In case you haven't noticed, marijuana stocks are blazing hot once again. This budding industry has taken flight on the expectation of rapidly rising sales and big profits tied to Canada's legalization of recreational marijuana in 36 days' time. When it becomes legal on Oct. 17, weed is expected to generate up to $5 billion in annual income, atop what the industry was already bringing in via domestic weed sales and exports.
Dealmaking has also sent pot stocks soaring. Major alcohol companies, Big Tobacco, and even pharmaceutical companies are looking to partner with the cannabis industry for a taste of this rapid growth. The biggest tie-up to date involves a $3.8 billion equity investment in Canopy Growth Corp. by Corona and Modelo beer producer Constellation Brands.
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Did you overlook this jaw-dropping statistic in Tilray's prospectus?
But in recent months, no stock has captivated the marijuana investors more than medical cannabis grower Tilray (TLRY +0.00%). What's truly amazing about Tilray is that it hasn't even been a publicly traded company for two months, yet it's seemingly risen through the ranks as investors' favorite pot stock. Since pricing its shares at $17 on July 18, Tilray has rallied as much as 470%. In fact, at one point, it nearly gave Canopy Growth a run for its money as the largest marijuana stock by market cap.
However, for as incredible as Tilray's move higher has been, it's a statistic cited in the company's S-1 prospectus filing with the Securities and Exchange Commission in June that should really have investors salivating with excitement. Among the 164-page prospectus -- which doesn't count dozens of extra pages in the appendix containing financial figures galore -- on pages 60 and 61, Tilray discusses a handful of factors affecting its business. The very last factor mentioned, "new product innovation," is where investors will want to pay close attention. As noted in the prospectus:
We believe our success will depend on our ability to continually develop, introduce and expand non-combustible products and brands, which we believe will have higher gross margins compared to combustible products. According to data from Health Canada, over the past six quarters ended December 31, 2017, dried cannabis sales had a compound quarterly growth rate, or CQGR, of 8% and cannabis oils had a CQGR of 39%.
That last sentence there is really important. Over the previous year and a half, leading up to the end of 2017, dried cannabis sales were growing at a sequential quarterly rate of about 8%. Meanwhile, cannabis oils, which focus on a narrower group of patients but have considerably higher margins, grew at a sequential quarterly rate of 39%!
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Pot stocks focused on oils are liable to be the most profitable
Back in March, I opined that marijuana stocks that focus on alternative products beyond just the dried flower would put themselves in a better position to succeed over the long term, and it would appear that those doing just that, like Tilray, are liable to be in the best shape.
Why should growers avoid becoming too reliant on dried cannabis, you ask? Though there's little precedence for legalizing recreational marijuana, a handful of examples in the U.S. have shed light on the answer.
In Colorado, Washington, Oregon, and even California, to a lesser extent, we've witnessed a precipitous decline in the per-gram price of cannabis not long after adult-use legalization. Whether it's big businesses using their deep pockets to gobble up available cultivation permits or growers simply flooding the market with marijuana in order to take advantage of early-stage euphoria, the per-gram price for dried flower has tended to decline significantly over time. Even with economies of scale working in favor of growers, they're still going to feel the sting of declining dried cannabis margins.
On the other hand, cannabis oils are targeted at a much narrower pool of consumers, but there's also far less competition and, at this point, no oversupply issues. While it's not out of the question that oils could run into supply issues at some point in the future, they are a high-price-point, high-margin product for the time being.
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Aside from Tilray, here are two oil-focused growers to watch
Aside from Tilray, which generated 46% of its second-quarter sales from oils, smaller growers like OrganiGram Holdings (OGRMF +1.41%) and CannTrust Holdings (CNTTF +0.00%) are devoting a decent percentage of production to oils.
In a somewhat recent email interview with OrganiGram Holdings' CEO Greg Engel, I was told that the company plans to generate half of its medical cannabis sales from higher-margin oils. Though the recreational market is unlikely to see anywhere near the same demand for oil products, the expected expansion of consumption options in 2019 by Canada's Parliament (i.e., edibles, infused beverages, vaporized cartridges, and concentrates) should broaden OrganiGram's high-margin alternative cannabis product options.
Then there's CannTrust, which is in the process of expanding its Niagara greenhouse facility to around 1 million square feet. CannTrust, though its production has been minimal relative to where it'll be once at full capacity, has consistently been generating more than half of its sales from cannabis oils. Its focus on hydroponics, as well as its continuous production system, which could counter the lumpy harvesting periods that its competitors could deal with, should allow CannTrust to produce superior margins to those of its peers.
Long story short, if you aren't paying attention to cannabis oils, then you're missing the bigger picture.
