For years, the marijuana industry has been "kicking bud" and taking names. Between 2014 and 2018, the duo of Arcview Market Research and BDS Analytics finds that global licensed cannabis sales have grown from $3.4 billion to $10.9 billion, which gives validity that certain pie-in-the-sky sales projections offered up by Wall Street over the next 10 years are very possible. This growth has also played a big role in pushing pot stock valuations considerably higher.
But the luster of the green rush has worn off in a big way since the first quarter ended. Following a blistering increase of at least 70% for more than a dozen popular marijuana stocks in the first quarter, 25 pot stocks hit the skids and lost at least 20% in the second quarter. Since July began, this weakness has continued to persist.
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Investors' favorite pot stocks have been clobbered
Last week, the four most popular marijuana stocks on the planet -- Aurora Cannabis (ACB -2.96%), Cronos Group (CRON 0.41%), Canopy Growth (CGC -0.66%), and HEXO (HEXO) -- all either hit levels last seen in January 2019 or came very close to doing so.
Despite these four pot stocks being perceived as industry leaders, there are a handful of catalysts holding them and the industry back. Let's run down the current problems, one by one.
1. Health Canada will take a while to resolve Canada's supply issues
For anyone who has followed the launch of recreational cannabis in Canada since mid-October, you're likely well aware of the country's persistent supply problems. Much of this can be traced back to Health Canada and the arduous (and slow) process it undertakes when reviewing cultivation, processing, and sales licensing applications. Through this past weekend, Health Canada had approved fewer than 200 total licenses since 2013, yet it had more than 800 applications on its desk for review, as of the end of 2018.
The good news here is that Health Canada has introduced new rules to help reduce its application backlog. However, it's still going to be many months, if not multiple quarters, before the regulatory agency is able to completely work through its backlog and give more growers and processors the green light.
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2. High-margin derivatives won't hit dispensary shelves on time
Health Canada is also to blame for the delay in rolling out high-margin derivative cannabis products. Derivatives are nontraditional dried flower products, such as edibles, vapes, cannabis-infused beverages, concentrates, tinctures, and topicals. With the industry long expecting a mid-October 2019 launch, at the latest, Health Canada recently announced that derivatives are unlikely to reach dispensary shelves until mid-December and that the rollout would be staggered, much in the same way the launch of dried flower went last year.
Although we're only talking about a relatively short-term delay in the grand scheme of things, it's nevertheless big news when you're dealing with pot stocks that sport premium valuations. Cronos Group, for instance, expects to be reliant on vape sales and commercial cannabinoid production, whereas HEXO has more than 600,000 square feet of facilities set aside for extraction and manufacturing. This delay really hurts the margin prospects for both companies in the near term.
3. Profitability is still a ways off
In case you haven't noticed, earnings reports actually matter now for marijuana stocks. Even though Canadian weed stocks have been suffering with the aforementioned supply shortage, Wall Street hasn't exactly been forgiving of widening losses and sequential quarterly sales declines.
Canopy Growth and Aurora Cannabis, which have both been busy expanding their international presence, are expected to lose money in fiscal 2020, while Cronos and HEXO have seen Wall Street's consensus profit projections decline considerably for 2020 over the past three months. Sure, there's still plenty of sales growth potential in the quarters that lie ahead, but none of the most popular marijuana stocks are expected to be significantly profitable anytime soon.
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4. Share-based dilution continues to rear its head
Another persistent problem throughout much of the industry is share-based dilution. Despite Canadian cannabis stocks now having access to traditional forms of financing from banks, many are still leaning on share issuances to generate capital for organic projects or to fund joint ventures and acquisitions.
Aurora Cannabis, as an example, has made 15 acquisitions in just shy of three years. But over the past five years has seen its outstanding share count increase by a not-so-subtle 1 billion. Even with the added value of the businesses Aurora has acquired, it's difficult for longtime shareholders to absorb so many stock issuances without there being adverse impacts. If and when Aurora does push toward profitability, this sea of shares could really constrain its earnings-per-share potential.
5. Scandals aplenty
These popular cannabis stocks have also fallen victim to trust issues in the marijuana space. Most recently, CannTrust Holdings (CNTTQ) announced that it was noncompliant with Canadian cannabis regulations and was growing pot in five unlicensed rooms between October and March. Since the announcement of this wrongdoing, CannTrust has seen 12,700 kilos of inventory placed on hold, and operations have partially ceased while the investigation by Health Canada is ongoing.
The admission that CannTrust, a projected top-five grower, had skirted growing regulations likely means that there are other companies out there failing to follow the rules. While that doesn't absolve CannTrust of its blatant blunder, it does raise trust issues throughout the entire industry.
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6. No quick entrance into the United States
Despite strong public favorability toward legalization in the United States, it's looking increasingly unlikely that cannabis will be de-scheduled by the federal government anytime soon. Republican Senate Majority Leader Mitch McConnell (R-Ky.) hasn't allowed riders or stand-alone cannabis bills to reach the Senate floor for vote, which likely means no chance of reform until well into 2021.
That's bad news for all four of these popular pot stocks, as they all have plans to enter a U.S. market that would dwarf Canada in terms of total legal weed sales. Canopy Growth and HEXO have already announced their entrance into the U.S hemp market, with Aurora and Cronos expected to lay out their plans to do the same over the next year. While it's still a positive that these companies are getting processing infrastructure in place on U.S. soil, as well as building U.S. business relationships, real cannabis reform in the U.S. is still years away.
7. All bubbles eventually deflate
Finally, it's important for investors to recognize the nature of "next-big-thing investments."
As potentially the fastest-growing industry over the next five to 10 years, marijuana very much qualifies as a next-big-thing investment. And this is why cannabis stock valuations have skyrocketed in recent years.
But investor expectations have a way of always outpacing actual results, at least in the early going for these up-and-coming fast-paced industries. The cannabis industry is going to need time to mature, and that probably means more bumps than investors in this space have been accustomed to in recent years.
