The Big News That's Moving Marijuana Stocks Higher

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Canopy Growth (CGC -1.90%) is the first cannabis company to take advantage of a new path to do business in the U.S., but it's unlikely to be the last. The recent Farm Bill removes hemp from the controlled substances list, providing the first opportunity for large, Canadian marijuana stocks to do business in America. How big of a deal is this? Analyst Shannon Jones is joined by Todd Campbell to discuss Canopy Growth's plans. 

Also, they discuss what Aurora Cannabis (ACB -6.53%) preliminary quarterly results tell investors about Canada's new recreational market and how Cronos Group's (CRON 1.01%) recent tie-up with tobacco giant Altria (MO 0.81%) puts it in an envy-inspiring position to profit from widespread legalization.

A full transcript follows the video.

This video was recorded on Jan. 16, 2019.

Shannon Jones: Welcome to Industry Focus, the show that dives into a different sector of the stock market every day. I'm your host, Shannon Jones. Today is Wednesday, January the 16th. We're talking Healthcare. I'm joined in the studio via Skype by healthcare guru Todd Campbell. Todd, how are you?

Todd Campbell: Hi, how are you today? It's great to be back! It's going to be a packed, fun show today. We'll cover some topics that we haven't talked about in a little bit. I think our listeners are going to love it. 

Jones: Yes. Super excited for today's show. We're going to be covering some of the bigger news stories surrounding the marijuana industry. Todd, it's been a couple of months since we've gone through the top stories and what's happening in the industry. There's been a lot going on over these past couple of months.

Campbell: It's really fascinating. You might think that, given that share prices of most marijuana companies fell dramatically after the Canadian recreational market opened in mid-October -- "buy the rumor, sell the news" proving itself out yet again -- people might think, "Well, these stocks have been horrible. Nothing good is happening." But underneath the surface, it's business as usual. We've got companies that are reporting big deals that could have billion-dollar impacts down the road. 

Jones: Absolutely. For investors that may be hurting, those that wanted to be the first movers into this industry, certainly with the marijuana industry, it's still very a young industry that's budding -- excuse the pun there. It's growing, so there's going to be growing pains. But just like you said, Todd, it's business as usual. 

Talking about deals, let's start off with the more recent news. It was big news coming from the largest marijuana producer by market cap, which is Canopy Growth, ticker CGC. It now appears to have a pathway to the United States. That's really thanks to some crucial pieces of legislation that came on both the federal and state levels. I took a look this morning -- right now, Canopy is sitting on a hefty $14 billion market cap. The shares are priced right around $41 a share. Year to date, shares are up about 54%, vs. the S&P up about 4.3%. Todd, lots of good news happening for Canopy Growth. Is it true? Is Canopy Growth coming to America?

Campbell: [laughs] Yeah, and we're not talking about the 80s Eddie Murphy movie, for anybody who's been around the block --

Jones: [laughs] And potentially a reboot coming for Coming to America! Which I'm super excited about! One of my favorite movies. But, I apologize, I digress. 

Campbell: The big news here is that Canopy Growth has long said, "Listen, we're not going to do business in the U.S." That's because cannabis is still illegal federally. Listing rules on stock exchanges in Toronto and New York say that if the business is illegal federally, you can't participate and still be on the exchange. So, they have long stated, "We're not going to do business in the U.S. until we find a legal pathway so that we don't run afoul of federal laws." 

They got their path. They got their path in December, Shannon, when the U.S. passed the newest, latest Farm Bill. That Farm Bill included some really important language tied to the legalization of hemp, which, as people may or may not know, is a low-THC strain of cannabis sativa. It's a strain of the same plant that marijuana comes from that does not have the same level of psychoactive activity that cannabinoid THC, normal traditional marijuana, has. Shannon, I'm sure you're going to dive into this little bit more. The Farm Act and the changes in the Farm Act open the door up now for companies to come in and start developing cannabis-based products that, up until now, couldn't have happened. 

