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Are Canadian Marijuana Stocks Ticking Time Bombs?

By Sean Williams - Jan 31, 2018 at 8:21AM

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Canadian pot stocks are sitting pretty at the moment, but they're harboring a secret that could destroy shareholder value within a few months or years.

Few industries have grown as impressively as legal marijuana in recent years. Investment firm Cowen & Co. predicted back in 2016 that the U.S. legal pot market could be generating as much as $50 billion in annual sales by 2026, while leading cannabis research firm ArcView has called for 26% compound annual growth in North American markets through 2021. These are growth expectations that aggressive investors simply can't ignore.

Buying into marijuana stocks has also been fueled by a steady shift in the way the public views pot. Once considered a taboo topic, cannabis is now a front-and-center issue that politicians regularly discuss. Mexico legalized medicinal cannabis in June 2017, while Canada has ambitions of green-lighting the sale of recreational weed by July.

A cannabis joint lying atop a cannabis leaf.

Image source: Getty Images.

Of course, the United States hasn't been the marijuana safe haven that investors initially expected. The federal government has dug in its heels and refuses to change its Schedule I classification. Also, Attorney General Jeff Sessions has all but declared war on the industry. Though the U.S. might have the most lucrative pot market on the planet, it's not very accessible to the industry or investors.

Canadian stocks have captivated investors

Instead, investors have been looking north, to Canada. Our neighbor is on track to become the first developed country in the world to legalize adult-use weed by the summer, which could add up to $5 billion in annual sales once fully ramped up. As a result, Canadian marijuana stocks have been spending feverishly on organic projects and acquisitions to expand their growing capacity.

For example, Aphria (NASDAQOTH: APHQF) has a flagship organic project it's working on that'll cost in excess of $100 million and expand its growing capacity to 1 million square feet. Once complete in January 2019, it'll be capable of 100,000 kilograms of annual production. At the same time, it also recently formed a strategic relationship with Double Diamond Farms to produce 120,000 kilograms a year by January 2019. The move made sense for Aphria, since it could expedite its ability to double its production, which otherwise wouldn't have happened till 2020 if it had to build out its own 100-acre site. 

A jar of cannabis buds lying atop a small pile of cash.

Image source: Getty Images.

Similar expansion can be seen in aggressive acquirers Aurora Cannabis (ACB -6.09%) and Canopy Growth Corp. (CGC -7.67%). Aurora just announced the biggest pot industry acquisition in history, with its $1 billion deal to buy CanniMed Therapeutics. The combined entity should be capable of more than 130,000 kilograms of dried cannabis output a year. Meanwhile, Canopy Growth has 2.4 million square feet under construction or in development in British Columbia, with an option to lease another 1.7 million square feet. 

Canadian marijuana stocks harbor a worrisome secret

There's a secret that underlies this expansion, which may expose Canadian pot stocks as nothing more than ticking time bombs within the next couple of months to three years.

You see, the vast majority of cannabis stocks aren't profitable. Even those that are profitable aren't generating a whole lot of cash flow. A few million dollars here and there in positive operating cash flow might sound great from medical pot sales alone, but it's nowhere near enough to cover the ambitious $100 million-plus projects and acquisitions previously described. To fund these projects, marijuana stocks have had to turn to secondary markets.

To be specific, marijuana stocks have turned to a common method of raising capital in Canada: bought-deal financing. With bought-deal financing, common stock or convertible debentures are typically sold to an investor or institution before the release of a prospectus. These deals tend to be pretty quick and have, as of late, had little trouble finding financing. Without bought-deal offerings aplenty, the Canadian marijuana industry wouldn't be expanding anywhere near as rapidly as it is now.

A hand reaching for a large stack of hundred dollar bills in a mouse trap.

Image source: Getty Images.

The issue, though, is that bought-deal offerings, whether they involve common stock, convertible debentures, options, or warrants, can dramatically increase the number of outstanding shares of common stock over time. It may not lead to an immediate increase, but many of these deals have involved convertible debentures that allow a conversion to stock within just a few years. If these noteholders choose to convert, the outstanding share count goes up -- and when the outstanding share count goes up, the value of existing shares goes down, as they become less scarce.

Many of the fastest-expanding Canadian marijuana stocks could see their outstanding share counts rise by tens or hundreds of millions of shares in the years to come as a result of these bought-deal offerings.

And keep in mind, it's not just dilution that's a worry. As the number of shares outstanding increases, profit per share could actually decline. In other words, these pot stocks would need a progressively larger profit just to stay par for the course from an earnings per share perspective.

While I can certainly see the Canadian marijuana industry succeeding if recreational pot is legalized this summer, it doesn't guarantee that investors will be winners as a result of this ongoing dilution.

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Stocks Mentioned

Aurora Cannabis Stock Quote
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CGC
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