I spy, with my eye, an industry that seemingly can't be stopped at the moment, and cannabis is its name.
According to a report from cannabis research firm ArcView, the legal weed market in North America is expected to grow by an average of 28% per year through 2021, leading to almost $25 billion in annual sales. How impressive is this? Back in 2016, the North American legal marijuana market totaled less than $7 billion in sales. By 2027, it could grow to north of $47 billion, per ArcView, while investment bank Cowen has placed an even more aggressive $75 billion value on the annual market by 2030 (assuming U.S. approval).
Instrumental to this growth has been a shift in public opinion about pot. Even one decade ago, polls regularly showed that the public was overwhelmingly against legalization. But over the past year, national polls from the likes of Gallup, Fox News, CBS News, the Pew Research Center, and Quinnipiac University have found overwhelming support for legalization, at least within the U.S.
Investors' attention turns to Canada
Yet, as you're probably well aware, legalization in the U.S. is likely a long way off. The drug remains firmly classified as Schedule I, putting it on par with LSD and heroin. Further, with Attorney General Jeff Sessions waging a personal war on pot, expansion in the U.S. will be slow and arduous, at best.
All eyes are currently on Canada, which is expected to become only the second country in the world, and the first developed country, to legalize recreational marijuana by this summer. A Senate vote is scheduled for June 7, with full legalization expected shortly thereafter, assuming passage of C-45, better known as the Cannabis Act. Green-lighting the sale of adult-use cannabis should open the door to $5 billion or more in added annual sales, which comes on top of the medicinal weed and export sales Canadian growers are already logging.
While a handful of Canadian growers, big and small, have caught the attention of retail investors, a select few have really stood out to Wall Street institutions. In particular, MedReleaf (NASDAQOTH:MEDFF) consistently finds itself at or near the top of the pack, with most analysts placing the equivalent of a "buy" or "outperform" rating on the company.
Wall Street really seems to like pot stock
It's certainly not hard to see why Wall Street likes MedReleaf. It's a company whose management team is approaching capacity expansion very smartly.
Just this past week, MedReleaf announced that it had closed on its purchase of 164 acres for a relatively minimal cost -- 21.5 million Canadian dollars ($17 million) and 225,083 shares of common stock. All told, this works out to about CA$26 million. Contained on 69 acres of this purchase is the Exeter facility, which MedReleaf plans to retrofit in the months ahead to grow cannabis and boost its annual production from 35,000 kilograms to 140,000 kilograms.
Rather than building a new facility from the ground up, MedReleaf made the wise decision to acquire an existing facility that merely had to be retrofitted for marijuana production, saving time and money. Plus, with 95 acres adjacent to the Exeter facility, up to a 1.5 million-square-foot expansion could be added, assuming demand merits it.
MedReleaf has also worked hard to expand its product line beyond just dried cannabis, which has the potential to be commoditized. MedReleaf announced that extract sales jumped by nearly 700% from the previous year in its fiscal third quarter, totaling 21% of aggregate sales, up from just 3% of total sales during the comparable quarter in 2016. Extracts, as well as its AltaVie premium cannabis strains, target niche consumers and have higher product price points. They also come with juicier margins -- a big reason Wall Street is so bullish on MedReleaf.
It also doesn't hurt that the company has produced a full-year profit in each of the past two years, something only one other pot stock (Aphria) has done.
Caveat emptor, investors
But even Wall Street's darlings in the pot industry come with potential drawbacks. If you're already invested in MedReleaf, or have considered this budding marijuana stock for your portfolio, be aware of three chief concerns.
One of the biggest uncertainties facing the Canadian pot industry is whether or not it'll face a supply-and-demand imbalance in the years to come. Since there is no precedent for a developed country legalizing adult-use weed, there are no previous cases to use for comparison.
According to a number of government reports and institutional estimates, Canada is likely to demand in the neighborhood of 800,000 kilograms of cannabis annually. Yet, if we look at the fully funded capacity of the six largest growers -- which includes MedReleaf's 140,000 kilograms -- they alone account for around 1.17 million kilograms annually. Add in the dozens of other licensed producers, and we could be looking at 600,000 kilograms to perhaps 1 million kilograms of annual oversupply.
What happens to this oversupply? Some could be shipped to overseas markets that have legalized medical marijuana. What we don't know is how much oversupply foreign countries could take off the hands of Canadian growers. That leaves MedReleaf and its peers in a potentially precarious situation. If oversupply isn't fully dealt with, dried cannabis margins could drop significantly.
Secondly -- and this is by no means unique to MedReleaf -- shareholders run the risk of being diluted by bought-deal offerings.
In Canada, bought-deal offerings are a common way to raise capital. They involve the sale of common stock, convertible debentures, options, and/or warrants to investors before the release of a prospectus. The good news is that publicly traded growers have had no trouble finding investors to raise capital to expand their capacity. The bad news is that shareholders could suffer over the long run because of these deals.
In January, MedReleaf announced the completion of a nearly CA$100.7 million bought-deal offering that wound up fully funding the expansion of its Bradford, Ontario, facility, as well as its recently announced 164-acre purchase that included the Exeter facility. Unfortunately, this offering included the sale of common stock and warrants, which have the potential to balloon the outstanding-share count immediately, and in subsequent quarters. It also makes it tougher for publicly traded companies to earn a substantial per-share profit, since net income is divided by a growing number of outstanding shares.
3. Being late to market
Finally, an oft-overlooked dilemma some growers could face is lagging their peers in getting product to market. Even though MedReleaf could weigh in as Canada's fourth-largest producer by annual volume, it could take until 2020 before it's pushing out 140,000 kilograms a year.
The company's Bradford facility should be completed by mid-2018, while the first harvest from Exeter likely won't arrive till the first quarter of 2019. Yet, the proverbial green flag could wave for recreational sales in August or September this year. The couple of months between then and when MedReleaf begins to churn out extra production from Exeter could allow its peers to lock in long-term supply agreements, as well as form attachments with domestic consumers, leaving MedReleaf on the outside looking in.
For what it's worth, MedReleaf's growing focus on niche products like extracts and higher-priced cannabis strains should help mitigate all three of these concerns. However, it's important to recognize that MedReleaf is far from a perfect pot stock.