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3 Marijuana Stock Risks No One Is Talking About

By Sean Williams - Nov 18, 2018 at 7:21AM

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Are pot stocks doomed to go up in smoke?

This has truly been a year to remember for the marijuana industry. The biggest event of the year is unquestionably the legalization of recreational pot in Canada on Oct. 17, 2018. Having promised to greenlight adult-use weed for years, Prime Minister Justin Trudeau held true to his word. When the industry is fully up to scale toward the beginning of the next decade, it could be generating in excess of $5 billion in added annual sales.

But this is far from the only news that's made headlines in 2018. We've witnessed two new states -- Utah and Missouri -- legalize medical marijuana in the United States and saw the first cannabis-derived drug get the thumbs-up from the U.S. Food and Drug Administration (FDA). And Canada-based Tilray became the first marijuana stock to IPO on a reputable U.S. exchange.

Multiple jars filled with dried cannabis on a countertop, with one spilling over.

Image source: Getty Images.

Everyone is overlooking these risks

As I said, it's been a busy year -- and it's well reflected in the rising share prices of pot stocks since the beginning of 2016.

However, despite their incredible growth prospects, marijuana stocks aren't without risks. Many of these risks have been well-documented, but some are flying so far below the radar that practically no one is talking about them. Here are three of these top under-the-radar risks.

1. Fair-value adjustments swing both ways

One thing all investors need to be aware of when investing in Canadian-based marijuana stocks is that they report their income statements using International Financial Reporting Standards (IFRS), which differs from traditional GAAP reporting that investors in the U.S. are accustomed to.

As agricultural companies reporting under IFRS accounting, marijuana growers are required to recognize the fair value of their biological assets (i.e., cannabis plants) throughout their grow cycle. Remember, cannabis plants can have different values based on whether they're in the process of growing, are flowering, or have been harvesting and/or processed. It's up the growers to assess this value, as well as the estimated cost to sell these assets. That's right... pot stocks have to guess what their cost of goods sold will be prior to actually selling their product.

A magnifying glass being held over a publicly traded company's balance sheet.

Image source: Getty Images.

As you can imagine, this can lead to some wild fluctuations in the fair value of these assets from one quarterly report to the next. In recent quarters, capacity expansion has led to a surge in fair-value recognition, pushing profits for marijuana stocks arbitrarily higher. For example, Aphria (APHA) recently reported a gross profit of 8.5 million Canadian dollars, which included CA$13.3 million in sales and approximately CA$4.8 million in production costs. However, fair-value adjustments to inventory and biological assets ultimately wound up adding CA$5.3 million to Aphria's gross profit.

The thing is, fair-value adjustments can swing both ways. Although capacity expansion has favored positive adjustments in biological asset valuations, this won't always be the case. Downward revisions could wind up stealing the thunder away from rapid sales growth for pot stocks. Companies like Aphria have yet to deliver an operating profit, and a downward adjustment in fair value could come back to sting investors.

2. Lawsuits

It probably goes without saying, but lawyers love Wall Street. Any time there's even the slightest question that a public-traded company's management team or board didn't act in the best interest of investors, it's an invitation to attack, so to speak. Lawyers especially love high-flying bubbles, and the marijuana industry may very well be one.

To be perfectly clear, the marijuana industry is now a viable business model. Within a few years, there will be winners that should go on to be successful over the long run.

A judge's gavel next to a pile of dried cannabis buds.

Image source: Getty Images.

But at the moment, all investors have is a boatload of promises from pot stocks that they'll produce "X" amount of cannabis at peak production or have "Y" partners and "Z" unique products. It could be argued that the bulk of pot-stock gains up to this point have been based almost entirely on promises -- and promises are easy to break or fall short of in the financial world.

If marijuana stocks fail to live up to expectations, it wouldn't be surprising to see these stocks deflate significantly. Each and every "next big thing" prior to cannabis -- e.g., internet business-to-business, genomics, blockchain technology, and 3D printing -- saw its bubble burst, and pot stocks will likely follow the same path. When this bubble does burst, lawsuits could follow. The long-term overhang and expenses associated with legal action could prove devastating to marijuana companies that value their cash above all else.

3. Long-term dilution

Third and finally, you've probably heard skeptics talk about the impact of share-based dilution on marijuana stocks, but have likely paid little attention to its longer-term impacts.

For instance, yours truly has regularly harped on Aurora Cannabis (ACB 8.70%) for its aggressive expansion efforts. Since the year began, Aurora has announced a brand-new construction project in Medicine Hat, Alberta that'll span 1.2 million square feet. The company also completed the two largest cannabis deals in history: the $852 million purchase of CanniMed Therapeutics and the more than $2 billion buyout of Ontario-based MedReleaf.

An accountant chewing a pencil while closely examining figures from his printing calculator.

Image source: Getty Images.

To finance these ventures, Aurora Cannabis has liberally used its common stock. The CanniMed deal was completed mostly in stock, with the MedReleaf transaction entirely in shares. Such a move immediately balloons the company's outstanding share count, thereby weighing on its share price and making it that much harder for the company to generate a meaningful per-share profit. Between Jun. 30, 2017 and Sept. 30, 2018, Aurora's outstanding share count soared from 366.5 million to 961.8 million.

But here's the thing: It's not done going up just yet. In addition to financing its acquisitions predominantly with stock, the company has engaged in multiple bought-deal offerings to raise capital. Selling stock creates an immediate bump up in the outstanding share count, but offering convertible debentures, stock options, and/or warrants can lead to a surge in the company's outstanding share count over many years.

As of the end of Aurora's first quarter, it had nearly CA$200 million in outstanding convertible debentures and almost 22.9 million share purchase warrants still available with 2020 or 2023 expiration dates. Translation: Aurora Cannabis' share count is going to head substantially higher, and that's going to have an adverse impact on the company's per-share profit potential.

Sure, the marijuana industry is growing like a weed, but there are plenty of overlooked risks that could wind up undermining investors.

Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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