Marijuana stocks are on a roll right now. Countries across the world have legalized medical marijuana. Canada is even moving toward legalization of recreational marijuana. More states now allow legal use of medical or recreational marijuana than ever before. And several additional states are considering legalizing recreational marijuana.
However, there are definitely risks. It's possible that Canada's efforts to legalize pot could be delayed. U.S. Attorney General Jeff Sessions caused an uproar for many marijuana stocks with his recent move to rescind Obama administration policies that kept the federal government from interfering with states that have legalized marijuana. A crackdown in the U.S. could impact some marijuana stocks.
But these aren't the things that you should be worried about the most. Instead, there's another potential issue that could really be problematic for some of the biggest marijuana stocks on the market, including Aurora Cannabis (NYSE:ACB) and Canopy Growth (NYSE:CGC).
A common denominator
In the span of two weeks, four of the biggest marijuana growers on the market announced similar actions. On Jan. 3, Aphria (NASDAQOTH:APHQF) reported that it had closed on a bought deal financing for gross proceeds of $115 million. Two days later, Aurora Cannabis announced a $200 million bought deal financing.
The next week, on Jan. 9, MedReleaf provided an update that it too entered into an agreement for a bought deal financing of $100.7 million, but soon afterward said the total would be increased to $132.5 million. Canopy Growth announced a bought deal financing for $175 million on Jan. 17.
What is a bought deal financing? It's a common way used by Canadian companies to raise cash. With this approach, an investment bank or syndicate agrees to buy all of the securities to be issued by a company at a predetermined price. These types of deals eliminate the risk to the company issuing the securities that it won't raise as much cash as it wanted.
This round of bought deal financing wasn't new for any of these big marijuana growers. Aphria raised $75 million in April 2017 and another $92 million in November 2017 through bought deal financing. Aurora completed a bought deal financing transaction in November for $69 million. MedReleaf closed on another deal totaling $100.5 million in December.
The good news is that these financing deals generated a lot of money for all of the companies to invest into expansion. With Canada's Parliamentary Budget Officer (PBO) estimating the nation's marijuana market could generate annual revenue between $4.2 billion and $6.2 billion -- and some experts predicting even higher sales -- increasing production capacity makes sense.
Why it could be problematic
There are two things of concern with the frenzy of bought deal financing, though. First, with so many new shares being issued, the result will be dilution of the value of existing shares. That hasn't been a big problem over the last eight months, though. (This time period was used because MedReleaf's initial public offering was in June 2017.)
As this chart shows, the increase in number of shares outstanding hasn't been too terribly bad for any of the top Canadian marijuana stocks. Aphria and Canopy Growth are leading the pack, but the dilution hasn't seemed to hurt the performance of their stocks at all. However, with so many big bought deal financing transactions announced in the last few weeks, we haven't seen the full brunt of the moves yet.
The second problem is that some of the companies have issued convertible debentures instead of stock. For example, Aurora's $200 million deal announced in January involved issuance of 200,000 convertible debentures. These convertible debentures start off as a loan, but they can be later converted into stock. That could prove to be like a time bomb, though, with dilution hitting the company later on -- potentially at a time when it could really hurt.
I think that the bought deal financing transactions are more worrisome for investors than anything else right now because they're tangible. Nothing Jeff Sessions does should impact Canadian marijuana stocks, even though there was a temporary, misguided sell-off when the change in U.S. Department of Justice policy was announced. And although there's a possibility that Canada could delay legalization of recreational marijuana, the odds still look pretty good that everything will stay on track. The bought deal financing done by all of these companies, on the other hand, is guaranteed to dilute existing shares.
My view, though, is that these companies made the right calls to raise cash. Their executives would be kicking themselves -- and the boards would be kicking the executives -- a year from now if they hadn't done everything possible to expand capacity in advance of the anticipated "green rush" for recreational marijuana in Canada.
Yes, the extent of the bought deal financing transactions could come back to haunt some of these companies, especially those that issued convertible debentures. However, the options are limited for companies to raise the amount of cash needed to aggressively expand. I won't say that there are no worries for investors. But without the needed money for investing, these concerns could have been bigger.