High Expectations For Marijuana Stocks – Market Risks Overlooked By Investors

Investors are betting heavily on Canadian marijuana companies, eagerly preparing for its imminent legalization in the country. The shares of the largest Canadian marijuana company, Canopy Growth Corp., for example, began a steep climb in mid-August when the company announced Constellation Brands would pay US$4-billion for a stake in Canopy. Canopy’s shares doubled between mid-August and the end of the month.

Marijuana companies raised a record US$4.3-billion as of the end of June, with Canadian firms accounting for more than half of that, says a report in Marijuana Business Daily, citing data from merger and acquisition monitoring firm Viridian Capital Advisors.

The latest annual and quarterly reports from several Canadian marijuana producers all discuss the construction of new greenhouses, the introduction of new cannabis products and increases in staff headcounts. It appears they are preparing for the country to be blanketed in a haze of marijuana smoke when recreational marijuana becomes legal in Canada on Oct. 17, with other countries soon to follow. Canopy, for example, has joint ventures, partnerships and minority stakes in marijuana companies in Jamaica, Brazil, Chile, Denmark, Germany, Spain and Australia.

In my opinion, the investor enthusiasm is overdone.

The Canadian legal marijuana market is not large enough to support several giant companies on its own. In 2017, Canadians aged 15 and over spent $5.527-billion on 777.3 million grams of marijuana at an average price of $7.12 per gram, says Statistics Canada’s Cannabis Status Hub. That’s less than half the entire market capitalization of Canopy Growth alone.

Marijuana is still illegal under U.S. federal law, which means that banks, investment dealers and other financial service companies that help U.S. marijuana companies get listed on stock exchanges, for example, could face charges of money laundering, Tom Angell, editor of the Marijuana Moment website, wrote in a recent report.

Canada is too cold and dark to grow marijuana outdoors year-round. If countries in warmer jurisdictions legalize marijuana, they likely won’t need the same costly greenhouses, lights, or well-paid workers that Canadian growers do, and in my opinion are therefore less likely to import it from Canada.

While Canadian companies have made great strides in developing safe cannabis products, the physical barriers to entry in the industry are not exactly insurmountable. Producers need plants, water and light. While the Cannabis Act says adults will be allowed to grow no more than four cannabis plants per household, many regular marijuana users to whom I’ve spoken -- who don’t want their names used -- say they wonder how strictly this will be enforced.

At the retail end, local communities may block licensed marijuana outlets from opening.

In California, where recreational marijuana was legalized on Jan. 1, only US$339-million worth of marijuana was sold in the first two months of the year, said BDS Analytics. That works out to only about US$2-billion a year in legal marijuana sales. Many California communities don’t allow marijuana dispensaries and as a result, users must often travel long distances to make purchases, says a CNBC report released in April.

Those legal dispensaries that are allowed to open will have to comply with regulations and will have to pay tax, insurance, rent and wages, putting them at a disadvantage to the local black market.

Despite these risks, shares of Canadian cannabis producers trade at huge multiples to their projected sales and earnings.

Investors who feel they absolutely must participate in the industry can take a small stake in the Horizons Life Sciences Index ETF (HMMJ/TSX), although its unit price also reflects extreme optimism.

Canopy Growth Corp. (WEED/TSX)

In the quarter ended June 30, Canopy had a healthy cash position of $657-million, so there is little doubt this is a big, solid company. Reported revenue was $25.9-million, generating a net loss of $90.1-million or 40c per share, but it would be unfair to expect profits at this juncture.

At a current price of about $60, Canopy’s market capitalization (shares times share price) is about $12-billion.

A median estimate compiled from seven analysts who follow the company predicts Canopy will lose 38c per share on sales of $335.4-million for its 2019 fiscal year ending next March, but Canopy should earn 28c per share on $941.6-million in sales for the fiscal year ending in March 2020, says a recent report from Reuters.

Based on these estimates, at $60 Canopy is trading at about 36 times fiscal 2019 sales, at 12.7 times fiscal 2020 sales and 214.3 times 2019’s estimated earnings per share.

Aphria Inc. (APH/TSX)

Leamington, Ont.-based Aphria, a licensed producer of medical cannabis products, has about $319-million in cash and near-cash net of commitments, making it a solid company. Aphria reported revenue of $12.03-million in the quarter ended May 31, with a net loss of about $5-million.

At a recent price of about $17, the company’s market capitalization is $3.57-billion, based on the 210 million shares outstanding at the end of May.

