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3 Hidden Risks That Could Steal Back Marijuana Stock Profits

By Sean Williams - Sep 22, 2018 at 7:21AM

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These concerns probably aren't on your radar -- but they should be.

Since 2016 began, marijuana stocks have been virtually unstoppable. Though pot stocks haven't delivered the once-in-a-lifetime gains cryptocurrency investors partook in during the fourth quarter of last year, they've still been of the three-digit or four-digit percentage variety. Popular investments like Canopy Growth Corp. (CGC -5.98%), Aurora Cannabis (ACB -6.49%), and Aphria (NASDAQOTH: APHQF) are up about 3,400%, 1,400%, and 1,700%, respectively, since the beginning of 2016.

With Canada set to begin legally selling recreational marijuana in less than four weeks, investors anticipate that these pot stocks can continue rolling higher. After all, various estimates suggest that legalizing adult-use weed could add $5 billion a year in sales to the Canadian pot industry.

A hundred dollar bill on fire on a stove's gas burner.

Image source: Getty Images.

Is it time to kiss those marijuana profits goodbye?

However, it's far from a guarantee that marijuana stocks can build on their gains, let alone maintain their substantially enlarged valuations. With no shortage of concerns on the table, here are three hidden risks that could be the undoing of marijuana stocks.

1. A resilient black market

Yes, Canada is set to become the first industrialized country in the world to legalize recreational weed, and yes, 30 U.S. states have given the thumbs-up to medical marijuana by passing broad-based legislation. But despite all of this, the illicit black market for cannabis remains intact.

You see, the underground pot market isn't bound by the same rules that legal channels are. A legally operating business has to purchase a cultivation license or sales permit (or at least go through the arduous process to obtain a sales permit), as well as pay rent, electricity costs, and employee wages, and cover excise taxes, along with corporate income tax on any profits. In some markets, such as California, all of these taxes can add up to around 45%, which makes it impossible for legally grown weed to compete with illicit pot.

A suspicious-looking man in a blue hoodie holding a potted cannabis plant.

Image source: Getty Images.

Of course, Canada is approaching taxation a bit differently. It's instituting just a 10% excise tax in an effort to compete with black market cannabis and, when commoditization hits and drives down dried cannabis pricing, pushes the illicit market out for good (or perhaps into legal channels). Still, even at 10%, and when coupled with corporate income tax rates, the illicit market has legal channels beat on price -- and price is usually what matters most to the consumer.

This is a worry for all marijuana stocks, but especially those that have been bestowed with aggressive valuations, like Canopy Growth. Ultimately, Canopy expects to have 5.6 million square feet of licensed capacity, which would likely yield around 500,000 kilograms of cannabis a year. But if consumer demand fails to hit lofty expectations due to the persistent presence of the black market, companies like Canopy Growth could struggle to find a home for all of its weed, hurting the price of dried cannabis and weighing on its margins.

2. Long-lasting dilution

Although it's something that bullish investors in the cannabis space hate hearing about, share-based dilution really is an issue that should concern them.

Prior to the passage of the Cannabis Act on June 19, access to non-dilutive forms of financing was virtually nonexistent for marijuana companies. Even though the federal government in Canada (and even the U.S.) had maintained a hands-off approach to pot-based companies, banks still didn't want to risk financial and/or criminal penalties if caught providing basic banking services to the industry. For Canadian weed companies, this meant one choice to raise capital: bought-deal offerings.

A bought-deal offering is an instance where common stock, convertible debentures, stock options, and/or warrants are sold to an investor or group of investors to raise cash. This was the overwhelming means of raising capital for pot stocks over the last couple of years. And while effective, it has its downsides.

A magnifying glass being held over a balance sheet.

Image source: Getty Images.

The biggest issue with bought-deal offerings is that they balloon the outstanding share counts of publicly traded companies. And as the share count rises, it becomes that much harder for marijuana stocks to produce a meaningful per-share profit. In other words, whereas share buybacks make a stock's valuation more attractive by inflating earnings per share, a bought-deal offering has the opposite effect.

Worse yet, the impact of dilution isn't always immediate. Even though common stock offerings are reflected in the company's next regulatory filing, the impact of convertible debentures, stock options, and warrants can build up for years. That's exactly what's going to happen with Aurora Cannabis.

Due to Aurora's acquisition-heavy approach that caused it on many occasions to raise capital through bought-deal offerings, its share count has ballooned from 16 million at the end of fiscal 2014 to what'll probably be 1 billion shares by the end of this year. And with options, warrants, and convertible notes still to be accounted for and exercised, the dilution will continue for years to come.

3. The regulatory seesaw

Regulatory concerns are a third issue that could crop up (pun fully intended), but which few people are discussing.

Although Canada is set to make history, there are still a lot of things left to be hashed out (yes, another pun) with regard to driving under the influence of cannabis, and approving other forms of consumption.

For instance, determining driver impairment with alcohol is relatively straightforward. A breathalyzer device, combined with a field sobriety test, can help a peace officer ascertain pretty conclusively whether a driver is impaired or not. That's not necessarily true with cannabis users. There are breathalyzers in development to isolate and test for tetrahydrocannabinol (THC), the cannabinoid that gets you "high," but they're still probably a year or longer from hitting the mainstream. This leaves peace officers and Parliament in a tough situation.

Cannabis leaves placed next to a brownie and pieces of chocolate.

Image source: Getty Images.

An even more direct concern is Canada's expected discussion and approval of new forms of consumption next year. When Oct. 17 arrives, only dried cannabis and oils will be legal, with vapes, edibles, infused beverages, concentrates, and other forms of consumable pot still banned. It's widely expected by industry execs that the government will take up discussion on, and approve, different forms of consumables in 2019.

But what if they don't, or simply fail to produce an expansion of approved consumables in a timely manner? Such a move would be devastating to marijuana stocks like Aphria, which is counting on a diverse product line beyond dried cannabis to bolster its margins. In particular, Aphria announced plans in June to build an extraction center in Ontario that'll produce approximately 25,000 kilograms of cannabis-equivalent concentrates each year, once fully operational. If Parliament delays this discussion, it could put Aphria, and other pot stocks, in a bind. 

Make no mistake about it: Marijuana stocks are no sure thing.

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Canopy Growth Stock Quote
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