The green rush is officially underway. Following years of promises, months of debate in Parliament, and another four months of planning, recreational marijuana is finally legal throughout Canada. When the industry is fully up to speed, it's expected to generate upwards of $5 billion in added annual sales, if not more.
Leading that charge has been perhaps the best-known marijuana stock, and the poster child for the industry's success, Canopy Growth Corp. (CGC -0.66%).
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Why Canopy Growth has been a top marijuana stock to date
Canopy Growth has seen its share price rise by more than 600% over the trailing-two-year period, and it's up 2,700% since the beginning of 2016, when the cannabis craze really kicked into high gear (pun fully intended). Much of this excitement surrounds the company's superior supply chain, which involves physical retail locations, online stores, and its premier brands. The company's Tweed line is arguably the best-known cannabis brand in Canada.
Canopy is also expected to be a leading producer, once it's at full capacity. As of its most recent quarterly report, the company had 2.4 million square feet of licensed grow space, with an ultimate goal of getting 5.6 million square feet approved for cultivation. Although the company doesn't specifically state what its peak production potential is, a rough guess of 500,000 kilograms (about 1.1 million pounds) by yours truly is likely in the ballpark.
And, of course, there's a lot of excitement surrounding Constellation Brands (STZ -0.04%) taking an additional $3.8 billion equity stake in Canopy Growth. This investment, which is actually Constellation's third in the company, will give it a 38% stake in Canopy, with the option of increasing its position to north of 50% thanks to 139.7 million warrants it'll be issued. The duo is expected to work on cannabis-infused beverages, as well as use their respective expertise to push into foreign markets where medical marijuana is legal.
In other words, there have been plenty of reasons to be optimistic about Canopy Growth's future.
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Seven reasons you absolutely shouldn't buy Canopy Growth Corp.
But what investors may not realize is that there are potentially a greater number of reasons not to buy Canopy Growth after its monumental rally. Here are seven good reasons to stick to the sidelines.
1. Canopy's production ramp-up will take time
To begin with, even though Canopy Growth will likely slot in as the second-largest grower by annual production, it's going to take quite a bit of time for the company to reach its peak yield. According to its first-quarter operating results, the company harvested nearly 9,700 kilograms, placing it on an annual run rate of about 40,000 kilograms. That's not even a tenth of what it should be at its peak; yet the market is valuing the company as if it's already running on all cylinders.
2. Cannabis shortages are a short-term worry
Second, but also building on the first point, we're already witnessing weed shortages in select provinces just days after legalization. This really shouldn't be a surprise to anyone, as similar scenarios have played out in a handful of adult-use-legal U.S. states. Though demand is strong, and that's a generally good thing for per-gram dried flower prices, marijuana growers simply can't produce enough at the moment to meet that demand. This could result in growers like Canopy Growth leaving money on the table in the near term.
3. Oversupply is a long-term concern
Perhaps a bigger worry is what'll happen over the long run to dried flower pricing. Based on what little precedence we have from select U.S. states, such as Colorado, Washington, and Oregon, growers will produce without any regard for actual consumer demand. This leads to rampant oversupply.
In Canada, growers like Canopy are angling to export much of their oversupply to foreign markets where medical pot is legal and grow industries are nascent or nonexistent. But there's no guarantee that these foreign markets will be able to absorb all of Canada's oversupply. Additionally, by the time Canadian growers are operating at peak capacity, these foreign markets may have cannabis grow industries of their own up and running. In short, there's a good chance that per-gram dried flower prices decline over time, which could hurt operating margins.
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4. The black market could eat into sales
Investors should understand that the black market isn't going away, even with Canada's generally low excise tax of roughly 10% on recreational marijuana sales. Though this excise tax is well below what consumers pay for alcohol products in our neighbor to the north, illicit producers don't have to pay excise tax or federal income tax.
Black-market growers and retailers also don't have to pay cultivation license or sales permit fees, or wait to receive approval from Health Canada to grow and sell cannabis. Illicit producers should be able to regularly undercut legal channels on price, which could adversely impact the sales potential of growers like Canopy.
5. Dealmaking is about to slow
Sure, Modelo and Corona beer maker Constellation's investment in Canopy Growth could prove game-changing, but we're also not going to see any additional investment in the company in the interim. Constellation's board of directors keeps a pretty tight lid on the company's use of leverage, and in the press release announcing its investment in Canopy, it was clear that no additional investment is likely to be made for a while. Even if Constellation decides to buy Canopy Growth outright (assuming the marijuana industry is everything it's cracked up to be), this isn't going to happen for years down the road.
6. Losses are expected to continue
News flash: Now that recreational pot is legal, profitability matters! Having moved beyond the promises stage, investors are eager to see tangible sales and profit growth, which they simply may not get from Canopy Growth.
There's absolutely no question that Canopy will deliver impressive top-line growth, thanks to its ongoing capacity expansion and superior sales channels. But Canopy is also busy building up its brands, marketing its products, and laying the groundwork for its international infrastructure. All of these things take time and cost money -- so much so that Canopy Growth isn't expected to be profitable in fiscal 2019, according to Wall Street's consensus estimate. With little to offer from a fundamental perspective, Canopy could be worth avoiding.
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7. History says you're smart to stay on the sidelines
Finally, every new "big investment trend" over the past quarter century has gone through a boom-and-bust cycle, and marijuana stocks aren't likely to be any different. Whether we're talking about the internet, business-to-business commerce, 3D printing, or blockchain technology, the bubble eventually burst.
The good news is that there should be clear long-term winners, and Canopy Growth may very well be one. But in the meantime, it's going to take years for the industry the mature and these winners to be determined. That could mean a substantial decline in the valuations of marijuana stocks, including Canopy Growth Corp.
