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Marijuana Stocks Could Have 30% Downside, According to 1 Wall Street Firm

By Sean Williams - Oct 16, 2019 at 7:21AM

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A terrible year for pot stocks may get even worse.

At this time last year, marijuana stocks were the greatest thing since sliced bread. Growth projections for legal marijuana were off the charts, with one analyst on Wall Street forecasting up to $200 billion in global annual sales by 2030.

But oh, how the tables have turned.

A visibly frustrated investor covering his face with his left hand, while holding a tablet that features a plunging chart with his right hand.

Image source: Getty Images.

One Wall Street investment bank sees significant downside to come in pot stocks

The past six-plus months have been a veritable disaster for cannabis stocks. Over that span, many of the biggest pot stocks have seen 30%, 50%, or even more of their market cap go up in smoke due to a variety of issues. And according to one Wall Street investment bank, the pain may not be over just yet.

Last week, Bank of America/Merrill Lynch analyst Christopher Carey, a noted marijuana bull, published a research note doling out his current thoughts on the industry. In that note, Carey suggests that while valuations are certainly more reasonable now than they were a few months ago, consensus estimates for the entire space may be at least 30% too high. 

According to Carey, marijuana stocks are unlikely to be worth buying until revenue estimates throughout the industry are adjusted to reflect the numerous issues that pot stocks are contending with. As a reminder, Health Canada began the year with more than 800 cultivation, processing, and sales license applications on its desk awaiting review and/or approval. Even with the regulatory agency changing the cultivation license application process to help work through its backlog, it'll probably take many quarters before the agency is caught up and supply levels are adequate to meet domestic demand in Canada.

Furthermore, certain Canadian provinces have been slow to approve licenses for physical dispensaries. This leaves consumers to either buy their product online and wait for perhaps more than a week for it to arrive, or to purchase their cannabis from an illicit grower.

The end result has been considerably underwhelming operating results, thus far, for practically all Canadian pot stocks.

A businessman putting his hands up as if to say no thanks.

Image source: Getty Images.

The one marijuana stock you should avoid

Interestingly enough, the only one of a small number of cannabis stocks to have coverage initiated by Carey that currently carries an underperform rating is HEXO (HEXO 11.34%). I say "interestingly," because back in April, HEXO was named as the top pick in the industry by BofA/Merrill Lynch.

The downgrade of HEXO from buy to underperform (the equivalent of a sell) came just prior to the company's fourth-quarter update last week, which I'll touch on in a moment. Carey's downgrade and price target cut to 4 Canadian dollars ($3.03) came after Chief Financial Officer Michael Monahan announced that he was resigning from his post after only four months on the job. Carey's thesis in the note behind the rating downgrade and price target reduction is that Monahan likely realized that HEXO's corporate finance organization was underdeveloped.

As you may also be aware, just days after BofA/Merrill Lynch issued its downgrade of HEXO, the company issued an abysmal preliminary update for the fiscal fourth quarter. Back in mid-June, HEXO had estimated that sales would essentially double from about CA$13 million in the third quarter into the fourth quarter, and that total sales would hit CA$400 million in fiscal 2020. HEXO walked back both forecasts, with a new Q4 revenue range of CA$14.5 million to CA$16.5 million, representing a modest 19% sequential growth at the midpoint, rather than 100%, and no 2020 sales guidance offered.

Metal dice that read buy or sell being thrown across digital screens containing volume and price data.

Image source: Getty Images.

Here's the one pot stock you can buy, according to BofA/Merrill Lynch

On the other hand, Carey and his team at Bank of America/Merrill Lynch view Cronos Group (CRON 4.25%) "as an especially attractive buying opportunity." BofA/Merrill Lynch has maintained its buy rating on Cronos following the company's more-than-70% pullback since early February.

The reason Carey likely views Cronos as an intriguing value is due to the company's robust cash position. Remember, Cronos Group netted a $1.8 billion investment from tobacco giant Altria Group (MO 0.80%) that closed in March and gave Altria a 45% non-diluted stake in the company. Since this deal, Cronos used more than $200 million in cash to purchase Redwood Holdings, owner of the Lord Jones cannabidiol-infused beauty products line in the United States, but likely has more than $1.5 billion in cash still on hand. This cash is viewed as an excellent downside buffer.

There's also the obvious partnership opportunity with Altria. As a leader in the tobacco arena, as well as 35% owner of the Juul vaping brand, Altria could prove invaluable in helping Cronos reach consumers who vape.

While I don't disagree that Cronos Group has become considerably more attractive than it was at the beginning of the year, it's still a company I, personally, wouldn't suggest investors buy.

To begin with, the vape-related health scare in the U.S. may translate into weaker vape sales in our neighbor to the north. Also, the aforementioned supply issues that have ravaged the Canadian pot industry are liable to also impact the launch of derivatives, which will occur in mid-December. Additionally, Cronos Group has lagged its peers pretty significantly in the sales and production department, which means it's still losing quite a bit of money on an operating basis, once a number of one-time benefits are removed.

Long story short, there's a lot of built-up worry in the pot industry at the moment, and it's unclear when it'll abate.

Sean Williams owns shares of Bank of America. The Motley Fool recommends HEXO. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Altria Group, Inc. Stock Quote
Altria Group, Inc.
MO
$44.45 (0.80%) $0.35
Cronos Group Stock Quote
Cronos Group
CRON
$3.56 (4.25%) $0.14
HEXO Stock Quote
HEXO
HEXO
$0.23 (11.34%) $0.02

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