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Part of cannabis and investing

CannTrust Holdings Inc. shares plunged more than 20 per cent on Monday, after the NYSE-listed cannabis grower disclosed that Health Canada discovered unlicensed growing activity at the company’s main greenhouse in Ontario and put a sales freeze on 5,200 kilograms of CannTrust’s inventory, pending further investigation.

Health Canada issued CannTrust a non-compliance order for growing cannabis in five unlicensed rooms at its 12-room facility in Pelham, Ont., between October, 2018, and March, the company said in a statement on Monday. The statement also said that CannTrust employees provided “inaccurate information” to federal regulators.

"We constructed these rooms in accordance with all the rules and regulations; the mistake that was made by CannTrust was putting plants in these rooms before we’d actually received the approval to do so,” CannTrust CEO Peter Aceto told The Globe and Mail in an interview.

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Mr. Aceto would not comment on whether he or other top management knew about the unlicensed growing activity, saying only that the company is “doing a root-cause analysis to figure out exactly who knew what when.” One unnamed employee has already been terminated, Mr. Aceto said.

The announcement is a bombshell for a company widely seen as one of the more sophisticated operators in the cannabis space. Mr. Aceto is the former CEO of Tangerine Bank and CannTrust has partnerships with firms such as alcohol distributor Breakthru Beverage Group and drug manufacturer Apotex Inc. In February, the company joined a small handful of Canadian cannabis firms to list on the New York Stock Exchange and, in May, the company raised US$200-million in a public offering co-led by Bank of America Merrill Lynch, Citigroup, Credit Suisse Securities (USA) LLC and RBC Capital Markets.

Monday’s news could have both immediate and long-term implications for the company, Bank of America analyst Christopher Carey wrote in a research note, in which he downgraded the stock from “buy” to “underperform” and dropped his price target for CannTrust from $9 to $4.50.

“It’s unclear when Health Canada will have comments on CannTrust’s internal audit, or if other disciplinary actions will unfold,” Mr. Carey wrote, adding that he expects sales for the current quarter to be significantly reduced and that near-term gross margins will be squeezed “as CannTrust fills supply gaps by sourcing cannabis from other licensed producers at a higher cost.”

Beyond the 5,200 kilograms of product that Health Canada has told CannTrust to hold, the company has put a temporary sales freeze on an additional 7,500 kilograms that were produced in the unlicensed rooms. That brings the total amount of product being held back to 12,700 kilograms, which is more than four times the amount of cannabis CannTrust sold in its most recent quarter.

Even if it is only temporary, 12,700 kilograms is a large amount of product to hold back from the Canadian market at a time when legal cannabis producers are struggling to meet consumer demand and investor expectations. At the end of March, according to Health Canada, total finished inventory held by all licensed cultivators, processors and distributors across the country stood at only 30,802 kilograms of dried cannabis and 62,188 litres of cannabis oil.

CannTrust is warning customers to expect a short-term shortage of products due to the sales freeze.

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"We do have inventory today that is available for our medical patients, and we do expect that that will be exhausted some time during this week, so we do anticipate shortages for our medical patients," Mr. Aceto said.

“We are taking steps in the market to source product. … We’ve got 72,000 patients, they rely on us for their medical cannabis and we want to do everything we possibly can for them. If we have to sell that to them with no profit or at a loss, that’s something that we would absolutely be willing to do.”

CannTrust has been allowed to continue production at its two Ontario facilities, in Pelham and Vaughan, including in the five rooms at the heart of the Health Canada non-compliance order; these rooms were licensed in April. However, Health Canada is conducting “quality checks” on the company’s product – a process that will take 10 to 12 business days – and has the power to take stronger action against the company, including licence suspensions.

Two Canadian cannabis companies, Ascent Industries Corp. and Bonify Medical Cannabis, had their licences suspended in the past 12 months after receiving non-compliance orders from Health Canada for alleged illegal activity.

The non-compliance order may also impact other licence applications from CannTrust that are currently being reviewed by Health Canada. Earlier this year, the company acquired an 81-acre property in British Columbia for outdoor cultivation, which it wanted to have licensed for the 2019 summer growing season. The property has still not received a licence and, last week, CannTrust cut its short-term projections for the site, saying that “if a crop is not planted by Aug. 5, 2019, there will be no outdoor harvest in 2019.”

“Long term, it impacts credibility,” Ryan Tomkins, an analyst with investment bank Jefferies International Ltd., wrote in a research note about CannTrust’s announcement. “The fact the company never spotted this, or indeed still doesn’t know how it happened, is a concern. For us, this will make institutional investors think twice, and could also likely make it harder for CannTrust to attract high-quality [fast-moving consumer goods] partnerships,” he said, referring to tobacco, beverage and food companies.

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This isn’t the first time federal regulators have taken “significant compliance actions” in relation to CannTrust. In 2017, Health Canada sent CannTrust a warning letter for changing its cannabis-oil production process without submitting a licence-amendment application. In February, 2016, Health Canada seized CannTrust products due to security issues and sent the company a warning letter.

Even before Monday’s announcement, CannTrust had underperformed its peers, with the company’s stock dropping from a high of around $15 in October to around $6.50 at the end of last week.

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