Shares of companies such as Canopy Growth Corp. (TSE:WEED) and Aphria Inc. (TSE:APH) have fallen sharply during the past week, a ‘buzz kill’ for marijuana investing
SmallCapPower | April 20, 2017: This past Thursday, the Canadian government introduced legislation as Canada moves one step closer to legalizing marijuana, however the ‘high’ for cannabis stocks and marijuana investing was short-lived. In less than a week, industry leaders such as Canopy Growth Corp. (TSX: WEED) and Aphria Inc. (TSX: APH) shed 5.8% and 14.8%, respectively, as the White House made comments to enforce Federal marijuana laws more strictly. With nearly 10 times the population of Canada, Canadian licensed cannabis producers were stung by the news, as many analysts had anticipated Canadian LPs would export their products to the United States.
Is this a buying opportunity, or signs of an impending bubble that is about to burst and worthy of selling into? Today, we will examine the catalysts for both the bull and bear case, and you can decide for yourself which side you reside.
Bull Case
Analysts estimate the number of recreational marijuana users to grow to nearly 3.8 million in Canada by 2021. Add to this the increasing number of American states as well as countries all over the world decriminalizing marijuana—such as Germany’s recent legalization of medicinal cannabis—and it almost guarantees billions of dollars in annual sales. This is the reason why cannabis companies are racing to increase production to fill the imminent supply gap that exists and to establish their footholds in select markets. In Canada alone, recreational pot sales could reach $6 billion by 2021, according to Canaccord Genuity.
- Increasing trend of legalization for recreational and medicinal cannabis around the world. Just last month Germany legalized medicinal marijuana use, and other European countries are expected to soon follow suit. Canadian companies are expanding their footprint globally.
- Increasing acquisitions and mergers in the licensed producers space and high valuation buyouts justify current market values of marijuana stocks. Consolidation is expected to continue as companies such as Canopy Growth grow their production via acquisitions.
- Canaccord Genuity forecasts a shortage of supply, giving recreational cannabis a ‘floor’ price of $8 per gram up until 2020, after which it will average $7 following increasing production. This stable outlook guarantees a consistent revenue stream and overall health of the industry.
- Recreational users have shown preference for safe, consistent, readily available, high-quality products that LPs offer, which will take market share from the black market.
- Countries such as Australia are easing restrictions on imports of cannabis for medicinal purposes. There is an increasing aging population as a result of advancements in health science and technology. There will be more and more patients for chronic illnesses for which cannabis is a treatment.
For the latest marijuana industry updates and cannabis stock analysis, be sure to check out our Marijuana Bubble Index Report.
Bear Case
It is akin to a deja-vu of the dot-com bubble, where having a domain name was enough to consider a company investment worthy. Instead, investors are buying up companies that have just merely applied to the Access to Cannabis for Medical Purposes Regulations (ACMPR) to become a licensed producer. Everyone is trying to cash in on the ‘green rush.’ A Canadian investment firm has even created the first medical marijuana exchange-traded fund (ETF) on the TSX with 14 holdings, one of which is Scotts Miracle-Gro!
Nonetheless, cannabis stocks are trading at astronomical valuations, 15-20x forward Price to Sales compared to 5-8x for revenue-generating, high-growth Software as a Service (SaaS) companies. In fact, sales multiples are being priced for post-legalization, which may be delayed to 2019-2020—in the U.S. if not Canada—and these estimates are based on production that doesn’t even exist! Most cannabis producers have yet to become profitable, let alone generate revenues, and these are not signs of a successful, growing industry. Let’s look at some of the upcoming catalysts that are sure to keep cannabis investors up at night:
- Threat of the black market to undercut LPs to maintain their footprint as well as the impending risk of home-cultivation
- Approximately another 20-30 companies to acquire licensed to produce cannabis in the upcoming 24 months, doubling the current number of LPs
- Oversupply from nearly 500,000 kg of annual cannabis production forecasted within five years, not including imports. Threat of price wars and low commodity prices will affect future free cash flows, which will not justify today’s valuations. Supply forecasts may be understated.
- Uncertainty of tax rates, production measures, distribution channels, possession limits, or when legalization will actually occur. Companies are stock piling, but with a shelf-life of 12 months (according to Health Canada), it may lead to big write downs with further legislative delays
- State legality vs Federal legality; White House Press Secretary Sean Spicer suggested recently that the federal government would enforce federal law in states where recreational weed has been legalized. If so, this would close one of the largest markets for recreational pot users.
Conclusion
Looking forward, being a relatively new and untested industry, the high evaluations and forward revenue expectations from a speculative high-growth industry are nearly unprecedented. Compounded with political, legal, health, and social risks, the near-term future appears volatile for the cannabis industry. Nonetheless, more and more countries worldwide are legalizing cannabis and increasing research is being published for the usage and benefits of marijuana. With over 7.5 billion people on this earth, perhaps the cannabis growth story is not so farfetched after all.
Disclosure: Neither the author nor any of the principals at Small Cap Power, or their family members, own shares in any of the companies mentioned above.
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