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Even the Safest Pot Stocks Are Now in Trouble

By Sean Williams - Nov 22, 2019 at 7:51AM

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Extraction-service providers appeared safe from near-term marijuana growing pains, but this isn't the case any longer.

For the better part of the year now, marijuana stocks have been taken to the woodshed. Following a first quarter that saw more than a dozen cannabis stocks rise by at least 70%, nearly every pot stock has since lost 30%, 50%, or maybe even more of its value.

The marijuana bubble is bursting

The problems and growing pains for the North American weed industry are abundant. In Canada, regulatory agency Health Canada has been slow to review and approval cultivation, processing, and sales license applications. In some instances, this has led to wait times of more than a year before growers can plant their crops and bring product to market.

A smoldering cannabis bud that's starting to turn black.

Image source: Getty Images.

Certain Canadian provinces have also been slow to green-light the licensing of physical dispensaries. Ontario, a province with approximately 14.5 million residents, has just two dozen open dispensaries. With so few locations in which to purchase legal marijuana, it should come as little surprise that the black market is thriving. In fact, this lack of retail channels has created an odd scenario whereby Canadian growers are dealing with oversupply despite very little legal-channel demand actually being met.

Then there's the United States, which has struggled with a tax problem in a number of states. California, the poster child of high tax rates, has been hitting cannabis consumers with a state and local tax, an excise tax of 15%, and a wholesale tax that varies depending on whether it's in dried cannabis flower or leaf form. In total, the typical marijuana consumer in California is on the line for around a 45% tax rate, which makes it virtually impossible for legal-channel providers to compete with the illicit market.

The Swiss cheese-like legalization process in certain states is also partially to blame. Municipalities in recreationally legalized states like California and Michigan have the right to ban adult-use dispensaries, which can further encourage consumers to turn to the black market.

Suffice to say that the going hasn't been easy for pot stocks.

A dollar sign shadow being cast atop a pile of cannabis leaves.

Image source: Getty Images.

A few cannabis safe havens have been bright spots in an otherwise decimated industry

Perhaps the only bit of good news for investors is that there have been a couple of niche bright spots within the marijuana industry.

For example, cannabis-focused real estate investment trust (REIT) Innovative Industrial Properties ( IIPR -1.31% ) has been a clear outperformer in 2019, with a year-to-date gain of 74% through Nov. 20. That's well over a 100-percentage-point outperformance when compared to the dismal year-to-date returns of brand-name pot stocks like Aurora Cannabis.

The beauty of Innovative Industrial Properties is the company's highly predictable business model. As a REIT, it's tasked with acquiring land and facilities that can be used to grow or process medical marijuana in the United States. It then leases out these assets for extended periods of time and simply sits back while reaping the rewards of rental income. Innovative Industrial Properties has an easy-to-understand and transparent business model with a weighted-average remaining lease length on its 42 properties of 15.5 years, and an average current yield on invested capital of 13.6%. Translation: IIP is going to get a complete payback on its $431 million in invested capital in just over five years, with everything after that being gravy. 

This predictability of cash flow was also apparent with extraction-service providers, such as Neptune Wellness Solutions ( NEPT -7.87% ), Valens GroWorks ( VLNCF -0.49% ), and MediPharm Labs ( MEDIF -4.31% ), all of which have done well for shareholders in 2019.

A person holding a vial of cannabinoid-rich liquid in front of a flowering cannabis plant.

Image source: Getty Images.

Extraction-service providers take cannabis and hemp biomass and process it to yield resins, distillates, concentrates, and targeted cannabinoids that growers can use to produce high-margin derivative products. Although some growers have processing capacity of their own, a majority have turned to a third-party processors to aid in extraction. Since the high margins derivatives bring to the table are a must for pot companies, this makes Neptune, Valens, and MediPharm indispensable middleman for the pot industry.

Uh-oh! Extraction-service providers have something to worry about

The reason these niche stocks have performed so well is their predictability. In other words, the apparent concreteness of their contracts makes it easy for Wall Street to plot out a growth and profitability trajectory for these stocks.

But what if extraction-service provider contracts weren't as rock-solid as everyone has been led on to believe?

Over the past six weeks, we've witnessed a cannabis megamerger called off, had a few pot stocks amend the conversion price of their convertible debentures, and seen a handful of pending acquisitions be altered. Then, on Wednesday, Nov. 20, we witnessed the largest marijuana stock in the world, Canopy Growth ( CGC -3.57% ), amend its three-year extraction-services agreement with Neptune Wellness Solutions. Although the deal length of three years remained unchanged, beginning June 30, 2020, "volume and pricing will be negotiated between the two parties based on market conditions," according to the press release. In other words, the predictability of fee-based volume and pricing agreements has been completely thrown out the window between Canopy Growth and Neptune.

Four vials of cannabinoid-rich liquid lined up on a counter.

Image source: Getty Images.

This is big news, because the allure of extraction-service providers is their presumably guaranteed volume and price agreements. In June, Neptune signed the largest extraction deal in history with The Green Organic Dutchman ( TGOD.F -5.60% ), which spans three years and will total 230,000 kilos in aggregate. However, Green Organic Dutchman recently provided a corporate update that entailed a massive cut to its 2020 production. Instead of getting anywhere near its 219,000-kilo-per-year peak output, Green Organic Dutchman anticipates yielding only 20,000 kilos to 22,000 kilos in 2020. That would seem to portend another amended agreement for Neptune may be on the horizon.

And it's not just Neptune that's at risk here. HEXO also announced a significant production cut during in its fourth-quarter operating results. It has a two-year agreement totaling 80,000 kilos (in total) with Valens GroWorks. Meanwhile, MediPharm has agreements in place with both Canopy Growth and Cronos Group. Cronos recently announced that it would repurpose some of its cultivation space at its flagship Peace Naturals grow site for processing and derivative production.

In short, we could be on the verge of real problems for extraction-service providers if major growers begin seeking amendments to already established agreements.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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Stocks Mentioned

Neptune Wellness Solutions Inc. Stock Quote
Neptune Wellness Solutions Inc.
$0.41 (-7.87%) $0.04
Canopy Growth Stock Quote
Canopy Growth
$9.99 (-3.57%) $0.37
The Valens Company Stock Quote
The Valens Company
$3.10 (-0.49%) $0.02
MediPharm Labs Corp. Stock Quote
MediPharm Labs Corp.
$0.15 (-4.31%) $0.01
Innovative Industrial Properties Stock Quote
Innovative Industrial Properties
$252.50 (-1.31%) $-3.36
The Green Organic Dutchman Stock Quote
The Green Organic Dutchman
$0.09 (-5.60%) $0.01

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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