For the company’s 2019 fiscal year ending next May, Aphria should have earnings of 13c a share on sales of $199.7-million, rising to 71c per share on $613.5-million of revenue the following year, based on the mean estimate from six analysts who follow the company, says a Reuters report.

Based on these estimates, at $17 Aphria is trading at about 17.9 times next year’s extimated revenue per share and 130 times next year’s estimated earnings per share, but only at 24 times 2020’s estimated EPS -- a less optimistic price than Canopy’s, but hardly cheap.

Aurora Cannabis Inc. (ACB/TSX)

Cremona, Alta.-based Aurora Cannabis closed the $3.2-billion acquisition of MedReleaf on July 25. When combined with MedReleaf, the company has 951 million shares outstanding, producing a market capitalization of $8.37-billion at a recent price of $8.80.

Aurora had $231-million in cash and short-term investment as of March 31.

The mean estimate among four analysts for Aurora’s sales for the fiscal year ending next June is $449.4-million, with earnings of six cents per share, says a Reuters report.

That means Aurora’s shares are trading at 18.6 times next year’s estimated revenue and 147 times next year’s estimated earnings per share, making the stock relativel more expensive than Aphria’s but cheaper than Canopy’s.

How Big Is The Market For Marijuana?

Cannabis consumption estimates portray the upcoming market as huge. However, such projections often come from marijuana companies or pro-marijuana advocates and therefore have a positive bias.

In the United States, Alaska, California, Colorado, Maine, Massachusetts, Nevada, Oregon, Vermont and Washington have legalized the sale and possession of marijuana for medical and recreational use, while Vermont and the District of Columbia have legalized personal use but not commercial sale.

Wikipedia lists Connecticut, Delaware, Michigan, New Hampshire, New Jersey, Ohio and Rhode Island as the most likely states to propose full legalization, while marijuana may be legal for medical use in Kentucky, Oklahoma, South Dakota and Utah.

In all cases, legal marijuana sales have brought in huge amounts of tax revenue for their states.

A Gallup poll in the United States taken in October, 2017 showed 64% of Americans supported marijuana legalization, with support among Democrats at 72% and Republicans at 51%.

Outside of these states, U.S. marijuana users must step carefully lest they end up behind bars. The current Republican administration still regards marijuana as a dangerous, illegal drug and has shown no signs of softening its views. In January, U.S. Attorney General Jeff Sessions rescinded a pro-marijuana Obama-era law and issued a new memo instructing U.S. attorneys to clamp down on cannabis.

Those who still insist on betting on the sector should avoid company-specific risk by taking a small stake in the Horizons Marijuana Life Sciences Index ETF (HMMJ/TSX). The fund, launched in April 2017, invests in companies that have a market capitalization of more than $75-million, with good trading volumes. The ETF has $916-million in assets and carries a management expense ratio (MER) of 0.75%. As of the end of June, HMMJ’s largest holdings accounted for 60% of the fund, and included big stakes in Aurora Cannabis, Canopy Growth and Aphria together with GW Pharmaceuticals PLC, a medical marijuana biotech company, and Scotts Miracle-Gro Co., whose Hawthorne Gardening subsidiary includes a portfolio of brands suited for marijuana growers.

Some Other Marijuana-Focused ETFs:

Horizons Emerging Marijuana Growers Index (HMJR/Aequitas NEO), which focuses on small-cap marijuana companies. The ETF, launched in February, trades on the new Aequitas NEO exchange. It has about $12-million in assets and carries a management expense ratio of 0.85%.

ETFMG Alternative Harvest ETF (MJ/NYSE Arca), with US$457-million in assets, holds all the major marijuana producers and carries an MER of 0.75%.

Purpose Marijuana Opportunities Fund (MJJ/Aequitas NEO) has $20.2-million in assets and an MER of 0.75%. Like most others, this ETF holds the major marijuana producers.

Evolve Marijuana (SEED/TSX) is an actively managed ETF with $6.5-million in assets and a 20% weighting in Aurora Cannabis, with 13% in Canopy Growth and 9.5% in Aphria among its 19 holdings. Its MER is 0.75%.

The current share prices of Canada’s major marijuana companies reflects too much optimism for conservative investors, and the sector is suitable only for speculators and those prepared to lose their entire stake. Those who feel they must have some action in the game should buy units in an exchange-traded fund, but even they look overpriced.

Richard Morrison, CIM, is a former editor and investment columnist at the Financial Post. richarddmorrison@yahoo.ca