In just over two weeks when we turn the page on 2019, it'll almost certainly go down as the worst year on record for marijuana stocks. What began as a very promising year that saw more than a dozen cannabis stocks rise in value by at least 70% during the first quarter looks as if it'll end with more than three-quarters of all marijuana stocks losing at least a double-digit percentage in 2019. Relative to the benchmark S&P 500, we could be talking about an underperformance of at least 35 percentage points, if not much more, for the typical cannabis stock.
Leading the pack in the disappointment department are Aurora Cannabis (ACB +0.73%) and Canopy Growth (CGC +0.00%), two of the largest and most popular pot stocks. Through this past Wednesday, Dec. 11, Aurora Cannabis had shed 53% of its value, with Canopy Growth down by a more "subtle" 30% year to date.
The thing is, Wall Street is always forward-looking, and these poor performances could easily be placed in the rearview mirror if the cannabis industry does a better job of executing in 2020. The big question is, between Aurora and Canopy, which pot stock looks destined to have a better year in 2020? Let's take a closer look by breaking down the positive and negative potential catalysts for each company and then make a final decision.
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Aurora Cannabis
Let's begin by taking a look at some of the positive catalysts that could send Aurora Cannabis' share price higher in 2020. In no particular order, these factors include:
- A move into the U.S. cannabidiol (CBD) market.
- Ontario rolling out additional dispensaries, thereby boosting legal-channel sales in Canada's most populous province.
- Improved economies of scale that should result in some of the lowest per-gram production costs among major growers.
- The ramp-up of cannabis derivatives, such as vapes and edibles, which are considerably higher-margin products than traditional dried cannabis.
- An improved regulatory environment throughout Europe that encourages Canadian imports.
- The potential to secure a brand-name partnership in the food or beverage industry.
Arguably the biggest catalyst of the group would be the ramp-up of high-margin derivatives, which could actually wind up outpacing dried cannabis in annual sales. Derivatives speak to a younger generation of users, and they're a considerably higher-margin product. In other words, a rapid ramp-up in derivative sales, when combined with improved production costs, could produce a more palatable income statement for Aurora.
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On the other hand, there are downside catalysts that investors will be on the lookout for. These include:
- Persistent supply issues throughout Canada that encourage black-market sales and constrain not only dried flower but derivative supplies.
- Ongoing pushback from the U.S. Food and Drug Administration (FDA) over the safety of CBD, leading to CBD-product sales weakness.
- A goodwill writedown, considering that Aurora's goodwill stood at 3.17 billion Canadian dollars at the end of fiscal Q1 2020.
- Continued share-based dilution given that Aurora has yet to land a brand-name partner.
- A delay by overseas countries in establishing medical marijuana regulations, thereby constraining overseas demand.
Just as the launch of derivatives would be Aurora's key catalyst, it's pretty clear that supply constraints impacting the ability of derivatives to hit dispensary shelves would also qualify as the company's biggest risk in 2020. Remember, as of the one-year anniversary of adult-use sales commencing in Canada, Ontario had a meager two dozen open dispensaries, or about one for every 604,200 residents.
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Canopy Growth
Now it's time to switch gears and take a closer look at the largest marijuana stock in the world by market cap, Canopy Growth. Next year, there are a number of catalysts that have the potential to send its share price higher. In no particular order, these are:
- The ongoing rise of CBD sales in the U.S., which is all the more important, given that Canopy will have a functional hemp-processing plant in New York next year.
- The launch of derivative products in the Canadian market.
- The awarding of new retail store licenses in Ontario.
- New CEO David Klein's belt-tightening at Canopy, which should dramatically improve its quarterly income statements.
- The possibility of overseas countries establishing medical marijuana regulations, thereby increasing import demand from Canopy.
Although derivatives will be incredibly important for Canopy, I'd place cost-cutting from incoming CEO David Klein as the top potential catalyst in 2020. In the company's most recent quarter, its share-based compensation was actually higher than its net sales, which is unacceptable for an industry that should be maturing and improving its bottom line.
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Similar to Aurora, there are also downside catalysts capable of pressuring Canopy Growth's share price next year. These catalysts include:
- Continued supply issues in the traditional dried flower and derivative markets.
- The inability of overseas countries to set medical marijuana regulations, thereby constraining international sales.
- Higher-than-expected expensing, especially as it relates to share-based compensation.
- A goodwill writedown (Canopy is lugging around CA$1.91 billion on its balance sheet).
- The potential crackdown on CBD by the FDA, which could inhibit demand for hemp processing.
- The lack of a clearly defined growth strategy.
Of these numerous concerns, the latter might be the most worrisome. While Klein coming over from Constellation Brands should lead to some serious cost-cutting, he has no experience in the cannabis industry. And make no mistake about it, consumer-packaged goods and cannabis are two different beasts. Without a well-defined growth strategy, the largest pot stock in the world could flounder in 2020.
Aurora vs. Canopy: The pot stock that'll have the better 2020 is...
Now that we've taken an extensive look at the positive and negative catalysts that Aurora Cannabis and Canopy Growth are probably contending with in 2020, we can circle back to the original question at hand: Which pot stock appears set for the better year?
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Considering that Aurora Cannabis is only a $2.45 stock and is the most-held security on online investment app Robinhood, it would seem like the logical choice to outperform Canopy Growth. But my expectation is that Canopy will log the better year when 2020 comes to a close.
If the positive and negative catalysts for the two companies are compared, you'll see quite a few similarities. But one thing that's very different between these pot stocks is their cash on hand. Canopy Growth ended the most recent quarter with more than CA$2.7 billion in cash and short-term investments on its balance sheet, stemming mostly from a major equity investment from Constellation Brands in November 2018. Even though this cash has been shrinking due to some hefty quarterly losses, it's protected the company from having to turn to dilutive capital raises.
Meanwhile, Aurora Cannabis has regularly sold its stock or issued convertible notes to raise capital or fund its more than one dozen acquisitions since August 2016. Over that span, the company's share count has risen from just 16 million to perhaps around 1.1 billion. Sure, Aurora may have what looks to be a low share price, but that's more a reflection of the company drowning its investors in ongoing share issuances.
Furthermore, I believe that goodwill could become a serious problem for pot stocks sooner rather than later. Of these two companies, Aurora's goodwill accounts for 57% of its total assets, compared to about 23% for Canopy. This makes a writedown more likely for Aurora than Canopy at this point.
To be clear, just because I expect Canopy to outperform Aurora, it does not mean I expect Canopy Growth to have a good year. Rather, I'm approaching this more in the sense of "which company will be less bad in 2020," which in my mind is Canopy Growth.
