The marijuana industry has blossomed before our eyes in a very short period of time. Having long been considered a taboo topic, cannabis is now a validated business model following the legalization of recreational weed in Canada this past October. It also doesn't hurt that two-thirds of all U.S. states have given the green light to medical marijuana in some capacity, and that more than two dozen countries worldwide now allow medical cannabis to be prescribed by a physician.
As the pot industry buds, big dollar figures are soon to follow. According to investment banks Jefferies and Cowen Group, global weed sales are projected to hit $50 billion by 2029 and $75 billion by 2030, respectively. That's a lot of money given that the global marijuana industry tallied less than $13 billion in legal sales in 2018, and it presumably has to go somewhere. That's why marijuana stocks have been so popular in recent years.
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Since the year began, the Horizons Marijuana Life Sciences ETF, the very first cannabis-based exchange-traded fund, has risen by 54%, through this past weekend. Of course, some marijuana stocks have done even better, such as CannTrust Holdings (CTST +0.00%), which is up 72% year to date.
Ontario-based CannTrust has clearly done a lot right to earn a market cap of roughly $900 million. However, it isn't quite at a level where I'd consider the stock to be a bargain for investors. Before I unveil the share price where I do believe CannTrust offers significant value, let me walk you through my thinking on both the buy and sell side of things.
Check out the latest earnings call transcript for CannTrust.
Understanding the buy thesis for CannTrust
Why should you consider buying CannTrust? The first answer is the company's top-tier production. Management has long been stating that this is a company that'll exceed 100,000 kilograms in peak annual production when running at full capacity. By my count, there are 11 growers (12 if you want to count Auxly Cannabis Group, which is more of a facilitator as a royalty company) on track to produce at least 100,000 kilos a year. These top producers should be logical candidates to land lucrative long-term provincial supply deals, as well as find partners in the beverage, snack, tobacco, and/or pharmaceutical industries.
But since production isn't everything, another very important reason to consider CannTrust for buy consideration would be its means of growth. Both of the company's core facilities -- its Niagara greenhouse and considerably smaller Vaughan facility -- employ hydroponic growing systems. This just means CannTrust is growing cannabis plants in nutrient-rich water solvents as opposed to soil. Since the company has relatively cheap access to nearby water and electricity, its unconventional grow operation may actually yield per-gram growing costs that are lower than the industry average.
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Building on this point, CannTrust is also utilizing moving containerized benches at its Niagara facility. In layman's terms, this just means that harvesting will be relatively constant at Niagara, rather than the lumpy planting-and-harvesting cycles you'd see with its peers. Management believes this should allow CannTrust to better meet the demand needs of its customers, be they retail, provincial, or overseas.
This is also a company that's recently made the move from the over-the-counter exchange to the New York Stock Exchange, which will lead to improved visibility, liquidity, and access to financing. It just so happens that shortly after making the move, CannTrust filed a shelf prospectus that'll allow the company to sell up to 700 million Canadian dollars (about $522 million) in debt securities, warrants, subscription receipts, or common shares over a 25-month period. Essentially, it means that cash is no longer an issue.
Why CannTrust should give investors reason to pause
On the other hand, there are reasons investors should consider sticking to the sidelines for a more attractive valuation with CannTrust.
To hit on the other side of the aisle, even though CannTrust no longer has any intermediate-term cash concerns as a result of its shelf prospectus, it also opens the door for common stock issuances. Now that marijuana is legal in Canada, we have seen a handful of non-dilutive deals completed with financial institutions. In this instance, CannTrust offers no reassurances to investors that common stock won't be the primary means of raising capital. And as we all know, issuing stock means dilution, which tends to weigh down existing shareholders and can push down earnings per share for profitable companies. Share-based dilution has plagued this industry, and CannTrust may prove no different.
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Arguably a more pressing issue was CannTrust's roughly six-month stalemate with the town of Pelham in Ontario over a phase 3 expansion at Niagara. Having already completed two phases totaling 450,000 square feet, CannTrust had planned to build an additional 600,000 square feet of hydroponic capacity. The company expected to start construction on this expansion during this past summer, but was halted by permitting delays with Pelham residents who objected to the expansion. In January, a resolution was reached to allow CannTrust a 390,000-square-foot expansion. Management suggests that it'll be leaning even more on technology to improve efficiency in this smaller approved expansion, but that 100,000 kilos in peak production is expected.
This monkey wrench in CannTrust's expansion plans is worrisome in two respects. First, it delayed the buildout of capacity for six months, which could allow the competition time to leave CannTrust eating their dust.
Secondly, CannTrust's management stated that the reduced Niagara expansion may cause it to look for outside acquisitions to hit 100,000-plus kilos a year. Translation: Higher production costs are likely imminent as a result of Pelham's permitting delays. Over the past 90 days, Wall Street consensus profit expectations for fiscal 2020 have dipped from CA$0.28 to CA$0.11 after the company announced the potential for acquisitions in order to hit its 100,000-kilo production target.
Here's the price where CannTrust becomes attractive
Now that you have a good idea of why I believe CannTrust is attractive over the long run, but also why I believe investors might want to pause in the interim, I can address the question at hand: At what price is CannTrust Holdings worth buying? Given all the above factors, I find the company to be attractively priced somewhere in the low $6 range.
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Within the pot industry, small caps have far less premium attached than the three or four brand-name pot stocks that investors can't seem to get enough of, so that's a positive for CannTrust. I'd also expect the company's existing 50,000 kilos of annual run rate to be produced at below industry average costs as a result of its hydroponic growing method and perpetual harvest system.
Conversely, I suspect the second 50,000-plus kilos in annual run rate that'll come online in about a year's time (perhaps sooner) is going to be at an above-average per-gram production cost. Additional technology investments in the phase 3 expansion at Niagara and the need to likely overpay for added capacity will weigh on the company's margins.
At a price in the low $6s, we'd see a company trading at roughly nine to 10 times next year's sales estimates and roughly 100 times earnings. Normally that would be a very rich valuation, but CannTrust's slower ramp-up than its peers means it'll be able to maintain a triple-digit annual increase in sales for a longer period of time. This would, hypothetically speaking, give CannTrust a PEG ratio of around, or perhaps just above, 1 -- and a PEG ratio of 1 is usually an indication of an "undervalued" stock.
Make no mistake about it, I like CannTrust a lot more than the popular mid- and large-cap pot stocks. But I believe the stock really begins to offer intriguing value to investors in the low $6s.
