The marijuana industry had an absolutely magnificent 2018, with major milestones throughout North America.
To our north, Canada became the first industrialized country, and only the second country overall aside from Uruguay, to have legalized recreational cannabis. Even though it'll take a couple of years for the industry's capacity expansion to be completed, this legalization should result in billions of dollars in added annual sales flowing into the pot industry. In other words, it legitimizes marijuana as a viable business model.
More validity was seen in the United States, where the U.S. Food and Drug Administration approved its very first cannabis-derived drug and President Trump signed the Farm Bill into law. The Farm Bill gives the green light to hemp and hemp-based cannabidiol (CBD) production. CBD is the nonpsychoactive cannabinoid best known for its perceived medical benefits.
With so many positives, you might be surprised to learn that marijuana stocks performed quite poorly in 2018. One such company that roared out of the gate but limped across the finish line is upscale dispensary operator MedMen Enterprises (NASDAQOTH:MMNFF). Over the trailing three-month period, shares of MedMen have fallen 23%.
Since this is one of the more visible names in the U.S. cannabis movement, the big question has to be: Should you buy MedMen in 2019? With valid arguments to be made from both sides of the aisle, let's have a closer look.
The "Apple of cannabis" belongs in your portfolio
Without a doubt, the most intriguing reason to add MedMen to your portfolio in 2019 is because of its acquisition of privately held, vertically integrated dispensary PharmaCann. Since the interstate transport of weed isn't legal in the U.S., per federal law, dispensaries like MedMen and PharmaCann need to also operate grow facilities in the states in which they have retail stores. This creates a vertical supply chain and helps to internalize costs while also keeping MedMen, PharmaCann, and other operators compliant with all applicable laws.
The $682 million deal, which would be the largest U.S.-based pot acquisition if it were to close, will combine MedMen's existing 48 retail licenses with PharmaCann's 18, leading to a current maximum of 66 licensed retail locations. For what it's worth, MedMen currently has 14 locations and, prior to its PharmaCann purchase, had been targeting about 50 open stores by the end of 2020. The combination would also see PharmaCann bring over eight production facilities, increasing the combined total to 13, and move the duo into 12 total states with an impressive addressable market.
Obviously, the excitement here is that MedMen would have a quick way to improve its U.S. exposure by doubling the number of states it's operating in. Coupled with its successful branding, this should send sales soaring.
That leads to the next reason MedMen could be worth buying in 2019: its branding. MedMen is looking to completely reshape how the American public views cannabis. Its easily recognizable stores and premium dried flower strains are clearly working, as the marijuana retailer has earned the nickname the "Apple of cannabis," since its sales per square foot of opened locations have averaged more than those of Apple stores. It's actually quite the accomplishment, and it demonstrates that the upscale retail concept works.
There's also plenty of room for expansion. In 2019, a number of states look to be on the verge of legalizing recreational weed, including New Jersey and New York. Meanwhile, a partnership with Cronos Group in Canada, which was forged prior to its going public via a reverse takeover last year, should allow MedMen to open its branded locations in our neighbor to the north.
It would seem there's ample opportunity for MedMen shareholders to prosper this year.
Kiss your money goodbye if you buy this stock
Then again, there are other signs that suggest buying MedMen could prove to be a very bad idea.
To begin with, Wall Street and investors have altered how they analyze marijuana stocks over the past couple of months. Prior to the legalization of pot in Canada, promises were often more than enough to get a marijuana stock moving higher. However, in a world where cannabis is no longer considered taboo, earnings results actually matter. That's not a good thing for MedMen Enterprises, which is liable to lose money hand over fist for the next year or two at minimum.
According to MedMen's fiscal 2018 operating results, it nearly doubled its sales to $39.8 million, but it lost a staggering $112.3 million, not counting a positive impact from a noncontrolling interest adjustment. As the company opens new stores, its general and administrative expenses are going to climb rapidly. This pretty much ensures that any fundamentally focused investors aren't going to be pleased with MedMen as it continues to produce losses.
Another big issue with MedMen (and the entire marijuana industry) is that there's minimal access to nondilutive forms of financing. Since most pot stocks are in the early stages of their development, operating cash flow is insufficient to drive expansion. Thus, the only significant means of raising capital is through bought-deal offerings or common stock issuances. Though selling shares does do the trick if a public company is looking to raise cash, it also balloons the outstanding share count, thereby weighing on existing shareholders and dragging down earnings per share (if a company is profitable). This share-based dilution will be especially prevalent given that MedMen is using its stock to cover the entire $682 million cost to buy PharmaCann.
A final concern would be competition. The U.S. could very well be the largest marijuana market in the world if the substance is legalized. But competition among dispensaries could be fierce. Not to mention, the Farm Bill's passage should open the door for nonmarijuana retail locations to carry hemp-based CBD oils. That's a product that had been exclusively sold through licensed U.S. retailers. Ultimately, the Farm Bill could hurt foot traffic and sales for dispensaries like MedMen.
So what's an investor to do in 2019?
On one hand, there's rapid sales growth and the expectation that MedMen will quickly grow in size once its PharmaCann deal closes. As long as MedMen continues to sell at a high level on a square-foot basis, there's no telling how profitable this company could become.
On the other hand, MedMen will continue to lose money and disregard shareholder value with the necessary evil that is dilution. It's for these reasons, and the expectation that MedMen may seek additional capital raises in the future as its expansion continues, that I'd suggest avoiding MedMen's stock in 2019.
Sean Williams has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.