Jones: Absolutely. Talking about the Farm Bill a little bit more, this was the 2018 Farm Bill, signed into legislation in December. Specifically doesn't change marijuana on a legal level. What it does is remove hemp. As you so well explained, hemp is very different than marijuana. There are actually a lot of differences. The main one, you mentioned, of course, is the levels of THC. For hemp, you're looking at THC levels below 0.3%. Marijuana THC levels can be anywhere from 15% up to 40% in terms of concentration level. So, you're talking about a product that has lower levels of the psychoactive ingredient that many people think of with the high that comes with marijuana. 

It's no longer scheduled, it's no longer a controlled substance in the United States. That opens the door wide open for all of these practical applications. Hemp has actually become a much more intriguing industry for a lot of investors apart from marijuana because of all the practical applications. We're talking about, of course, the oils, clothing, think about athletic wear. You already have some companies that have hemp in place of cotton in their clothing. You're talking about building materials, food products, skin creams. The list goes on and on. This has really opened up the door a whole lot in terms of practical applications. 

Also, it's interesting because hemp compared to marijuana in the court of public perception is much easier to be digested overall because it's not marijuana. It's not lighting up a joint. When you talk about oils and creams, and even vapes, in the court of public perception, people are much more willing to use these products than marijuana itself. I think this Farm Bill in and of itself has really opened the door wide open here in the United States.

Campbell: Right, by making it an agricultural commodity now, you have farmers that will be able to take advantage of all sorts of supports that are in place from the USDA to be able to dedicate more of their land back to growing hemp. You could see an explosion of hemp farming over the course of the next couple of years because of this change. It's a change that a lot of people have been lobbying for for a long time. According to the Congressional Research Service, I believe that the U.S. was the only developed nation that still listed hemp not as a crop but as a controlled substance like this. Finally getting on board with many other countries, including Canada, when it comes to hemp, and opening the door now, again, to a path for Canopy Growth to come into the United States, start developing products that contain the other chemical cannabinoids that are in hemp, specifically cannabidiol, or CBD, which is known to have more medicinal properties. CBD is what's behind the drug Epidiolex, which we've talked about on the show in the past. It's the drug that won approval from the FDA for use in epilepsy patients. A lot of excitement around the potential to create products containing CBD, whether it be beverages or edibles or vapes or whatever. 

As part of this, backing up a second to what's going on here with Canopy Growth, after that announcement, Canopy Growth said, "We think this provides us with the path we need." And then, sure enough, now we find out that they have inked a deal where they've received a license to process hemp in New York State. They plan on investing $100 million to $150 million into this industrial park that will be filled with hemp-based companies. It's like a hub of hemp innovation, if you will.

Jones: Very similar to where I got my start in healthcare, Research Triangle Park in North Carolina, where a lot of smaller biotechs are now housed. It'll be just like that, but for hemp in New York. Just like you mentioned, Todd, it does open up the door for U.S. farmers. And not only Canopy Growth, but many of the other large producers you'll also see benefiting from this. On both the federal and state level, good news there.

With all that's happening with Canopy, we'll have to wait and see, even on the industry level. Will other states follow suit when it comes to Canopy producing these products, these CBD-based products and hemp-based products? Can they distribute across state lines? There will be a lot of questions to watch moving forward. But, it's certainly a positive on the side of Canopy Growth right now. 

Campbell: The other thing to consider here, this is something that investors may not have really thought about, there are CBD products on the market today, but they're sold as nutritional supplements. There's no real controls, and as a result, there's a lot of variability in the amount of CBD that they claim is in a package and, when testing is done, how much CBD is actually in there. So, clearing this pathway through the USDA is going to open up all sorts of doors for companies to get serious about making sure they're using processes and practices that will allow them to consistently produce a product. When you pick it up one week, it's going to have the same exact flavor, taste, content of CBD or whatever cannabinoid is in it, as next week or the week before. I think that's really important to drive demand. 

Like you said, a lot of it's going to come down to how the government or regulators treat these goods. Will they just be limited to sale in New York? Will you be able to sell them across state lines? My assumption is they'll be able to sell across state lines. That would be great news for Canopy Growth because 38% of Canopy Growth is owned by Constellation Brands. Constellation Brands is one of the largest beer, wine, and spirits makers in the country. Their headquarters is in New York already. They've got plenty of branding experience, distribution experience, research experience -- all the things that would be necessary to take products that are made in New York and distribute them throughout the country. 

