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Marijuana Value Traps Do Exist: Here Are 3 to Avoid

By Sean Williams - Oct 5, 2019 at 10:51AM

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Two of these three pot stocks are trading below their book value, but that doesn't make them worth buying.

Investors would have a hard time finding an industry with more impressive long-term growth potential than legal cannabis. After generating close to $11 billion in worldwide sales last year, some on Wall Street foresee anywhere from $50 billion on the low end to as much as $200 billion on the high end in global sales by the end of the upcoming decade.

What makes this growth opportunity so exciting is the fact that marijuana stocks have, pardon the cliché, gone up in smoke over the past six months. The Horizons Marijuana Life Sciences ETF, the first exchange-traded fund focused on cannabis, has lost nearly half of its value over that time, which in investors' eyes may be creating some intriguing bargains throughout the pot industry.

On the other side of the coin, this decline in pot stocks could be creating bona fide value traps in an industry where the word "value" would have been almost laughable six months ago. Right now, there are three cannabis stocks that look to be incredible values, based on their price-to-book ratios, but are, in reality, nothing of the sort. Consider these three marijuana value traps as companies you'd be best off avoiding.

A hand reaching for a neat stack of hundred-dollar bills in a mouse trap.

Image source: Getty Images.

Aurora Cannabis

Among millennial investors, there isn't a more popular company on the planet than Aurora Cannabis (ACB -38.46%). Aurora is projected to be Canada's leading marijuana producer, with the potential for up to 700,000 kilos annually of peak output. It's also the top pot stock in terms of international reach, with a growing research or export presence in 25 countries, including Canada. At a mere 1.3 times its book value, Aurora Cannabis might look like a screaming buy. However, a deeper dive would reveal otherwise.

Arguably the biggest reason investors should be leery of Aurora Cannabis is the company's balance sheet. After making well over a dozen acquisitions over the previous three years, Aurora has racked up a frightening 3.17 billion Canadian dollars in goodwill, or premium above and beyond tangible assets. While it's possible that the company might be able to recoup some of this goodwill by developing the assets and monetizing the patents of the businesses it's acquired, the fact that 58% of the company's total assets are comprised of goodwill is a major red flag.

Also of concern is the fact that Aurora Cannabis has a CA$230 million convertible note coming due in March. Though the company does have some cash on hand, the conversion price is well above where Aurora is currently trading. This makes it far more likely that the company will have to redeem these notes with cash, rather than stock, and also increases the likelihood of Aurora issuing more stock to raise capital. Over the past five years, Aurora's outstanding share count has ballooned by 1 billion.

Lastly, it's worrisome that Aurora missed its own sales guidance in its fiscal fourth-quarter report, despite issuing that guidance a mere five weeks earlier. The company continues to lose money on an operating basis, and it's still not generating positive adjusted EBITDA, as was forecast during the calendar year first quarter.

There's no doubt Aurora has long-term potential, but for now, it's nothing more than a value trap.

A hand holding a magnifying glass over a company's balance sheet.

Image source: Getty Images.

iAnthus Capital Holdings

In terms of price-to-book ratio, no marijuana stock is cheaper than iAnthus Capital Holdings (ITHUF -8.23%). Currently, iAnthus is valued at only 41% of its book value.

Like Aurora, and pretty much every pot stock, there are redeeming qualities that are liable to attract investors to vertically integrated multistate operator iAnthus. Namely, it's one of the largest dispensary operators in legalized U.S. states, making it one of the beneficiaries of the state-level legalization movement. iAnthus has a presence in 11 states, including 27 open dispensaries, and licenses for around five dozen retail locations.

But not to sound like a broken record, the devil is in iAnthus' balance sheet details.

Earlier this year, the company acquired MPX Bioceutical in what was the largest U.S. marijuana deal to close at the time. Unfortunately for shareholders, iAnthus recorded the majority of the value of this deal as goodwill on its balance sheet. At the end of the company's June quarter, iAnthus had CA$440.7 million in goodwill and another CA$179.1 million in intangible assets, recorded on its balance sheet out of CA$811 million in total assets. Put another way, goodwill represents 54% of total assets, or a whopping 76% of total assets when combined with intangible assets. This looks like a writedown waiting to happen.

iAnthus also isn't anywhere close to profitability. The company's latest quarter featured a gross profit, before fair-value adjustments, of CA$9.2 million, which compared to operating expenses of CA$35.2 million. Its aggressive expansion plans likely means ongoing near-term losses and the possibility of more share-based dilution.

A large cannabis dispensary sign in front of a retail store.

Image source: Getty Images.

MedMen Enterprises

Lastly, investors would be wise to tread lightly around vertically integrated multistate operator MedMen Enterprises (MMNFF -3.17%), which is currently valued at 98% of its book value and less than 1 times Wall Street's consensus sales in 2020.

The MedMen investment thesis revolves around the company's early-mover advantage in select U.S. states, and its ability to normalize the cannabis-buying experience for more affluent consumers. MedMen is building, or expects to build, a plethora of retail locations in California and Florida, which should represent two of the three most lucrative markets by total cannabis spending in 2024, according to the State of the Legal Cannabis Markets report. It already has well over a dozen open retail stores in California, and has licenses to open up to 35 stores in the Sunshine State. 

However, MedMen is an absolute mess on the earnings front, which makes it an easy stock to avoid. Through the first nine months of fiscal 2019, MedMen lost $178.4 million on an operating basis (MedMen reports in U.S. dollars) -- and that's with the company actively reducing its general and administrative expenses.

What's more, MedMen is in the process of acquiring privately held vertically integrated dispensary operator PharmaCann in an all-stock deal. Though this'll double its presence to 12 states from six, it's also going to boost MedMen's near-term expenses and expansion costs. Even with an ongoing capital infusion from Gotham Green Partners, MedMen's capital situation looks somewhat dicey in the intermediate term.

Until MedMen demonstrates a serious turnaround on its quarterly income statements, this stock should remain off-limits for pot stock investors.

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Stocks Mentioned

Aurora Cannabis Stock Quote
Aurora Cannabis
$1.68 (-38.46%) $-1.05
iAnthus Capital Stock Quote
iAnthus Capital
$0.08 (-8.23%) $0.01
MedMen Enterprises Stock Quote
MedMen Enterprises
$0.08 (-3.17%) $0.00

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