most valuable assets at a discount.

In relation to Canada’s cannabis supply, we don’t see any significant effects. With most LPs significantly ramping their production capacity, CannTrust’s capacity will be covered by the rest of the industry.

Finally, it’s important to consider the effects of their international activities. CannTrust is listed on the NYSE, immediately exposing them to additional oversight by U.S. regulators who are known to be a lot less forgiving.

Further, a recent report confirms that they shipped one product lot internationally to their Denmark subsidiary. While it has been placed on hold now, the Cannabis Act clearly states the export of illegal product is an indictable offense.

Overall, their international dealings may force Health Canada to take a swifter and more unforgiving path.

We dive into more detail below.

Patience is a Virtue – CannTrust Doesn’t Have It

While the industry has had its fair share of suspect companies, from self-dealing man-bun CEOs to the “Warren Buffet” of cannabis, few expected one of the top ten producers (by revenue) to be caught doing some something blatantly illegal.

For those who don’t know the details, Health Canada performed an unannounced audit of CannTrust’s Niagara facility after a whistleblower alerted them to the illegal activity. Health Canada then followed up with a non-compliance notice for growing cannabis in 5 unlicensed grow rooms and for providing inaccurate information to regulators.

The rooms, part of a Phase 2 expansion at the facility, were illegally used from October 2018 to March 2019. The illegal growing stopped in March because the rooms were being considered as part of a license application to Health Canada. They subsequently became licensed grow rooms in April 2019. This is where the “inaccurate information to regulators” issue likely stems from.

While every company wants to maximize profits, this is clearly a rash decision made out of impatience and greed and the company is paying for it.

Health Canada ordered a hold on 5,200 kg of product at the Niagara facility, while CannTrust “voluntarily” put a hold on another 7,500 kg at their Vaughan manufacturing centre and a subsidiary in Denmark.

Currently, Health Canada is performing quality tests on the products, with results expected within two weeks.

A Silver Lining in the Clouds?

Things could be a lot worse.

The OCS has stopped the distribution and sale of all CannTrust products. However, in contrast, BC and Alberta continue to sell their product. A BC Liquor Distribution Branch spokesperson has even stated they will continue to distribute and sell CannTrust products until a formal recall has been issued or guided otherwise by CannTrust.

Their other facilities, including the legal, licensed grow rooms, continue to be used.

Further, while the product has already been distributed to provinces throughout Canada and into Denmark, they have confirmed that the product has been subject to the same standard of testing as all other legally grown cannabis. This includes third-party testing from Health Canada sponsored labs. So, it seems unlikely there will be any consumer health-related issues.

However, to really understand what this could mean for CannTrust, we have to look at past Health Canada license suspensions and revocations.

Two come to mind: Ascent Industries and Bonify.

Greed Over Brains

Starting with the latter, Bonify is a Winnipeg-based company that had their sales license suspended in February 2019 after Health Canada determined they were selling illegally sourced cannabis. This came shortly after a December 2018 recall due to contamination concerns that resulted in the dismissal of senior management.

The sale of this illegal cannabis was a direct violation of the Cannabis Act and obviously very short-sighted – we are talking about only 200 kg of cannabis. The company naturally appealed the suspension after hiring an outside investigator to audit their operations.

While they said they had confidence in the appeal process, as of today, their website still has the same banner that was put up when their license was suspended: “Product ordering is temporarily on hold. An email notification will be sent to Members once resumed. We apologize for the inconvenience.”

The incident with 2018-2019 Ascent is a little more enlightening.

Ascent is a US-based company with a wholly-owned Canadian subsidiary, Agrima Botanicals Corp. Their rumoured transgression was selling cannabis in illegal dispensaries (the grey market), although Health Canada described it as an issue with record keeping.

Here is a breakdown of the full timeline:

September 26thHealth Canada partially suspends Agrima’s licenses after an August audit reveals the company “did not meet all of its record keeping and other compliance requirements”
September 28thAscent announces a series of changes to address Health Canada’s concerns.
October 18thAscent “made formal submissions to Health Canada for the reinstatement of the Agrima licences.” No timeline on the review was provided.
November 21stAscent announced that Health Canada intends to revoke its license. They appealed the decision.
February 6thHealth Canada repeated their previous ruling: “the Company has failed to demonstrate that the suspension, and proposed revocation, of Agrima’s Licenses is unfounded”

Since that time, Ascent has sold its Canadian assets.

Will Health Canada Look Favourably On Weak Management Stance?

While CannTrust has attempted to put things right, their attempted corrective actions sound awfully familiar to Ascent’s failed attempt.

CannTrustAscent
  • Further comprehensive employee training
  • Retained external advisors for an independent review of compliance processes
  • Comprehensive review and update of processes and procedures
  • Voluntarily advised Health Canada of issues that may impact compliance at its Vaughan facility regarding product storage
  • Enhanced our Quality Assurance & Regulatory Compliance team with the addition of three experienced staff
  • The Company has conducted an audit of its record-keeping controls and procedures, identifying areas for enhancement, and commenced implementation of operational improvements.
  • Further, the Company has or will be relieving certain managerial staff of their positions with the Company.

In reality, CannTrust’s attempt may be weaker. The Chairman has gone as far as saying it’s “too premature” to assume management changes need to occur. A company with a weak Chairman is never a good sign. It’s comical to think the entire management team was unaware of these actions.

Let’s think about this. These activities took place at the company’s primary growing facility – not a partially owned subsidiary – in the middle of a significant expansion. This is not a rogue individual employee, but a coordinated effort that took place over multiple months.

At a minimum, we expect all product on hold to be destroyed, and fines and warnings handed down.

Health Canada has had no patience for egregious breaches of compliance in the past. They’ve also proven they aren’t afraid to take their time making decisions.

At a minimum, we expect all product on hold to be destroyed, and fines and warnings handed down. It’s harder to handicap the chances of a full license suspension, however.

Given CannTrust’s international dealings, it may be more difficult to forgive the company. There will be more eyes watching the outcome than with either of the previous non-compliance issues.

However, it’s also important to consider how Health Canada will approach the situation when they are dealing with a company that has a significant cohort of medical patients (70,000 patients, with over 67% of revenues coming from medical). Eliminating a person’s access to medicine overnight is not something they would do lightly.

Ultimately, it may come down to the public’s response to this incident. If there is significant noise from the public, we expect CannTrust’s licenses to be revoked. If this storm blows over, we can see Health Canada giving one of the top Canadian LPs a pass with only a slap on the wrist.

Either way, we will have to wait for Health Canada to determine the outcome.

Looking back, the worst part of this whole incident may have been all the bad puns about CannTrust’s untrustworthiness.

The opinions provided in this article are those of the author and do not constitute investment advice. Readers should assume that the author and/or employees of Capital 10X hold positions in the company or companies mentioned in the article. For more information, please see our Content Disclaimer.

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Peter

Great article but it is hard to compare to Ascent and Bonify. I have met ascent at an event and it was clear to me that they are nothing but a pump and dump. Also, they lost their license in Nevada as well. Bonify is another unfair comparison. It should be noted that these rooms were given licenses vs mouldy weed from Bonify. Yes, it does beg a question that how mgmt doesn’t know about the weed growing in the unlicensed facilities. Certainly an oversight. I’m just hoping for fines and stern warning but not the revocation of licenses.