You might look at the performance of Auxly Cannabis Group Inc. (NASDAQOTH:CBWTF), formerly known as Cannabis Wheaton, and quickly decide to stay away from the stock. Auxly was one of the worst-performing marijuana stocks in the second quarter. Its share price has plunged more than 40% so far this year.
But Auxly's market cap has actually soared in 2018. The stock's decline stemmed entirely from dilution caused by issuing new shares with bought-deal financing transactions. Is Auxly Cannabis Group a stock to consider buying now?
Reasons to buy
The obvious reason to buy Auxly Cannabis is the growth opportunity that the company should have once the recreational marijuana market opens in Canada this October. Demand is widely expected to outpace supply for quite a while.
Auxly isn't like most businesses in the Canadian cannabis industry. Instead of building its own facilities and cultivating marijuana, Auxly has a streaming model where the company provides financing to other businesses in exchange for a portion of their crop yield.
This "upstream" business isn't Auxly's only focus, though. The company thinks that investing in "midstream" assets related to activities such as extraction, processing, branding, manufacturing, and research could offer even better long-term opportunities. This view led to Auxly's acquisition of Dosecann, which specializes in cannabis-based medical products and consumer products such as cannabis edibles and concentrates.
In addition, Auxly has made investments in "downstream" cannabis distribution channels. For example, the company launched Kolab Project Inc. to offer a monthly subscription program to medical cannabis patients in Canada. Kolab is also planning to open a cannabis retail store in Saskatchewan.
There's also a case to be made that Auxly is a bargain compared to many other marijuana stocks. The company's market cap of around $430 million combined with its projected annual production capacity in 2019 of 230,000 kilograms stacks up very favorably against most of the big Canadian marijuana growers.
Reasons to stay away
However, valuation is also one big reason to avoid Auxly stock. While the stock price might look attractive relative to other marijuana stocks, those stocks have astronomically high valuations. Auxly's trailing-12-month revenue is only a sliver of its market cap. That means tremendous growth expectations are baked into its share price. It's possible those growth expectations won't be met.
Another significant risk is that Auxly continues to dilute its stock through more bought-deal financing transactions. The company's entire business model hinges on providing funding to other businesses or acquiring stakes in other businesses. That requires money, which could keep Auxly on the path it's been on so far this year -- market cap up but share price down.
Probably the biggest risk for Auxly is that a supply glut is almost inevitably on the way in Canada. Every marijuana grower in the country appears to be frantically ramping up production capacity. But within a couple of years or so, capacity will catch up with and overtake demand.
What will happen then? Prices will fall. Smaller businesses that depend on selling cannabis to larger companies will be hurt the worst. The companies most likely to survive and thrive will be those that have extensive operations in international markets.
Auxly could feel the brunt if this scenario plays out. The company does have an upstream partner in Uruguay, but the country doesn't have a huge cannabis market.
Putting it all together
Could Auxly Cannabis Group be a big winner over time? I wouldn't rule it out. The strategy of diversifying in upstream, midstream, and downstream cannabis businesses could pay off.
I'm leery of buying the stock, though, because of the risks that Auxly faces. Perhaps my concerns about the coming supply glut are overdone, but I'd rather be safe than sorry. For this reason, my view is to watch this intriguing marijuana stock from the sidelines.