Now, in New York alone, I was speaking with Matt Karnes at GreenWave Advisors the other day, he thinks that the medical and recreational New York market for marijuana and marijuana products could be about $2.7 billion in five years. That's still incredibly significant when you consider that last year, Canada's recreational and medical sales only totaled about $1.6 billion. That state alone could generate out more total market opportunity than Canada did in 2018. 

Jones: Very good point there. I believe they're announcing the location for this new hemp industrial park in the next 100 days. I'm sure a lot of eyes will be on that, and I'm sure you'll hear more announcements moving forward from other marijuana companies.

Let's shift gears and talk about the second company making headlines. That second company was none other than Aurora Cannabis, ticker ACB. They released their preliminary Q2 guidance last week. Todd, with that guidance, we're finally getting a sneak peek to see what exactly is happening on the sales side post this Canadian legalization.

Campbell: Right. This is their fiscal second-quarter numbers, but it would be of the calendar fourth-quarter results. As we already said, Canada's recreational market opened in the middle of October, so you've got a pretty good period of time now to get a feel for how that market may move the needle for these various companies. Aurora Cannabis is particularly important to watch because alongside Canopy Growth, they're arguably neck-and-neck for the biggest producer, in terms of production capacity and in terms of sales. 

While the results -- I'm sure you're going to talk about this in a second -- may have fallen shy of some people's expectations, they were still pretty impressive nonetheless. According to management, sales clocked in at between $50 million and $55 million. At least a $200 million run rate for Aurora Cannabis last quarter. For perspective, that's a 327% year over year. 

Jones: That's impressive, but still, Todd, not everyone was quite pleased with that. You alluded to it, but there were some analysts that were actually hoping to see sales much higher than that. They were looking for at least $67 million in Canadian dollars in terms of sales. Of course, they fell a little bit short of that. But, as you and I talked about before the show, there are so many factors that go into this. The first is the fact that, No. 1, the marijuana industry is so new, I think it's hard for analysts to get a good benchmark in terms of what sales should be. We're only looking at a couple of months' worth of sales coming out of the Canadian legalization. It's hard to set a benchmark, and it's even harder to set a benchmark for an industry that's so new. Also, there's supply issues going on on top of that, not necessarily the fault of Aurora. With any new industry, you're going to have logistics and distribution issues, too.

Campbell: We had so much demand in the first weeks when the recreational market opened up in Canada. A lot of products were out of stock. It was taking people weeks to get the products that they were ordering online. If they went to the shelves, there weren't many choices there. I think that you hit the nail on the head. You have to remember, people, when we think about consensus estimates about big U.S. companies, they can be based on 10, 15, 20 different analysts. The marijuana market is so young and so emerging, there aren't a lot of the big institutional analysts covering this industry yet. It's going to improve as time goes on. They'll get better at building their models, and those consensus numbers will get more useful. But for now, they're not quite as useful. I wouldn't put as much weight on them as I would, say, the consensus earnings estimates for a company like Altria. 

I think the thing to watch more for investors is the sales and growth run rates; what that translates into for operating margin, which we don't know yet. That wasn't released in the preliminary figures that were outlined. And, what that could mean for eventual profitability. The other thing I would keep an eye on is how quickly companies like Aurora Cannabis are growing their production to meet all the demand that's emerging, not only in Canada, but also in other markets like Germany. They did provide us with a little bit of insight into that. Production capacity in November was 70,000 kilograms per year. That was the run rate. Now, it's about 100,000 kilograms per year. Their expectation is that they'll reach a run rate of 150,000 kilograms, which is more than a doubling from November, by the end of their first calendar quarter, so, the third quarter of 2019. Rapid production there could provide the fuel that's necessary for even greater sales as we go forward. I expect that we're going to see that. I think a $200 million run rate probably undersells what we'll be talking about in six months. 

