Tomorrow is the day the legal cannabis industry has been anticipating, for what seems like a lifetime. On Thursday, Canada's Senate will be voting on bill C-45, best known as the Cannabis Act. If the vote proves favorable, which is pretty much the expectation at this point, the Cannabis Act will be one step closer to being signed into law, which would make adult-use marijuana legal in Canada.
Legalizing recreational pot would add $5 billion, if not more, to Canada's burgeoning legal cannabis industry. Mind you, this would come atop what the industry is already generating from medical marijuana sales, and via exports to countries where medical weed has been legalized.
Image source: Getty Images.
In anticipation of this vote, and based on generally strong growth in medical cannabis sales up to this point, the consensus question among investors is simple: "Which marijuana stock should I buy?" Of course, it's probably also the hardest question to answer given that most pot stocks have already been vaulted into the stratosphere. And since there's no precedent for a developed country legalizing marijuana, no one is exactly sure what to expect on the supply-and-demand side of the equation.
On the other hand, deciding which marijuana stocks should be avoided is a considerably easier question to answer. While I myself have reservations about investing in the cannabis industry, and have yet to purchase any pot stocks, I can say with relative certainty that I won't be buying the following four marijuana stocks.
Aurora Cannabis and MedReleaf
Though Aurora Cannabis (ACB -3.10%) may turn out to be the industry leader in annual production -- and it's worked hard on expanding its distribution channels and in diversifying its product line away from a sole reliance on dried cannabis -- it's near the top of my "do not buy" list. Why, you wonder? One simple reason: dilution.
Aurora Cannabis has been hell-bent on becoming Canada's leading producer of cannabis. In addition to its organically built-out, 800,000-square-foot Aurora Sky facility, it's partnered with Alfred Pedersen & Son in Denmark to retrofit an existing greenhouse facility in what will become Aurora Nordic, and recently announced its intention to build a 1.2-million-square-foot facility in Medicine Hat, Alberta, to be known as Aurora Sun. These expansions come atop the huge premium it paid to acquire CanniMed Therapeutics, and the $2.5 billion, all-share deal to buy Ontario-based MedReleaf (NASDAQOTH: MEDFF).
Image source: Getty Images.
Don't get me wrong: Being among the largest producers will have its benefits, such as being able to take advantage of economies of scale. And it's likely to be among the first growers chosen for long-term supply deals by Canadian provinces and foreign countries in need of medical cannabis. Its newly announced buyout of MedReleaf will also bolster its cannabis-oil product line. Oils are important for their niche consumer base, strong pricing power, and beefier margins, compared to dried cannabis.
However, in order to construct this cannabis empire, Aurora Cannabis has had to issue common stock, convertible debentures, stock options, and/or warrants at a breakneck pace in order to finance its expansion. Raising capital for pot stocks essentially means turning to bought-deal offerings. And for Aurora, it means potentially seeing its outstanding-share count rise from 16 million at the end of fiscal 2014 to perhaps more than 1 billion shares by this time next year, following the closure of the MedReleaf deal. That dilution is going to crush existing shareholders and make it veritably impossible for Aurora to turn a meaningful profit (on a per-share basis) anytime soon.
Although MedReleaf is otherwise an intriguing company that's been profitable in each of the past two years and has a strong focus on oils and extracts, the only reason I would lump it in here is because as an all-share deal, MedReleaf shareholders are now intricately tied to Aurora Cannabis stock. And, as noted, that's not something I particularly care for.
MedMen Enterprises
Last week, MedMen Enterprises (NASDAQOTH: MTTPF) became the largest U.S.-based marijuana stock to list in Canada in history. The initial cash raise priced MedMen -- an operator of a dozen upscale marijuana dispensaries in three U.S. states, and the owner of four existing, or under construction, grow facilities -- at more than $1.6 billion. Even after the stock shed close to 20% of its value in the four days following its listing via a reverse merger, this investor wants absolutely nothing to do with it.
Image source: Getty Images.
Understandably, it does have its selling points, otherwise it wouldn't command such a price. Those selling points being its ability to rapidly expand its operations -- i.e., going from one dispensary to 12 in just two years -- and its ability to connect with the upscale consumer. Focusing on a more-affluent customer is a smart business move that should allow MedMen Enterprises to overcome minor hiccups in the U.S. economy, when they occur. In other words, higher-income consumers are less likely to be impacted by economic fluctuations.
Yet, even with the opportunity to move its business into Canada via a partnership with Cronos Group (CRON 2.63%), MedMen appears to be grossly overvalued. Keeping in mind that fundamental metrics are somewhat up for interpretation in this still-illegal industry, MedMen's business generated just $8.4 million in sales in the six months ending Dec. 31, 2017, yet it lost $43 million over that same time frame. Though it's not uncommon for early stage companies to burn through cash in an effort to expand, these huge losses suggest that additional capital raises -- even above and beyond what MedMen netted from its public listing -- may be needed in the future. That's a recipe for dilution.
There's also the ongoing risk of operating the bulk of its stores in the United States. Even though the U.S. federal government has taken a hands-off approach with regard to regulating cannabis, it doesn't change the fact that it's a Schedule I drug (wholly illegal) at the federal level. The possibility of a federal crackdown remains, even if it seems unlikely at the moment. Between this risk and its lofty valuation, this is a niche marijuana stock to avoid.
Cronos Group
The fourth and final marijuana stock that certainly won't be on the buy list is Cronos Group.
As noted, it does have a deal in place with MedMen that'll allow Cronos to introduce this high-end cannabis retailer into Canada, and the company did record a better than 600% increase in year-over-year sales in full-year 2017. Cronos Group also became the very first over-the-counter-listed pot stock to up-list to a more reputable exchange earlier this year. But these small morsels of good news are about all Cronos Group has going for it.
Image source: Getty Images.
The biggest issue I have with Cronos Group is its valuation relative to its peers. Even with a focus on the higher-margin medical side of the equation, its ownership in Peace Naturals, and its Israeli joint venture (Gan Shmuel), this grower could struggle to generate much more than 70,000 kilograms of production per year when at full capacity. Yet, Wall Street has pushed its market cap to $1.2 billion.
Meanwhile, Aphria (NASDAQOTH: APHQF) has over three times as much production potential when at full capacity in 2019 – an estimated 230,000 kilograms of dried cannabis – but is valued at only $1.9 billion. What's more, Aphria has considerably stronger sales to speak of, and it's already been generating quarterly profits, unlike Cronos Group, which continues to lose money each quarter. This is why I've referred to Cronos as possibly the most overvalued marijuana stock of the bunch, and a stock that I wouldn't touch with a 10-foot pole.
