The marijuana industry delivered a year for the ages in 2018. Although marijuana investors found themselves on the outside looking in, with most pot stocks ending the year down, the cannabis industry gained validity like never before.
When the curtain closed, Canada had become only the second country in the world (other than Uruguay), and the first industrialized nation, to have legalized recreational marijuana. Beginning Oct. 17, 2018, adults were able to purchase marijuana legally throughout Canada, laying out the red carpet for what should be billions of dollars in added annual sales in the years to come.
There's little doubt that the burgeoning pot industry offers plenty of opportunity for investors. The question remains: Which marijuana stocks to buy? Though I'd bet it's an increasingly unpopular opinion, my take on the current year is that it won't be very friendly to large, brand-name pot stocks. In other words, big is bad for pot stocks in 2019.
Now, I know what you're probably thinking, and you're partially right. Bigger marijuana stocks are well known, are predominantly listed on major U.S. exchanges that improve their liquidity allow for Wall Street investment, and have what look to be tangible competitive advantages over smaller peers. But there are a number of issues that could disproportionately impact bigger pot stocks in 2019 that have me believing they're largely worth avoiding.
Supply shortages reduce their competitive edge
One of the biggest problems for larger marijuana growers is that Canada's supply shortage minimizes their competitive edge. Sure, they may be able to grow a lot of marijuana at peak capacity, but regulatory red tape, along with the need to complete existing projects, is going to keep these giants from producing anywhere near their peak capacity for another one, two, or even three years.
Health Canada is perhaps the biggest obstacle of all, with more than 500 cultivation license applications in backlog, per Marijuana Business Daily, as of May, and the wait period for sales permits lasting more than 11 months, on average. Health Canada isn't going to work through this backlog overnight, creating a bottleneck for new production
Unfortunately, these big-name growers have been priced as if they'd be producing more than enough cannabis to meet demand once Canada legalized recreational weed. This hasn't been the case, and it's liable to result in disappointing sales projections as black market producers pick up the slack.
Share-based dilution comes back to bite
Since the biggest pot stocks have nowhere near enough operating cash flow to fund their capacity expansion projects, let alone new product development, an international push, and/or acquisitions, the biggest marijuana stocks have had no choice but to turn to bought-deal offerings to raise capital. A bought-deal offering involves the sale of common stock, convertible debentures, stock options, and/or warrants to an investor or group of investors to raise money.
The good news is that bought-deal offerings have provided plenty of capital to fund pretty much any project desired by brand-name marijuana stocks. The bad news is that bought-deal offerings lead to a ballooning share count, which then weighs down the share price of publicly traded companies and can reduce earnings per share if the company is profitable. What's more, since many of the largest pot stocks sold convertible debentures, options, or warrants, these instruments can be executed in the months or years to come, meaning share-based dilution is far from finished.
Aurora Cannabis (ACB -8.05%), which is on pace to be the largest marijuana grower by peak annual yield at 700,000 kilograms (in my best estimate), became the largest grower by making multiple acquisitions, and undertaking numerous organic construction projects. Aurora funded these projects with bought-deal offerings, and made most of its acquisitions entirely with common stock. As a result, Aurora's share count has skyrocketed from 16 million shares at the end of fiscal 2014 to almost 962 million shares by the end of the first quarter of fiscal 2019. This amount of dilution is seriously going to impede shareholder upside in the near term.
Operating losses continue
Building on the previous points, another reason to shun big pot stocks is that they're probably going to be losing a lot of money in 2019, even with their sales expected to soar.
In order to achieve those perceived competitive advantages, brand-name marijuana stocks like Canopy Growth (CGC -3.05%) have had to work on multiple aspects of their businesses. Canopy Growth is busy with capacity expansion, expanding internationally, bolstering its product diversity and branding, and making acquisitions. None of these processes are quick or inexpensive. That means Canopy Growth is liable to lose money in 2019, even with triple-digit sales growth.
According to Canopy's fiscal second-quarter report, its sales and marketing costs, and general and administrative expenses, totaled 167% and 159% of its total sales, respectively. On an operating basis, the company lost almost 215 million Canadian dollars. Although things could improve a bit as its top line expands, Canopy Growth will almost certainly end the year in the red.
Check out the latest Canopy Growth earnings call transcript.
It's also important to remember that a handful of the largest companies recently went public, which means they'll soon be facing their lock-up expiration. There's perhaps no better example than Canadian cannabis grower Tilray (TLRY).
A lock-up period describes a 180-day stretch following the initial public offering of a stock whereby insiders and pre-IPO shareholders are restricted from selling their shares. Considering that Tilray listed its shares at $17, then rallied to as much as $300 on an intraday basis just two months after its debut, there are probably plenty of insiders eager to take some gains. Even with Tilray losing three-quarters of its value since hitting its intraday peak, the stock has more than quadrupled from its list price.
When is Tilray's lock-up expiration? How about tomorrow, Jan. 15, 2019! Investors can expect added volatility and an increased likelihood of downside pressure as lock-up expirations hit newly public billion-dollar-plus pot stocks.
Biggest built-in premiums
Last, but not least, big-name marijuana stocks also have the largest built-in premiums. Therefore, in my view, they also have the most potential downside.
Take Cronos Group (CRON -5.26%) as a good example. Cronos galloped higher in December after Marlboro cigarette maker Altria announced that it'd be taking a $1.8 billion equity stake in the company. In terms of value, this works out to a 45% stake, with additional warrants giving Altria an opportunity to up its stake to 55%. But what investors are probably overlooking is just how little Cronos Group brings to the table for what could be a $4 billion-plus valuation, assuming closure of the equity investment.
This is a company with maybe 110,000 kilograms to 130,000 kilograms in peak cannabis output that'll have a lot of cash, but be producing as much as OrganiGram Holdings in New Brunswick on an annual basis, which has a market cap of around $550 million. Cronos Group, like Canopy Growth, is also busy expanding other aspects of its business, which means it'll either lose money or only be marginally profitable.
The point is this: Whereas brand-name pot stock have led the way until now, it's time for smaller, niche players to shine in 2019.