Jones: You talked about them beefing up their production capacity. We really won't see them hit peak capacity for at least another year, year and a half. There's still some ways to go. You also talked about margins. Aurora is also developing a series of products, like many of the others, that are higher-margin products beyond just marijuana itself. You're talking about the CBD oils, the vapes, a number of different things that they're actually investing in. I think you'll see both the top line and you'll see some margin expansion, as well. 

But that wasn't the only thing that Aurora announced. They also announced an acquisition of a specialty marijuana brand named Whistler. Todd, what can you tell us about that deal?

Campbell: Whistler was one of the first 10, I believe, to get granted licensed by Health Canada. It's a niche player. They make premium cannabinoid-type products, marijuana products. They have indoor facilities, which are typically more expensive, but you have greater control over your ability to produce a premium-type product. Their average prices are significantly higher than the average prices of marijuana that you would typically find, say, on any shelf in Canada or inside of a dispensary. This is an important move as far as trying to differentiate their product lineup. Like a lot of consumer goods companies, they have products that are at the entry-level point, they'll have products for the average person, and then they'll have these high-end premium products that will most likely offer better margins. 

One of the things that's interesting is, they alluded to how important developing value-added consumer goods could be to the profitability of these companies. Dried bud is a commodity. As we produce more and more and more, there's less of an opportunity for them to command really high prices. You could see price pressure like we saw in Colorado and Washington and some of these other states where marijuana is legal in the United States. That won't really be as big of a deal for these value-added products. If anything, it'll help their margins because they'll have lower input costs, especially if they're buying supplies from other growers. That will change a little bit with Whistler. Whistler has these high-end strains, so it can command a higher price than, say, traditional dried bud inside one of these stores. 

Jones: Absolutely. They're actually really highlighting the fact that Whistler is the first organic certified company. So, really going after that market that I think we can all safely say is the Whole Foods consumer of today. Whistler represents a really interesting opportunity. I think it was a $175 million deal. It wasn't typically one of those billion-dollar blockbuster deals that we're looking at here. I think it was a very smart move. Everything that you said, Todd. It really helps them start to differentiate. That will be key to pricing power moving forward with all of these marijuana players now. More to come. That'll be a key area to watch. 

I also think, moving forward with Aurora, just to level-set, we'll get their Q2 earnings, I believe that comes out on February 11th. We'll actually see exactly what they did and be able to dive into that a little bit further. But I think one of the key takeaways is, overall, this is still a new industry. You'll have to give it some time to allow the industry to mature. It's going to have growing pains, for investors out there that are sitting on stocks that maybe aren't doing that well. Be sure to keep up with the news, see what they're doing to differentiate their product lines. Take a look at their margins. Compare them to their peers. Really identify and see if you're, A, holding on to one that likely won't be around much longer because it will become just another commodity, like you mentioned, Todd; or, one that will truly have a product line that will drive top- and bottom-line growth for the long term.

Campbell: Wise, wise words. 

Jones: Our last major headline is going to take us back, again, to December. It's one I wanted to make sure that we covered, Todd. We got news of the second-largest marijuana deal. This was behind, of course, the Canopy-Constellation deal that we heard about in 2018. This is a deal between Altria, ticker MO, and Cronos Group, ticker CRON. Altria, the tobacco giant, parent company of Philip Morris, announced it would invest $1.8 billion into Cronos in exchange for a 45% stake in The Cronos Group, which has a portfolio of various marijuana investments and some joint ventures, including some smaller growers. Todd, what else is Altria getting in this deal? 

Campbell: This is a massive deal. This is something that a lot of people were wondering and have been wondering for the better part of a year, what other companies, specifically tobacco companies, might be interested in diversifying the portfolio away from tobacco and embracing the movement toward marijuana? Altria had been rumored for a while to be kicking tires alongside some of the other major alcohol companies and beverage companies. Coca-Cola was even mentioned. Altria was the one that made the big splash, though, with this deal.

They get the 45%, as you mentioned, of Cronos Group. They hand Cronos Group $1.8 billion, which is huge. That's massive financial flexibility that Cronos can use now to elevate itself into the leadership of this emerging industry. Altria also got a warrant that will allow it to buy an additional 10%, bringing its ownership to 55%. They can do that within four years at a price of about $19 Canadian per Cronos Group share. Right now, they're at 45%. We could go to 55%. Cronos Board of Directors has expanded from five to seven directors. Altria will get to nominate four of them. So, the majority of the members of the board will now be those who have been nominated by Altria. That's also useful to know.

