If you think the stock market has been taken on a wild ride, have a conversation with a cannabis stock investor. Over the past three years, they've probably witnessed their pot stock holdings double or triple in value, and then lose 50% or more of their value.
There's little question that marijuana is going to be one of the fastest-growing industries throughout North America in the 2020s. Unfortunately, all next-big-thing investments encounter growing pains, and that's exactly what marijuana stocks have been dealing with since the end of March 2019.
However, this cannabis reckoning should prove to be a blessing in disguise for patient investors since it's allowing them to pick up shares of pot stocks on the cheap. With the understanding that trying to time the market isn't something that can be done with any success, my top cannabis stock to buy in September (and hold for years to come) is Canadian ancillary player Valens Company (VLNS -3.35%).
The biggest challenges awaiting Valens
As has become tradition for my monthly top marijuana stock selection, let's first take a look at some of the hurdles that Valens will have to contend with in the months and years to come. Afterwards, I'll cover all the reasons investors can be excited about this company's long-term prospects.
Easily the biggest concern for Valens has to do with regulatory shortcomings in Canada. Since Valens is responsible for processing hemp and cannabis biomass for the distillates, resins, concentrates, and targeted cannabinoids that are used in the production of high-margin derivatives, and Canadian regulators delayed the launch of derivative products by two months until mid-December 2019, it's somewhat tied the hands of processing companies. In other words, the buildup and launch of derivative products has been slower than anticipated.
What's more, provincial regulators in select provinces have really dropped the ball. For example, Ontario utilized a lottery system to award cannabis dispensary licenses until Dec. 31, 2019. This method was highly ineffective, and it resulted in just 24 retail locations opening in the first full year of legal adult-use sales in Canada. The newly implemented method of reviewing and vetting applications has led to a steady increase in retail locations throughout Ontario, albeit the most-populous Canadian province is still playing catch-up. With an inadequate number of retail channels, it's been difficult for licensed producers to reach consumers. This has backed up demand throughout the supply chain, which includes processing companies like Valens.
Valens can also expect a potentially crowded field of processors. It's not going to simply waltz in and become the dominant third-party processor for the cannabis and hemp industry.
But even with these concerns, Valens and its currently depressed valuation (its shares are down roughly 45% since mid-February) make for an intriguing buy.
Here's why Valens should be on your buy list in September
One of the top reasons to buy Valens is the plain-as-day pathway to success for derivative pot products in Canada. Although dried cannabis flower remains the most popular legal cannabis item purchased to our north, flower is easily commoditized and oversupplied. To avoid having their operating margins wrecked, licensed producers have no choice but to lean on higher-margin derivative products going forward. Even though the rollout of these products has been marred by regulatory issues, supply hurdles for derivatives are beginning to clear a bit. That gives Valens a growing runway to step in as a third-party processing provider for high-margin derivative products.
Keep in mind that it doesn't matter which licensed producers eventually ascend to the top in Canada, as long as Valens establishes itself as a major player in third-party extraction.
Despite being a relatively new company -- Valens has only been processing cannabis and hemp biomass for about two years -- it's also managed to turn a profit in three of the past five quarters. While a lot of focus is going to be levied on the significant decline in sequential quarterly sales in Valens' most recent quarter, this can predominantly be blamed on the coronavirus pandemic and licensed producers paring back production to match current demand levels. In other words, it's a speed bump and not anything resembling a shift in the company's operating model. The important point is that Valens has shown its operating model can be profitable on a recurring basis.
Another critical point to the company's success is that it leans on volume and price commitments from its clients. By signing processing contracts that are often valid for two or more years, Valens locks in predictable cash flow that allows it to plot out capital expenditures and expansion plans with excellent near-term visibility. That means few surprises for its shareholders.
Valens has also done an excellent job of drumming up its white label business. Instead of just processing cannabis and hemp products and delivering the extracts to a client, Valens has taken on the role of manufacturing and/or formulation, too. For instance, Valens struck a five-year deal with a division of Iconic Brewing Company in September 2019 to supply a minimum of 2.5 million cannabis-infused beverages (in aggregate), with the opportunity to further expand their relationship. By taking on a role as a white-label manufacturer, Valens has broadened its revenue base beyond just extraction and found another way to lock its clients into predictable (and lengthy) contracts.
To be certain, it could take a few quarters before revenue begins to really ramp back up for Valens. The ongoing shakeout of licensed producers is overdue, but it's going to result in a more efficient legal pot market in Canada. Having already shown its ability to be profitable so early on in its expansion, I'm confident Valens can outperform over the long run.