For years, the marijuana industry has been an unstoppable force. Many of marijuana's biggest and best-known names have delivered substantial gains for investors, driven by aggressive growth projections for the pot industry.
After logging $10.9 billion in global sales last year, the duo of Arcview Market Research and BDS Analytics has forecast a practical quadrupling in worldwide weed sales by 2024. Wall Street has taken things a step further by calling for as much as $200 billion in global cannabis revenue per year by the end of the next decade. Such a scenario probably includes the legalization of marijuana in the U.S., the crown jewel of the cannabis movement.
On paper, everything looks great. But there's been a pretty big gap between expectations and reality in the pot industry since the end of March.
The green rush went up in smoke in a big way in Q3
For the past six months, marijuana stocks have been in a sizable funk – and things just keep getting worse. During the third quarter, the Horizons Marijuana Life Sciences ETF, the first exchange-traded fund focused on cannabis, lost 34% of its value, inclusive of dividends paid. However, it's the thorough beating that brand-name pot stocks took over the past three months which has really stood out.
Marijuana's "Big Four" -- Canopy Growth (NASDAQ:CGC), Aurora Cannabis (NYSE:ACB), Cronos Group (NASDAQ:CRON), and Tilray (NASDAQ:TLRY) -- collectively shed close to $14 billion in market value during the third quarter. To be more specific, aggregate market cap losses in Q3 2019 shook out something like this:
- Canopy Growth: $6.05 billion.
- Aurora Cannabis: $3.49 billion.
- Cronos Group: $2.33 billion.
- Tilray: $1.77 billion.
The magnitude of these losses is even more impressive when considering that Canopy and Cronos have the respective highest and second-highest cash balances on hand, with Aurora Cannabis also exceptionally well-capitalized with a $750 million shelf offering at its disposal, should the company need it. In other words, cash isn't the downside buffer it was as recently as six months ago for the pot industry.
Let's take a closer look at what, specifically, has drained a mammoth amount of value out of marijuana's Big Four.
Canadian supply issues
The entire Canadian pot industry has been reeling since day one of legalization in October 2018 because of persistent supply issues. Some of these problems are self-inflicted, with growers waiting too long to begin capacity expansion projects. The Aurora Sun grow farm, for instance, will be a monster with 230,000 kilos of peak annual production for Aurora Cannabis. However, it's not going to be fully operational until around the midpoint of next year.
The bigger problems have been procedural, with regulatory agency Health Canada buried in licensing applications. Even with changes to how growers apply for cultivation licenses, there's no quick remedy to the supply issues that the Big Four are contending with. In fact, Aurora mentioned this in its fiscal fourth-quarter operating results, with certain supply issues being out of the company's control.
In addition to Health Canada, certain provinces have been slow to license physical dispensaries, further delaying the ability of product to reach consumers. The demand is clearly there; unfortunately, it's being met by black market cannabis, for the time being.
No tangible profits
Building off the previous problem is that a lack of supply, and therefore a lack of sales, has led to some pretty ugly income statements.
Canopy Growth produced an abysmal 15% gross margin in its fiscal first quarter, as well as totaled an operating loss, without fair-value adjustments and one-time benefits and costs, that would have exceeded 215 million Canadian dollars. The largest pot stock in the world's cannabis revenue has essentially run in place for two consecutive quarters.
Meanwhile, Cronos Group has turned two consecutive quarterly profits, albeit with a major asterisk. That's because Cronos Group's profit was the result of revaluing its derivative liabilities tied to an equity investment from Altria. If investors simply remove the icing from the cake and focus on the company's operations, Cronos Group continues to lose money where it matters most.
Neither Canopy, Cronos, Aurora, nor Tilray looks as if it'll be profitable in fiscal 2020.
An increasing likelihood of writedowns
This weakness in the Big Four can also be blamed on rising goodwill. Goodwill being the premium a purchasing company pays for another company, above and beyond tangible assets. While some amount of goodwill is common during an acquisition, the amount being racked up by some pot stocks suggests that they're grossly overpaying for their deals.
As an example, Aurora Cannabis has made more than a dozen acquisitions over the past three years, and in many instances has recorded a large chunk of these deals as goodwill. The biggest red mark being the roughly CA$2 billion in goodwill derived from its CA$2.64 billion deal to buy MedReleaf, which closed in July 2018. Aurora is now carrying CA$3.17 billion in goodwill on its balance sheet, representing 58% of its total assets. The likelihood of Aurora recouping all of this goodwill is slim, in my opinion, making a future writedown likely.
On top of Aurora's mammoth goodwill, Canopy Growth has CA$1.93 billion in goodwill following a slew of acquisitions, and Tilray now sports $155 million in goodwill after its Manitoba Harvest purchase (Tilray reports its figures in U.S. dollars). These are all candidates for possible writedowns in the future.
Growing intolerance to dilution
I believe it's also fair to assume that investors have grown tired of the constant dilution that comes with owning cannabis stocks. Since marijuana stocks may have limited access to basic banking services, many have turned to issuing their own stock to either raise capital or finance acquisitions. While share offerings have done the trick for pot stocks, they've also diluted shareholders into oblivion.
In Aurora's case, the company has financed every major acquisition since 2016 by issuing common stock. The aforementioned CA$2.64 billion deal to buy MedReleaf was financed entirely as an all-stock deal. The result has been an absolute ballooning in the company's outstanding share count from 16.2 million in June 2014 to 1.02 billion five years later. That's a 1 billion share increase, and it's been a tough pill for investors to swallow.
Of course, this isn't just an Aurora problem. Canopy Growth has been guilty of diluting shareholders by financing many of its deals with its own common stock. If its contingent-rights acquisition of Acreage Holdings ever comes to fruition, most of the purchase price will be paid for with common stock.
Suffice it to say that investors have plenty of reasons to be displeased with brand-name cannabis stocks right now.