This has been a year to remember for the cannabis industry. In October, Canada became the first industrialized country in the world to legalize recreational marijuana, paving the way for billions of dollars in added annual sales once the industry is fully up to speed. This legalization brings legitimacy to the table and should, over the long run, attract big investment dollars and partnerships.
We also witnessed plenty of success in the United States, with residents in two additional states voting to legalize medical pot in November. In total, 32 states have given the green light to medical marijuana in the U.S., along with 10 that allow adult-use weed.
And yet despite this success, marijuana stocks themselves have had a miserable year. The very first publicly traded pot ETF, the Horizons Marijuana Life Sciences ETF, has lost around a third of its value since the year began. Worse yet, things may not improve much in 2019. Here are five reasons pot stocks could deliver another subpar performance in 2019.
1. Earnings matter now, which is bad news
For starters, operating results actually matter now that cannabis is legal in Canada, and that's not necessarily a good thing for an industry that's thrived on promises to expand capacity, grow product portfolios, and forge partnerships. With the need to actually deliver on the bottom line, many pot stocks will likely disappoint Wall Street and investors.
For example, Canopy Growth (NASDAQ:CGC) is widely viewed as the premier cannabis name on Wall Street. It'll likely slot in as the second-largest grower by peak annual yield at 500,000 kilograms, boasts a major investment partner in Constellation Brands (NYSE:STZ), has what's arguably the most recognized brand throughout all of Canada (Tweed), and has a bounty of sales channels at its disposal. And yet it's probably going to lose money hand over fist in fiscal 2019. That's because Canopy Growth is in the process of completing its capacity expansion, marketing its brands, extending its reach to new markets, and making acquisitions. Even with rapid sales growth, Canopy is liable to lose a lot of money on an operating basis in the near term.
In Canopy Growth's most recent quarter, it recorded a whopping operating loss of 214.6 million Canadian dollars, which ballooned even further to more than CA$330 million once one-time benefits and costs were included. Fiscal year-to-date losses are now up to CA$421.6 million. While investors were previously able to turn a blind eye to such poor operating performances, that's not going to be an option in 2019.
2. Supply shortages will constrain potential
Sure, marijuana stocks are increasing their production capacity at a very rapid pace, but there's no guarantee that they'll be able to plant their crops or sell their harvest anytime soon. That's because of the red tape surrounding the cultivation license and sales permit process with Health Canada.
According to an analysis from Marijuana Business Daily back in May, Health Canada had received well over 500 cultivation license applications that it had to review and either approve or deny. These take months or even years to review. Then, assuming a grower receives the green light to plant cannabis, they may have to wait a while for the sales permit. On average, it was taking 341 days for sales permits to be approved back in May, with the fastest on record still taking about four months from permit filing to approval.
Following the official legalization date of Oct. 17, it took just hours in some provinces for product to run out. At the moment, more than half of all provinces and territories in Canada are contending with some degree of cannabis shortage, and it looks unlikely to abate anytime soon. That means sale and profit estimates for pot stocks are probably too high, which'll lead to disappointment next year.
3. The black market is here to stay
You may not want to talk about it, but the black market is going to make its presence known in 2019. If cannabis shortages do persist, as is the expectation at this point, it wouldn't be a surprise to see consumers turning to the black market to fill the void, so to speak.
Not only does Health Canada's red tape create an opening for a black market that was otherwise on its heels leading up to legalization in October, but it further emphasizes the cost advantages that illicit pot growers can bring to the table. Namely, black-market operators don't have to pay the 10% excise tax, they won't owe any federal income tax to the Canadian government, and they don't have to wait for approval from Health Canada to grow or sell their cannabis.
The black market can consistently undercut legal sales channels on price, which means it's not going anywhere. And if illicit growers are here to stay, it means, once again, that sale and profit estimates for marijuana stocks are probably too high.
4. Not all brand-name companies are sold on legal weed
Fourth, even though we've witnessed a handful of brand-name equity investments and deals in 2018, don't count on there being a rush to partner with cannabis companies in 2019.
The deal you're probably most familiar with is Corona and Modelo beer maker Constellation taking a 37% equity stake in Canopy Growth for $4 billion. More than just angling to develop infused beverages, Constellation's massive equity stake in Canopy signals its expectation that legal weed will be a long-term, high-growth industry. But not all brand-name beverage, tobacco, and pharmaceutical companies are sold on the weed industry.
In September, multiple news outlets reported that Coca-Cola (NYSE:KO) was in discussion with Aurora Cannabis (NYSE:ACB) to either make an equity investment in the company or create a partnership that would seek to develop new products, presumably including cannabis-infused beverages. There were plenty of reasons a tie-up between Coca-Cola and Aurora Cannabis would have made sense, such as Aurora's market-leading peak production potential and Coca-Cola's deep pockets and marketing expertise.
Ultimately, however, Coca-Cola chose not to invest or partner with Aurora, or with anyone for that matter. Instead, its management team is simply watching from the sidelines. This is a view that many brand-name companies could take as the pot industry attempts to find its footing in the early going.
5. Share-based dilution
Last but certainly not least is our old nemesis: share-based dilution.
As a refresher, access to nondilutive forms of financing has been very limited for pot stocks, even in the postlegalization environment. Banks have simply not wanted to take on the risks of facing financial and/or criminal penalties by offering loans or lines of credit to marijuana companies. This has resulted in pot stocks turning to bought-deal offerings for capital.
A bought-deal offering involves the sale of common stock, convertible debentures, stock options, and/or warrants in order to raise capital. The sale of common stock, or using common stock to finance an acquisition, leads to an immediate uptick in a company's outstanding share count. Meanwhile, convertible notes, options, and warrants can lead to a steady increase over many years. This has the effect of diluting the value of existing shareholders as well as weighing on earnings per share, since there are more shares to divide net income into.
Aurora Cannabis, arguably the biggest diluter of all, could see its share count eclipse 1 billion when it next reports its quarterly results. For context, it had just 16 million shares outstanding less than five years ago.
In sum, things aren't as green as you might expect for the marijuana industry heading into the new year.