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3 Reasons Pot Stocks Won't Be Rolling in the Dough If Canada Legalizes Recreational Weed

By Sean Williams – Mar 7, 2018 at 8:21AM

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Despite rapid sales growth projections, profits may not follow for marijuana stocks.

In case you've failed to notice, the marijuana industry is growing at an exceptionally quick pace. Growth estimates from cannabis research firm ArcView, in partnership with BDS Analytics, suggest that legal sales could soar by an average of 28% through 2021. Chances are investors would struggle to find an industry that's consistently been growing at 28% or more for multiple years. This growth is a big reason investors have piled into pot stocks. 

Also important has been the shift in the way consumers think about cannabis. A number of U.S. polls have found that the public wants to see pot legalized nationally, with even stronger support for medicinal marijuana. As favorability improves, so does the resolve of investors.

Cannabis buds next to a piece of paper that says yes, lying atop dozens of miniature Canadian flags.

Image source: Getty Images.

Legalization in Canada may not equal big profits for Canadian pot stocks

But make no mistake about it, the real treasure in the marijuana industry can be found in our neighbor to the north, Canada. Having legalized medicinal cannabis all the way back in 2001, Canada's parliament is currently discussing the possibility of legalizing recreational weed by this summer. All but one of Canada's provinces has agreed to a two-year tax-sharing deal, while conservatives in Canada's Senate who'd oppose such a move are handily outnumbered by progressives. In other words, legalization looks like a very likely outcome at the moment.

What might adult-use weed do for Canada's pot market? Estimates suggest it could add $5 billion or more in annual sales, as well as boost the jobs market. Remember, the cannabis industry is about way more than just growers, distributors, and dispensaries. Marijuana stocks investors are fully expecting this surge in sales to push profits for pot stocks through the roof. Unfortunately, that may not be the case.

Assuming the Canadian federal government does green-light the sale of recreational weed to adults by August or September, three factors could keep pot stocks from realizing much in the way of profits.

Jars filled with dried cannabis stacked on each other.

Image source: Getty Images.

Oversupply could crush margins

To begin with, there's a very real possibility that cannabis oversupply could wreck margins and minimize any opportunity for growers to generate hefty profits. Though the Canadian government expects demand to be robust, and quite a few growers do have the ability to export their dried cannabis to foreign countries that have legalized medicinal marijuana, there's simply no precedent to legalizing recreational weed in a developed country, so there's no way of knowing what'll happen.

There are three growers that appear to have the capacity to produce in excess of 230,000 kilograms of dried cannabis by 2019 -- Aurora Cannabis (ACB -3.85%), Canopy Growth Corp., and Aphria (NASDAQOTH: APHQF) -- along with MedReleaf, which can deliver up to 140,000 kilograms. Combined, just these four growers could produce over 900,000 kilograms in 2019. 

Here's the issue: Estimates from a cannabis research report compiled by Grizzle show a demand base of about 800,000 kilograms a year in Canada. The above four companies are competing against dozens of other licensed growers than can generate thousands or tens of thousands of kilograms of cannabis on their own. By 2021, Canada could be oversupplied by more than 850,000 kilograms, in its best estimate. 

In such a scenario, where supply drowns demand, prices could plummet. Even with larger operations yielding exceptionally low per-gram production costs, pot stocks could struggle to turn much of a profit.

An outdoor cannabis grow farm.

Image source: Getty Images.

Operating cash flow will likely be reinvested in capacity expansion

Secondly, investors should understand that there's a very strong likelihood growers will reinvest practically every cent in positive operating cash flow into capacity expansion in the early going (i.e., 2018 and 2019). Just as first-to-market prescription drugs boast advantages that allow them to scoop up significant market share, growers that can produce significant amounts of dried cannabis and cannabis oils have the opportunity to secure long-term supply agreements with provinces and large retailers, pushing smaller growers out of the picture.

However, spending money on capacity expansion isn't something financial statement bookworms are going to overlook. Costs for cannabis growers are probably going to increase at the same pace, if not faster, than sales. Plus, if a cannabis company has a marketing team, those expenses would be expected to rise dramatically, too.

With the exception of a company like Aphria, whose management team has placed an emphasis on maintaining annual profitability, it's unlikely many growers will be profitable, or significantly profitable, anytime soon.

A frustrated businessman looking at his laptop.

Image source: Getty Images.

Dilution will take its toll

Finally, months or years of bought-deal offerings are beginning to catch up with Canadian pot stocks, and it should mean less in the way of per-share profits.

A bought-deal offering is a common method of raising capital in Canada. It involves a company selling common stock, debentures, warrants, or options to an investor or institution prior to the release of a prospectus. The good news for Canadian marijuana stocks is that they've had no issue whatsoever raising capital. Unfortunately, it means the outstanding share counts for these stocks are heading significantly higher as a result. Even if companies choose not to directly sell common stock, they're offering convertible debentures, warrants, or options that can be converted into shares within a matter of months or a few years.

This dilution will have two effects. First, it makes every existing share less scarce, thusly devaluing current shareholders. Secondly, it makes it considerably tougher for a company to grow its earnings per share since there are more shares outstanding. Even if net income rises, it's possible we could see instances where EPS actually falls for pot stocks as a result of a ballooning share count.

For instance, Aurora Cannabis's share count has risen from 16.2 million shares at the end of fiscal 2014 to almost 490 million shares as of the end of the second quarter for fiscal 2018. That's a more than 2,900% increase in the company's outstanding share count in less than four years, and it'll all but ensure that Aurora's EPS is nominal at best. 

Even Aphria, which, as noted, has a clear focus on profitability, won't be immune. Recently completed bought-deal offerings could push its share count higher and make it difficult to generate year-over-year EPS growth.

Long story short, even though cannabis sales appear ready to rocket through the roof in Canada, profits on a per-share basis might not go anywhere for a while.

Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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