Since the beginning of 2016, marijuana stocks have been on fire, and it's not hard to understand why. Just over three weeks ago, on Oct. 17, Canada became the first industrialized country in the world to legalize the sale and use of recreational cannabis.
Although recreational weed is generally a lower-margin market than medical pot, it has a considerably larger consumer pool, thus offering a much bigger long-term sales opportunity. Just how big? Although that's still very much up to interpretation, with no other country the size of Canada having legalized adult-use marijuana before, Wall Street and investors are looking for legal cannabis to blossom into a multibillion-dollar industry in Canada within just a few years. This is why pot stocks have ascended to the heavens in recent years.
Marijuana stocks have been on an acquisition binge
Of course, it's not just marijuana stock investors who have been angling for their piece of the pie. The marijuana companies themselves have been busy expanding their capacity, diversifying their product lines, forging partnerships, and making acquisitions, all in an effort to improve differentiation from their peers and bolster their long-term growth and profit outlook. In fact, most pundits would agree that mergers and acquisitions are going to be necessary to thin out what's a very crowded field.
Pretty much all of the largest cannabis deals in history have occurred since the beginning of the year. While I won't list them all, here are some of the more notable deals:
- In May, Aurora Cannabis (ACB -3.65%) completed what was, at the time, the largest cannabis acquisition in history when it gobbled up CanniMed Therapeutics for $852 million. CanniMed brought new capacity into the fold for Aurora, as well as added a new line of alternative cannabis products (i.e., cannabis oil softgel capsules).
- In July, Aurora Cannabis was at it again -- this time with the largest acquisition in marijuana history. Aurora completed its purchase of Ontario-based MedReleaf for more than $2 billion, gobbling up an estimated 140,000 kilograms of peak production when at full capacity, as well as a number of well-known, high-quality cannabis brands.
- In March, Aphria (APHA), which recently uplisted to the NYSE, completed its acquisition of Nuuvera for 425 million Canadian dollars. What's unique about Aphria's purchase of Nuuvera is that it didn't do anything to boost the company's existing capacity. Rather, Nuuvera was well positioned in eight markets where Aphria wasn't currently operating, which meant it was a quick way to buy the infrastructure needed to service foreign legal markets.
- In September, Canopy Growth Corp. (CGC -18.57%) closed on its CA$269.2 million deal to acquire Hiku Brands. The purchase by Canopy Growth signaled its desire to attract adult-use consumers, as well as marked the shift away from capacity expansion and toward brand building. Canopy Growth already has what's arguably the best known brand in Canada, Tweed, in its product portfolio.
The list could easily go on, but this offers an overview of the aggressive dealmaking that's been ongoing in the space in recent months.
Investors are being set up to fail
Publicly traded pot stocks and many of their investors would argue that these deals add significant value toward the bigger picture. However, they may also be setting investors up for disaster.
According to new data provided by Dealogic, as reported by BNN Bloomberg, a majority of the $5.3 billion in year-to-date cannabis deals have been conducted entirely by using common stock. According to Dealogic, 69% of year-to-date marijuana deals were paid for entirely in stock, with 30% being cash-and stock deals, and just 1% being all-cash deals. Comparatively, just 17% of global mergers and acquisitions have been financed using only shares this year, compared with 54% being all cash. The remaining 28% (figures don't add to 100% because of rounding) were cash-and-stock deals.
Based on the listed deals, Aurora Cannabis acquired CanniMed Therapeutics in a cash-and-stock deal (most of which was a stock component), and purchased MedReleaf entirely with common shares. Meanwhile, Aphria bought Nuuvera in a cash-and-stock deal (again, with a very small cash component), whereas Canopy Growth's acquisition of Hiku Brands was entirely completed with shares.
What's the big deal, you ask?
For starters, this is an industry that's just getting off the ground. It's crowded, and there's basically zero clarity on which companies will emerge as winners. As investors, we know that not every company will thrive. Yet, here are these top-tier pot stocks gobbling up unproven business models left and right. It's very possible that a number of these acquisitions could prove to be rotten eggs within a few years.
However, the bigger issue is what these share-based deals could do to the bottom lines of these marijuana stocks. With each new deal (and bought-deal offering) the outstanding share count for these stocks balloons higher. As their outstanding share count rises, it not only puts pressure on stockholders, but also makes it that much harder for pot stocks to generate a meaningful per-share profit.
I may pick on Aurora Cannabis a lot, but it's a company that deserves a lashing for having increased its share count from 16.2 million at the end of fiscal 2014 to perhaps as much as 1 billion within the next few months. The company will need CA$100 million in net income just to deliver $0.10 in annual earnings per share, which would only be good enough for a price-to-earnings ratio of just under 100.
Long story short, the means by which marijuana stocks such as Aurora Cannabis, Aphria, and Canopy Growth, are approaching dealmaking could be setting up investors to fail.