A Grim Reality for Marijuana Stock Investors

When discussing the fastest growing industries in North America, the legal marijuana industry is liable to be at, or near, the very top of the list. According to Cowen Group's recently updated long-term forecast, the legal weed industry could hit $75 billion in annual sales by 2030. Meanwhile, research firm ArcView Group estimates that legal cannabis sales in North America could vault from $9.7 billion in total sales in 2017 to more than $47 billion by 2027. 

What's leading this charge? On a broader scale, we're witnessing a big shift in how the public perceives cannabis. Back in 1995, the year before California became the first state to legalize medical marijuana for compassionate-use patients, Gallup finds that just a quarter of the American public favored legalization. As of October 2017, favorability had shot up to an all-time record of 64%. 

Image source: Getty Images.

Even more impressive is the expectation that Canada will do something no other developed country has ever done: legalize recreational marijuana. Bill C-45, which is better known as the Cannabis Act, looks to have a green light for passage by this coming June. If legalized, marijuana could become available for adult-use sale in approved dispensaries by sometime in August or September. This would add $5 billion or more in annual sales atop what growers are already generating from medical cannabis sales and exports to medically legal countries.

In short, investors are seeing green in more ways than one.

Pot stock investors have to face the facts

There's also a grim reality pot stock investors have to come to terms with -- a reality that I don't believe many have factored into marijuana stock valuations. This being that profits on a per-share basis are going to be negligible or nonexistent in 2018 and 2019.

Admittedly, no developed country has ever legalized recreational marijuana before, so Wall Street analysts don't exactly have a good precedent to lean on when evaluating sales and profit potential. In fact, supply and demand estimates for Canada vary wildly, but one thing that remains somewhat consistent throughout Wall Street's forecasting is the expectation that most pot stocks will only be marginally profitable in 2019.

Here's a quick look at the consensus full-year EPS estimates in 2019 for some of the largest marijuana stocks by market cap. All EPS estimates are in Canadian dollars, courtesy of Yahoo! Finance.

• Canopy Growth Corp. (TWMJF +0.49%): $0.00
• Aurora Cannabis (ACBFF +1.17%): $0.10
• Aphria (NASDAQOTH: APHQF): $0.18
• MedReleaf: $0.21
• OrganiGram Holdings (OGRMF +0.00%): $0.14
• Hydropothecary Corp.: $0.09

Image source: Getty Images.

Now, here's what that translate to on a price-to-earnings basis in 2019:

• Canopy Growth Corp.: infinite since EPS is $0.00
• Aurora Cannabis: 77
• Aphria: 54
• MedReleaf: 97
• OrganiGram Holdings: 28
• Hydropothecary Corp.: 46

With the exception of OrganiGram, which I've referred to as the only "marijuana value stock," the industry is very pricy on a forward basis.

Two reasons marijuana stocks may not produce much green, initially

You might be wondering why such a fast-growing industry with strong consumer demand would have trouble generating strong profits out of the gate. The answer boils down to two factors.

To begin with, it's an expense issue. Cannabis growers are investing practically every cent of operating cash flow, and a lot of the capital they have on their balance sheet, into capacity expansion. Similar to how Amazon reinvests a lot of its operating cash flow back into its business, marijuana stocks are taking their capital and putting it to work by expanding their production.

Image source: Getty Images.

The reason? Growers with a lot of upfront production are the likeliest to secure long-term supply deals with retailers and provinces. Though there's nothing necessarily wrong with ramping up slower than their peers, growers that take longer to significantly increase their production could miss out on lucrative long-term supply deals. As long as these deals are available, expenses are likely to remain high.

The other issue -- and I'm sure you're probably sick of hearing about it by now -- is dilution. Marijuana stocks haven't had traditional access to basic banking services like normal companies, leaving Canadian growers to turn to bought-deal offerings in order to raise capital. In effect, bought-deal offerings have allowed common stock, convertible debentures, stock options, and/or warrants to be offered in exchange for capital. The good news is these offerings have had no issue raising money for weed stocks. The bad news is it leads to either immediate or intermediate-term dilution by ballooning the outstanding share count.

There are two specific issues with dilution. Firstly, as noted, it makes each existing share less scarce. The other problem is that it means dividing net income by more outstanding shares. This works to reduce EPS and makes marijuana stocks look even pricier from a fundamental perspective.

Just how bad has dilution been for marijuana stocks? Here's a look at how outstanding share counts have grown for the aforementioned pot stocks since the end of fiscal 2016, through their most recently reported quarter. Note that MedReleaf has been excluded since it only went public in 2017, and Hydropothecary wasn't included due to a lack of accurate share count data in 2016.

Data source: Morningstar, individual company quarterly reports from SEDAR. Table by author. Share count in millions. MRQ = most recent quarter. 

In each instance, the outstanding share count has more than doubled, leaving existing shareholders to feel the pain. While this could be considered a necessary move to secure long-term supply deals, dilution is nevertheless likely to wreak havoc on full-year EPS for years to come.

It'll probably be a few years before the supply and demand picture in Canada, and globally, is clearer to Wall Street and investors. But as things stand now, a lot will need to go right for the weed industry if these lofty valuations are to hold up.