Few industries are buzzier these days than the legal marijuana industry. According to Gallup, which has been conducting polls on cannabis perception since the late 1960s, more people now favor legalizing pot -- almost two out of three respondents -- than at any point throughout history. This dramatic shift, at least in the U.S., has a lot of people excited.
Furthermore, legal weed sales have been picking up at an extraordinary pace. Cannabis research firm ArcView notes that legal marijuana sales rocketed up by 33% in North America last year to $9.7 billion. By 2021, even with the U.S. holding firm on its Schedule I classification for pot, North American marijuana sales could hit $24.5 billion. That's growth Wall Street and retail investors simply can't ignore.
More recently, investors in pot stocks have been excited about the prospect of Canada legalizing recreational marijuana use for adults. With the exception of Uruguay, no other country has legalized pot for adult consumption, and certainly no developed countries. With Canada having laid the groundwork with its medicinal cannabis industry, its legalization of adult-use weed could generate $5 billion or more in annual sales.
Risks abound, and pot stocks may wind up disappointing Wall Street
On paper, legal marijuana looks like a no-lose investment. However, there are always risks involved with investing in a high-growth industry, and a handful of factors could come back to haunt investors. Here are four ways pot stocks might actually disappoint Wall Street in the near and intermediate term.
1. Domestic oversupply crushes cannabis margins
Arguably the biggest worry from Canada is that a capacity expansion free-for-all is going to lead to an absolute glut of marijuana that sinks per-gram cannabis prices and wrecks margins.
Admittedly, no one has any clue what domestic demand might look like. Various provincial and/or federal government reports, along with industry analyst estimates, often peg annual demand around 800,000 kilograms of dried cannabis. However, some of the largest annual producers include:
- Canopy Growth Corp. (NYSE:CGC): an estimated 300,000 kilograms, if not more.
- Aurora Cannabis (NYSE:ACB): an estimated 283,000 kilograms.
- Aphria: an estimated 230,000 kilograms.
- MedReleaf: an estimated 140,000 kilograms.
- OrganiGram Holdings (NASDAQ:OGI): an estimated 113,000 kilograms.
Mind you, these five growers make up a relatively small snippet of the more than 90 licenses issued by Health Canada. Yet, these five growers account for more than 1.06 million kilograms of production. If we add in the dozens of other growers that are unaccounted for, and in the midst of expanding their capacity, getting to 1.5 million to 1.8 million kilograms of annual production isn't out of the question. We could be looking at a full 1 million kilograms of oversupply in the domestic market by, say, 2020.
The good news is that there are avenues for lessening this oversupply via export. Canopy Growth, Aurora Cannabis, and Aphria, for instance, all have access to multiple overseas markets that have legalized medical cannabis but otherwise have nascent growing industries. However, it seems overly optimistic to expect foreign countries to offset up to 1 million kilograms in annual oversupply. In other words, margins are a serious concern.
2. Dilution weighs down investors
Next, Wall Street and investors could be surprised by the negative impact of dilution -- i.e., the increase in the number of outstanding shares, which makes each existing share less scarce.
Most publicly traded marijuana stocks, regardless of being based in Canada, the U.S., or elsewhere, have faced funding issues at one point or another. Remember: With the exception of Uruguay, marijuana is still illegal. This mean most banks are unwilling to lend money or open up lines of credit to marijuana producers. Additionally, most pot stocks are losing money. And, if by some chance they are profitable, they're generating just a few million dollars in operating cash flow, which is not enough to cover the costly capacity expansions and acquisitions currently being undertaken.
Instead, pot stocks have been turning to dilutive bought-deal offerings, whereby common stock, convertible debentures, stock options, and/or warrants are being offered. The good news is bought-deal offerings have successfully raised capital for a wide swath of cannabis companies. But what investors often don't realize is what those capital raises are doing to outstanding share counts. Not only do common stock offerings dilute investors up front, but options, warrants, and convertible debentures could lead to ongoing dilution for months or years down the road.
For example, Aurora Cannabis has witnessed its Canadian-listed share count rise by more than 2,900% since the end of fiscal 2014 to almost 490 million outstanding shares. Yet, this figure doesn't take into account ongoing options, warrants, and convertible debentures, or the shares it issued to complete its acquisition of CanniMed Therapeutics.
What's more, this dilution could make it difficult for pot stocks to turn a meaningful profit. It's possible Aurora Cannabis may need to earn $6 million in net income just to produce $0.01 in earnings per share.
3. Fundamental investors come out of the woodwork
Another factor that could surprise Wall Street is the return of fundamental investing. Following a nine-year bull market in the U.S., stocks have been nothing short of a roller coaster over the past two months. As such, growth investors are beginning to take a backseat to fundamental investors in search of a solid value. True values aren't likely to be found in the marijuana industry.
The closest thing to a marijuana value stock is OrganiGram Holdings, which is valued at a price/earnings to growth ratio of less than 0.5 and a forward P/E of under 29. Wall Street isn't giving this mid-level grower a lot of credit despite recently upping its annual production targets to 113,000 kilograms from 65,000 kilograms. This has to do with concerns about OrganiGram's capacity expansion not expected to be finished until April 2020, potentially hurting its chances to land long-term supply deals compared to its peers.
Beyond OrganiGram, values really don't exist. Canopy Growth Corp., for example, has intangible aspects that make it quite attractive to pot stock investors. It had spirits giant Constellation Brands take a 9.9% equity stake in the company late last year, and it has multiple avenues to unload its product via its online operations, brick-and-mortar outlets, and strategic partners. But Canopy Growth is also a company that may not even be profitable until 2020 or beyond since it's reinvesting everything into its distribution and growth channels.
Long story short, if value-oriented investors get wind of the cannabis industry at any point over the next couple of quarters, things could get ugly.
4. Jeff Sessions motors on
Lastly, U.S. Attorney General Jeff Sessions still has an opportunity to rain on the cannabis parade. Incidentally, pot stocks have been falling precipitously since the beginning of January, when Sessions announced that he was rescinding the Cole memo.
This memo, crafted by former Deputy Attorney General James Cole, outlined guidelines that states would follow if they wanted to keep the federal government off their backs. These guidelines included aspects like keeping cannabis grown in a state within that state, and ensuring that adolescents stay away from pot. Its rescinding on Jan. 4 opened the door for state prosecutors to use their discretion when bringing criminal charges against individuals and businesses violating the Controlled Substances Act.
While Sessions has no control over Canadian companies, he's certainly put the kibosh on any chance of the U.S. being a cannabis leader. He's also closed off Canada's neighbor as an export opportunity, hurting the hopes of Canadian investors in the process.
Of course, we also know that Sessions would much prefer that marijuana remain wholly illegal. Should Sessions continue to press his war against cannabis, marijuana stocks could feel the effect.
No one knows exactly what the future holds for marijuana stocks, but these risk factors suggest it's likely to be a bumpy ride.