In just 15 days, the wheels are likely to be set in motion to make adult-use marijuana legal in our neighbor to the north. On June 7th, Canada's Senate will vote on the Cannabis Act, with a positive outcome expected to lead to recreational legalization not long after. By August or September, roughly eight to 12 weeks after the bill is signed into law, adults aged 18 and over will be able to legally purchase marijuana in Canada.
This expectation of legalization, and the triple-digit multiyear sales growth that could follow, has had investors buzzing about the opportunity pot stocks offer. After all, with around $5 billion in sales expected to be added to the Canadian weed industry, someone has to profit, right?
However, if investors were to take Wall Street's consensus profit forecasts for marijuana stocks in 2019 to heart, they might not feel so excited about this budding industry.
Sales growth is through the roof...
Make no mistake about it, breakneck capacity expansion is expected to lead to rapidly rising sales. Canopy Growth Corp. (CGC 4.72%), the world's largest marijuana stock by market cap, has tripled its licensed growing capacity since the year began to 2.4 million square feet, and it's targeting a final licensed capacity figure of 5.7 million square feet in British Columbia. With this much growing space, 500,000 kilograms of annual production isn't out of the question when it's at full capacity. And, per Wall Street, the company could generate as much as $405 million in annual sales in 2019, based on the high-end estimate. This would mark a 562% increase over the consensus 2018 sales forecast.
Similarly, Aurora Cannabis (ACB 7.75%), which is the other giant in the Canadian growing space, recently announced plans to acquire Ontario-based MedReleaf (NASDAQOTH: MEDFF) for $2.5 billion in an all-stock deal. Combining Aurora's 430,000 kilograms in fully funded capacity with MedReleaf's 140,000 kilograms at full capacity should yield 570,000 kilograms per year. By 2019, assuming we combine the high-end sales estimates for both companies, the new Aurora Cannabis could generate $408 million in sales.
...but profit forecasts are still falling
Yet as these sales figures rise, Wall Street profit projections on a per-share basis have fallen for most pot stocks. Here's a quick rundown of what 2019 full-year EPS estimates looked like for some of the biggest marijuana stocks 90 days ago, and what they look like today. All figures are in Canadian dollars per share.
|Company||2019 FY EPS Estimate, 90 Days Ago||2019 FY EPS Estimate, Current|
As you can see, none of these major players have had their profit projections increased over the past three months. With the exception of OrganiGram Holdings, which is valued at 34 times next year's EPS, all of these other pot stocks are valued at nosebleed forward P/Es. Yes, these are rapidly growing pot stocks, but they're not offering much value to fundamentally oriented investors if they're not delivering on the bottom line.
Why are Wall Street's profit projections falling for pot stocks?
Though Wall Street has been pretty mum about its marijuana stock profit projections, there are likely three factors negatively influencing full-year EPS estimates.
1. Reinvestment in capacity expansion
First, there's the strong likelihood that marijuana growers are reinvesting every ounce of operating profit back into capacity expansion. They're doing this in order to gobble up as much market share as possible when the proverbial green flag waves. Once recreational cannabis becomes legal, a number of long-term supply deals may become available with provinces and retailers, and growers want to nab as many of these lucrative deals as possible. This means front-loading their production and reinvesting most of their operating cash flow into more growing space. Doing so could be hurting short-term profitability.
2. Concerns regarding oversupply
Secondly, there's probably some concern on Wall Street about marijuana oversupply dragging down per-gram prices in Canada. Though euphoria following legalization has generally been a positive for weed prices in a handful of adult-use legal states in the U.S., this euphoria typically doesn't last long. In Washington, Oregon, and Colorado, marijuana prices are down significantly from where they began a few years ago.
In Canada, annual demand estimates range from around 800,000 kilograms to as much as 1 million kilograms, according to Health Canada. Yet, annual production could hit as high as 2.3 million kilograms to 2.4 million kilograms by 2020 or 2021. What happens to this excess cannabis? Some of it will be exported to foreign markets where medical cannabis is legal. But can these foreign markets absorb more than 1 million kilograms of excess capacity? That remains to be seen.
3. Shareholder dilution
The third factor weighing down full-year EPS estimates in 2019 just might be dilution. Since the marijuana industry has extremely limited access to basic banking services, including loans and lines of credit, they're often forced to turn to common stock offerings, convertible debentures sales, and stock options and warrants to raise capital. All of these measures can increase a stock's outstanding share count, diluting existing shareholders in the process and making it tougher for a company to earn a meaningful per-share profit.
Rising share counts have been particularly noticeable, and worrisome, for the aforementioned two industry kingpins, Canopy Growth and Aurora Cannabis. At the end of fiscal 2016, Canopy Growth had 77 million shares outstanding. Just seven quarters later, it now has almost 195 million weighted average outstanding shares. Meanwhile, Aurora Cannabis's share count has jumped from just north of 16 million at the end of fiscal 2014 to nearly 565 million as of its most recent quarter. My suspicion is it's this dilution, more than anything, that's crushing pot stock EPS estimates in 2019.
At this point, there's little doubt that legal marijuana will lead to a big jump in revenue for Canada's pot industry in the years to come. But the jury's still out on whether or not this big increase in sales will translate into healthy long-term profits for this highly competitive industry.