This is also a very important deal because it came only about a week before Altria announced another huge deal. That was its $12.8 billion investment in the e-cig player Juul. They got 35% of Juul in that deal. Those who aren't familiar with Juul, Juul has about 30% of the e-vapor market. Now, it doesn't take a rocket scientist to see where Altria may be going with this! They may be looking at this and saying, OK, if the barriers to entry federally are falling in the United States, why wouldn't we want to have a company like Cronos that's on the cutting edge of being able to figure out how to extract not only CBD and THC, but the other hundred cannabinoids that are found in marijuana, to be able to include them in vapes that could be sold throughout the United States using our massive distribution marketing brand experience? I think that's maybe the end game. Again, we're still far away from that in terms of marijuana itself. But, it wouldn't shock me if Cronos was one of the next companies to join Canopy Growth and say that they're going to use the Farm Bill passage in December to enter the U.S. market to start creating hemp-derived CBD products. Whether or not those end up in Juul someday, we'll have to wait and see.

Jones: Totally agree on all fronts, Todd. This is such an interesting deal. Strategically, you really see the benefit to both companies in making this deal. What I like from Altria's perspective is the optionality. This is a risky industry to dive into. Obviously, it finally gets Altria a foot in the game in the marijuana space. But, with this 45% stake, which gives them the option to up that to 55% over the next four years, I love the fact that they're going to give the market and the industry some time to mature.

I also love the fact that Cronos Group is now also going to be the benefactor of the regulatory compliance know-how that Altria brings to the table. That couldn't be more important, especially as they start to dive into U.S. markets. Altria is known as the leader in tobacco when it comes to the U.S. markets. They're getting that. In addition, they're also getting the manufacturing expertise, scale of production, all of these things which I think are key to the underlying thesis with Cronos Group. Now, they've got a match made in heaven. 

You mentioned Juul. I talk about the regulatory know-how of Altria, but I just have to say, with Juul, some investors have probably been watching the news, it's got its own fair share of regulatory scrutiny from the FDA thanks to their vapes, which allegedly have been targeted toward teens with their fruity mango flavors and these vapes. That'll be interesting to watch, to see how they navigate that. It's certainly not the first time they've dealt with regulatory issues at Altria. I like the expertise and the experience that they're bringing to the table. 

Campbell: [laughs] Yeah, they've been there, done that, no question. If you look at Juul, they make the ones that look like a pod, it looks like a USB stick that you'd stick into your computer. They look less like traditional cigarettes. Altria had actually made a decision to stop selling its own pod vapes prior to entering the Juul agreement as a nod to the FDA, saying, "OK, we recognize that maybe these pods are much more attractive to younger people to smoke than, say, something that looks like they're smoking a regular cigarette, so we'll stop manufacturing those." The FDA has since come out after this deal was announced and said, "Shame on you," essentially, for going out and buying such a big stake in Juul and raising, again, those question marks. But, yeah, this is not new territory for Altria. I think they'll be able to navigate this. If they do navigate it well, there's obviously a tremendous amount of synergies.

The other thing that we didn't mention, Shannon, is that it's kind of a back-door way for Cronos Group to potentially get relationships going with Anheuser Busch. 

Jones: Yeah. They've got a 10% stake in Anheuser Busch. This certainly gives Anheuser Busch the actual opportunity to make a move into the cannabis-infused beverage area. That'll be a really interesting play. I'm sure all investor eyeballs are on that right now, Todd.

Campbell: Absolutely. This is going to be so much to watch. It's going to be a fast-growing market in 2019. Investors are going to want to be paying attention.

Jones: Wise, wise words. We'll certainly keep you updated on all the latest. 

In terms of Industry Focus, that's it for this week's show. Thank you so much for tuning in! As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Todd Campbell, I'm Shannon Jones. Thanks for listening, and Fool on!