The cannabis industry is literally budding before our eyes, and investors simply can't help but take notice. Nearly a month ago, following years of promises from Prime Minister Justin Trudeau and months of debate in the Senate, Canada became the first industrialized country in the world to legalize recreational marijuana. In doing so, it paved a path for the industry to generate $5 billion or more in added annual sales when running on all cylinders.
It's rare that we see an industry develop from a few hundred million dollars in sales to potentially $5 billion within a few years -- and investors know it. That's why pot stocks have been fancied by Wall Street, and it explains why valuations for marijuana stocks have gone through the roof.
Marijuana's "necessary evil"
Unfortunately, this rapid success can have its drawbacks. More specifically, the high-cost needs of pot stocks have resulted in a rash of bought-deal and shelf offerings throughout the industry. A bought-deal offering involves the sale of common stock, convertible debentures, stock options, and/or warrants to an investor or group of investors in order to raise capital. This money is what's used to pay for capacity expansion projects, international infrastructure, marketing, branding, and alternative product development.
On the one hand, this money is being put to use in an industry where market share has yet to be determined. There's therefore the belief that spending aggressively now will lead to healthy market share in the future.
Then again, these share issuances can have a negative impact on shareholders. To begin with, they can weigh down the existing value of a company's shares. Perhaps more importantly, a rising outstanding share count can make it that much harder for a company to generate a meaningful per-share profit. In other words, these capital raises have become something of a necessary evil for marijuana stock investors.
Get ready for dilution
Last week, another marijuana stock took its turn in announcing a dilutive event. Quebec-based HEXO Corp. (HEXO) announced on Friday that it had filed a preliminary prospectus to "make offerings of up to $800 million [Canadian dollars] of common shares, warrants, subscription receipts and units or a combination thereof of the Company from time to time." The company's shelf offering would be good for a period of 25 months, giving HEXO the unique flexibility to raise capital as it saw fit.
What's craziest about this shelf offering is that, at CA$800 million, it represents close to 70% of the company's current market cap in Canada. In other words, HEXO could wind up dumping the equivalent of more than 125 million shares of stock on the market in order to raise money. In doing so, it would almost certainly hamper its ability to generate meaningful earnings per share in the near term.
To be clear, HEXO does have valid reasons to consider raising capital. It's in the process of boosting its capacity by 1 million square feet, which should be complete by the end of this calendar year. When fully up to speed, HEXO will be capable of 108,000 kilograms of peak production, placing it right on the borderline of the top-10 growers.
The company also formed a 57.5%-to-42.5% joint venture with Molson Coors Brewing Co. (TAP -0.40%), where Molson Coors has the majority stake. Although Molson clearly has deeper pockets than HEXO, the duo will be focused on creating a line of cannabis-infused beverages. Interestingly enough, cannabis-infused beverages aren't yet legal in Canada, but the industry widely expects Parliament to increase consumption options to include infused beverages, edibles, vapes, and concentrates by next summer. Having plenty of capital on hand will be important to maximize its joint venture with HEXO.
But at the end of the day, these capital raises are going to be to the detriment of investors in the near term.
HEXO isn't alone
And don't think for a moment that I'm just picking on HEXO here. Pretty much the entire industry, minus some of the newly public pot stocks, are guilty of drowning investors with bought-deal and shelf offerings.
For instance, vertically integrated weed company Auxly Cannabis Group (CBWTF 13.51%), which reported its quarterly results earlier this week, had fewer than 185 million shares outstanding as of Sept. 30, 2017. Fast-forward one year later and its share count has more than tripled to almost 565 million. Auxly's investors have seen warrants exercised, convertible notes changed into common stock, shares issued to raise capital, shares issued to complete an acquisition, and shares issued to exercise stock options. Auxly has hit shareholders from every which way, and it's weighed down the company's share price. And while this capital raise is necessary if it's to meet its long-term goals of becoming a leader up and down the marijuana supply chain, Auxly isn't doing investors any favors in the meantime.
This case isn't unique. The same can be said for Aurora Cannabis, Cronos Group, and pretty much every major pot stock. Bought-deal and shelf offerings are the silent killers of shareholder value, and investors need to be aware of their existence.