What happened
A funny thing happened in the cannabis market today. Analysts at investment bank Wells Fargo initiated coverage across the sector, warning of overvaluation among marijuana companies and suggesting investors turn their attention to hydroponics suppliers instead -- but marijuana stocks leapt higher anyway.
As of 12:35 p.m. ET, shares of Tilray (TLRY +0.73%) are gaining 4.6%, and both Aurora Cannabis (ACB +0.45%) and Canopy Growth (CGC 1.83%) are up 7.1% each.
Image source: Getty Images.
So what
The focus of Wells Fargo's ire this morning is the last company on that list -- Canopy Growth. As the analyst warns, Canopy Growth is unlikely to achieve sales sufficient to reach break-even profit anytime soon without federal action to legalize marijuana sales in the United States. Investors seem to be misinterpreting this prediction today, and taking Wells Fargo's warning as a promise that when legalization happens, Canopy (and its peers) will suddenly become profitable.
And yet, even assuming legalization is imminent, it's uncertain how soon Canopy Growth can become profitable, leading the analyst to conclude that "weakness [in Canopy Growth's stock price] is [not] a buying opportunity." To the contrary, Wells thinks investors should sell the stock, warning of as much as 42% downside (a target price of 8 Canadian dollars) ahead.
Now granted, a negative assessment of Canopy Growth doesn't necessarily imply bad things for Aurora Cannabis and Tilray as well. But at last report, Canopy was "earning" a negative operating profit margin of 107% on its sales. Tilray's not profitable, either (negative 19% operating margin), and Aurora's margins are actually worse (negative 119%) than either of the others.
Now what
Suffice it to say that these are not great numbers, and while a boost in marijuana sales from legalization in Washington, D.C., might help, well, Aurora's sales are already up 13 times in size over the last five years, according to data from S&P Global Market Intelligence. Canopy Growth's sales are up 15 times, and Tilray's something like 37 times. If that level of sales growth hasn't been enough to lift this industry into profitability, it's hard to say how much more growth would be needed to do the trick.
It's perhaps for this reason that Wells Fargo's advice to marijuana investors is to avoid the big cannabis companies entirely, and invest instead in suppliers such as Scotts Miracle-Gro (SMG +0.39%) -- the stock of which is up 7.9% today by the way -- on the theory that the "leader in lawn/garden and hydroponics ... can take advantage of market dislocations ... to consolidate more share" and grow its business.
And I have to say: That argument makes a lot of sense. If growing sales across the big marijuana companies is contributing to excess supply of marijuana, depressing prices and preventing companies like Canopy Growth, Aurora Cannabis, and Tilray from earning a profit, well, it makes sense that a company like Scotts, which sells the products needed to grow those marijuana sales in the first place, must have a bright future ahead of it.
It's a lesson as old as California: Don't buy the gold miners. Instead, invest in the folks selling them picks and shovels.
