5 Off-the-Cuff Thoughts About the Marijuana Industry
According to a handful of Wall Street investment firms, the marijuana industry is slated to grow by leaps and bounds over the next decade. Depending on your preferred source, annual global sales could hit $75 billion by 2030, placing the industry on par with, or perhaps even ahead of, worldwide soda sales.
It's also an industry that investors have seemingly accepted with open arms. Since the beginning of the year, the Horizons Marijuana Life Sciences ETF, which holds about four dozen pot stocks with various weightings, is up around 60%. Looking back over the trailing three-year period, quite a few of the largest pot stocks have risen by a triple-digit or quadruple-digit percentage.
But if you ask me, things are probably too good to be true for the legal weed industry. Sure, there will be substantial revenue growth to come, but not without hiccups along the way. With that being said, here are five off-the-cuff thoughts about the legal cannabis industry moving forward.
1. Every high-growth industry has had its bubble burst over the last quarter century
As much as investors would like to believe that it's up, up, and away for the cannabis industry, other high-growth industries over the past quarter century suggest that the road to riches for pot stock investors will probably be paved with at least one major industry downturn (and no, the downturn during the fourth quarter of 2018 doesn't count).
Looking back on the introduction of the internet, genomics, business-to-business commerce, 3D printing, and more recently blockchain, huge dollar amounts were associated with all of these up-and-coming technologies or industry niches. But as we also know, the bubble burst with each one.
Understandably, it doesn't mean there won't be long-term winners. But it does suggest that the maturation process of any high-growth industry involves hiccups, and cannabis investors should be prepared for what could be a wild ride.
2. Smaller marijuana stocks are more attractive than larger pot stocks
On one hand, I fully understand why investors are sold on the prospects of top-tier growers. A company like Canopy Growth (NYSE: CGC), with a $15 billion market cap, is likely to produce more than 500,000 kilos a year at its peak, has some of the best-known brands throughout Canada, and landed a mammoth equity investment of $4 billion from Constellation Brands last year. But it's also a company that likely won't turn a profit on an operating basis until 2021. This is a pretty common recurring theme among the largest weed stocks.
Rather, there is a laundry list of reasons why small-cap marijuana stocks are much more attractive than large- and mid-cap pot stocks. Take OrganiGram Holdings (NASDAQOTH: OGRMF) as an example. OrganiGram's location in New Brunswick gives the company a geographic advantage when providing product to its home province, as well as Nova Scotia, Newfoundland and Labrador, and Prince Edward Island, all of which consume cannabis at a higher rate than the national average (at least in recent survey data).
OrganiGram is also expected to yield a tad north of 230 grams per square foot (113,000 kilos over 490,000 square feet), which is more than double the industry average. Add this to the fact that the company only has one growing campus at Moncton in New Brunswick, which helps minimize supply chain costs, and it's easy to see why its stock could run circles around a giant like Canopy Growth from this point forward.
3. Most acquiring pot stocks are grossly overpaying for their assets
Acquisitions have played a big role recently in the cannabis space, with consolidation expected to really pick up in the Canadian grow space and in the vertically integrated dispensary niche within the United States. Buyouts are a quick means of expanding a brand without going through the arduous process of waiting for licenses and permits to be filed and approved with local, state, or federal regulators.
But there's a downside to acquisitions in a relatively new and fast-paced industry: namely that the acquiring company appears to be grossly overpaying for the assets they're purchasing.
Investors are absolutely enamored with Aurora Cannabis (NYSE: ACB), which purchased CanniMed Therapeutics for $852 million, MedReleaf for about $2 billion, ICC Labs for $200 million, and Whistler Medical Marijuana for approximately $130 million over the past year. These purchases will play a role in pushing Aurora's peak output to perhaps 700,000 kilos per year. But as of Dec. 31, 2018, 63% of the company's total assets (3.06 billion Canadian dollars) was tied up in goodwill. Some of this premium should be recouped as greenhouse assets are developed and brought online. But having 63% of the company's total assets related to goodwill suggests that Aurora Cannabis drastically overpaid to get its hands on increased production capacity.
4. Fundamentals will matter sooner than investors realize
With the pot industry losing money hand over fist, I keep hearing excuses about how Amazon.com lost money for years, yet it turned out to be a winner. The "Amazon" defense works great if we're talking about a game-changing technology or an innovation that we've never seen before. However, it doesn't work so well when we're talking about an industry that's been around for a long time, such as cannabis. Changing the regulation of an industry isn't the same as innovation.
What am I getting at? Namely that fundamentals are going to matter a lot sooner than you realize. Wall Street typically lacks the patience to wait for profits, and it may be even more unforgiving than usual given that this is an industry that's been around for ages.
As noted, Canopy Growth is busy laying the framework to push into new overseas markets, diversifying its product line, making complementary acquisitions, and moving into the U.S. hemp industry. All of this is going to cost a pretty penny, and it's liable to keep Canopy from generating a recurring profit for at least two more years. Can this company really support a $15 billion market cap with operating losses of more than CA$400 million through the first nine months of fiscal 2019? My belief is no, it can't.
5. Share-based dilution is a long-term issue
I'm well aware that most investors get sick and tired of the dilution rant, but the fact of the matter is that not only is share-based dilution a worry in the near term, but it's likely going to weigh down valuations for years to come.
Prior to the passage of the Cannabis Act, most pot stocks had little or no access to nondilutive forms of financing. Bought-deal offerings became sort of a necessary evil in order to raise capital for the purposes of capacity expansion. But some pot stocks took things to the extreme when it comes to raising capital or making acquisitions.
Following the closing of its Whistler Medical Marijuana buyout, Aurora Cannabis hit the dubious milestone of having issued 1 billion shares of its common stock in less than five years. As a result, long-term shareholders have seen just a 20% gain on their investment since the beginning of 2018, all while Aurora's market cap has tripled. This 180-percentage-point underperformance is directly attributable to the company's issuance of its common stock.
Having more than 1 billion shares outstanding is also going to make it difficult for Aurora to generate a meaningful profit. Even with the company forecasting recurring positive EBITDA (earnings before interest, taxes, depreciation, and amortization) by its fiscal fourth quarter (April 1, 2019 to June 30, 2019), it's unclear when Aurora will be even remotely palatable to fundamentally focused investors.
Long story short, the cannabis industry has potential, but you should expect a bumpy ride.
10 stocks we like better than Aurora Cannabis Inc.When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has quadrupled the market.*
David and Tom just revealed what they believe are the ten best stocks for investors to buy right now... and Aurora Cannabis Inc. wasn't one of them! That's right -- they think these 10 stocks are even better buys.
*Stock Advisor returns as of March 1, 2019
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Sean Williams has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon. The Motley Fool recommends Constellation Brands and OrganiGram Holdings. The Motley Fool has a disclosure policy.