The buzz is building in the marijuana landscape. In less than seven weeks, Canada will raise the curtain on retail marijuana sales in licensed dispensaries, thereby opening the floodgates to what could be billions of dollars in annual sales once the industry is fully operational.
As you can imagine, the legalization of recreational weed in Canada has been a long time coming, and investors are expecting it to translate into big profits for marijuana stocks, as well as their investment accounts. This excitement is what's led the North American Marijuana Index higher by more than 30% between Aug. 14 and Aug. 27 and by roughly 180% on a trailing 12-month basis through Aug. 27, 2018.
However, this overwhelming optimism could have a downside, too: overvaluation. Historically, the "next big thing" in the stock market has consistently failed to live up to the hype, and marijuana stocks may prove no different. While some pot stocks have partnerships, products, or profitability estimates in place that can somewhat back up their existing market caps, others look nothing short of incredibly overvalued.
Keeping in mind that valuation is in the eye of the beholder and that each and every marijuana stock is worth exactly what someone is willing to pay for it, here are two pot stocks that I believe are grotesquely overvalued and primed to deflate.
Ontario-based Cronos Group (CRON -3.49%) wasn't exactly a company I thought was a good value two weeks ago. So you can imagine how I now feel after it shot higher by approximately 100% following word of Constellation Brands' $3.8 billion equity stake in Canopy Growth Corporation. Shares of Cronos Group skyrocketed after this announcement on the hope that it would be next to line up an investment from a major alcohol producer. That investment has yet to materialize.
Now, understandably, there are a few things Cronos Group is doing right. It's been pushing into international markets, which will prove crucial to offloading excess domestic production. It also signed a lucrative take-or-pay agreement with Cura Select Canada that'll see at least 20,000 kilograms of cannabis purchased by Cura annually for a period of five years.
What I don't like about Cronos are the timing of its capacity-expansion plan and underlying fundamentals.
Only recently did Cronos Group announce the formation of a joint venture with investors to create Cronos GrowCo. This joint venture will construct an 850,000-square-foot facility capable of 70,000 kilograms of annual weed production when fully operational. Along with Cronos' other key assets (Peace Naturals and Original BC), it should help push peak production to around 140,000 kilograms, in my best estimate. However, it's going to take a lot of time before this production hits the market, potentially cutting off Cronos Group's ability to land additional long-term supply deals.
The other issue is that Cronos Group isn't profitable on an operating basis, and it could be some time before it is. As noted, it's only now getting around to doubling its production capacity, which could mean an astronomically high price-to-earnings ratio for years to come.
Comparatively, I prefer Atlantic-based grower OrganiGram Holdings, which can hit peak production of 113,000 kilograms by 2020, has a more reasonable forward P/E of 43, and likely has a PEG ratio below 1 (no current PEG ratio estimates exist, so this is an author estimate).
If you ignore the share price and focus on market cap instead, Aurora Cannabis (ACB -6.20%) and its nearly $7 billion market cap look to be nearly priced for perfection.
Like Cronos, Aurora Cannabis has made moves that are impressive. Management is angling the company to be a leading medical cannabis supplier -- and medical marijuana patients traditionally yield better margins than recreational consumers. This is because medical pot patients are far more willing to purchase high-margin alternative cannabis products such as oils, relative to recreational consumers.
Aurora Cannabis's acquisition and partnership spree during the first half of the year may also result in it leading the pack in annual peak production at around 570,000 kilograms of cannabis. Though it'll take time to reach peak production capacity, there are likely pricing and deal perks that come with Aurora's leading position as a weed producer.
What isn't to like is the almost reckless willingness of management to dilute investors with one bought-deal offering after another.
Prior to the passage of the Cannabis Act on June 19, traditional banks weren't able to offer basic banking services, such as loans and checking accounts, to cannabis companies out of fear of criminal and/or financial penalty. This left Aurora Cannabis and its peers with one option to raise capital: selling common stock, convertible debentures, stock options, and/or warrants via bought-deal offerings. In Aurora's case, it undertook numerous bought-deal offerings, leading to the ballooning in its outstanding share count from 16 million at the end of fiscal 2014 to around 950 million today.
The issue here is threefold. First, these outstanding shares diluted existing shareholders, pushing Aurora Cannabis's share price down precipitously since January. Second, with convertible notes and warrants still outstanding, further dilution in the quarters ahead is likely. And finally, these added shares will make it incredibly difficult for Aurora to turn in a meaningful per-share profit. With up to 1 billion shares outstanding, Aurora would need 100 million Canadian dollars in net income just to generate CA$0.10 in EPS -- and this would give the company a less-than-stellar forward P/E ratio of 85.
Even as a brand-name pot stock, Aurora Cannabis is a name I'd suggest strongly avoiding.