Canada: Smokin’ Hot, Then Not: What’s Driving Marijuana Shares

Photo Credit: Wayne Cuddington

This is what happens when investors begin to lose their moorings.

In the space of just a few days in 2018, Canada’s marijuana companies saw their market value race part way to the moon and plummet back to earth’s orbit.

Canopy Growth Corp., the industry giant based in Smiths Falls, was a mirror held up to the flight path.

From Jan. 2 to 9, Canopy’s share price on the TSX soared 48 per cent to $44, giving it a market value of $8.4 billion — astonishingly large for a company with revenues growing at an annual rate of just $70 million.

Then, over the following three days, Canopy’s share price slipped 26 per cent to $32.35. The firm shed $2.2 billion in market value, including $1 billion last Friday.

Remarkably, these gyrations took place in the absence of any significant news from the company about actual operations or sales. The share prices of Canopy’s main competitors — Aurora Cannabis of Vancouver and Aphria of Leamington, Ont. — showed similar, wild trajectories.

This month’s trading in shares of cannabis firms was a clear warning of the opportunities and dangers that await investors as the federal government gets set to legalize marijuana for recreational use July 1.

Consider first the opportunities. For marijuana producers, the potential upside could hardly be brighter.

Sales of medical marijuana, currently the only legal variant, are expanding more quickly than originally predicted. An estimated 275,000 patients now have cannabis prescriptions, based on Health Canada data, compared with 40,000 in April 2014, when the new medical marijuana laws favoring industrial producers went into effect.

For the licensed producers of medical pot as a group, revenues likely exceeded an annual rate of $280 million during the latest quarter. Sales will likely be more than double that amount when the market matures in a few years.

More impressive, sales of recreational marijuana and related products could top $5 billion annually following legalization, according to an estimate prepared 15 months ago by the parliamentary budget officer.

Not only that, Canadian producers have already laid the groundwork for selling into foreign markets — from Australia to Germany.

Little wonder then, that producers are rushing to add capacity. To pay for it, a handful of ambitious players — including Aphria, Aurora Cannabis and Hydropothecary of Gatineau — have collectively raised more than half a billion dollars in the past few months by selling shares to the public.

Hydropothecary for instance is proposing to sell at least $130 million worth of equity in a deal expected to close at the end of the month. The cannabis grower expects by year end to have 1.3 million square feet of growing space capable of producing 108 metric tons of marijuana per year. This compares with a total potential market for recreational pot of 655 metric tons annually.

Aurora Cannabis is building an 800,000-square-foot facility near the Edmonton airport, and Aphria expects soon to have a million-square-foot operation ready at its Leamington headquarters.

Canopy Growth, which is adding 2.5 million square feet to bring its capacity to four million square feet, is the most ambitious of the lot. The Smiths Falls firm also has an option under a B.C. joint venture to augment this by another 1.7 million square feet.

Canopy has plenty of cash to pay for the expansion. Constellation Brands, a U.S. winery giant, shelled out $245 million in November to buy nearly 10 per cent of Canopy Growth’s equity and has the right to double its ownership stake on similar terms starting Aug. 1.

Since Health Canada has already issued licenses to 31 companies for the production and sale of marijuana, it seems clear than any lingering concerns about shortages of marijuana — medical or recreational — can be set aside, at least for the longer term. There might be shortages during the first year recreational pot is legal as marijuana producers complete their various building projects.

Given the industry’s remarkable growth prospects, euphoria can at times seem the appropriate mood.

So what triggered last week’s share price reversals?

Reality. This new industry might have huge momentum, but it’s not growing quickly enough to justify the massive market valuations that were in play earlier this month. This is reflected in a Jan. 9 research note published by AltaCorp, a financial services firm in Calgary, regarding the prospects of Canopy Growth.

AltaCorp managing director Keith Carpenter that day revised upward his estimates for Canopy Growth’s revenues in fiscal 2019 (ending March 31) to $264 million from $226 million, citing his conviction that foreign sales would be stronger than he had previously forecast. In part, this justified bumping up his one-year target for the firm’s share price to $38 from $20.50. That was huge, but it was also the day the share price of Canopy Growth surged through $40 — meaning Carpenter was telling clients that if you buy this stock there’s a good chance you’ll lose money over the next 12 months.

Indeed, financial estimates for individual cannabis firms are all over the map these days. The range of revenue projections for Canopy’s 2019 fiscal year runs from $185 million to just shy of $500 million, according to Thomson Reuters, which surveyed eight analysts. The variations reflect sharply different assumptions about when different segments (recreational pot, edibles, foreign markets) become fully legal, how will black market prices will change, the impact of taxes, and which producers will win market share.

At this stage Parliament seems unlikely to delay legalizing recreational pot beyond this summer, but a wild card is whether provinces will be ready with retailing regimes. A longer-term risk to the industry is whether any studies might someday challenge the notion that marijuana use is relatively safe. Another unknown concerns the rate at which marijuana consumers convert from illegal to legal variants of the drug.

After Colorado legalized recreational pot in 2014, the majority of marijuana sales in the state were still in the illegal sector, with medical prescriptions accounting for 40 per cent and legal recreational marijuana, just 10 per cent.

Within a year, however, sales of recreational pot had matched those of medical marijuana, according to the Colorado Department of Revenue. By last fall, legal recreational marijuana sales were outrunning those of medical pot by 2.5 to 1, with most of the increase coming at the expense of the illegal market. Revenue from the sale of all legal forms of marijuana was an estimated $1.5 billion last year. That was slightly more than double the tally in 2014, but on a rapidly slowing growth trajectory.

That’s another reason Canadian cannabis firms are racing to be ready for the early years of legalization, when revenue growth is likely to be strongest. This is an industry expected to settle into maturity relatively quickly. In as few as five years after legalization, annual growth rates for marijuana sales could slow to less than five per cent. What we’re seeing now is an early scramble for dominance by a handful of producers, combined with the start of a longer-term battle over the sale of new cannabis-infused drinks and foods. Certainly that’s the driving force behind Canopy’s partnership with Constellation Brands.

Are we in a pot stock bubble?  Yes, but it’s still relatively constrained because it’s based on something real — that in the absence of a studies showing a theoretical health issues, millions of Canadians will buy cannabis products year after year.

Consider what a real stock market bubble looks like. When optical components maker JDS Fitel of Ottawa first issued shares to the public in 1996 it did so at just $12 a pop. If you had plunked down $12,000 to buy 1,000 shares, your investment would have been worth $2.6 million at the peak of the telecom madness in 2000. Bottom line: each dollar invested in 1996 would have returned $212.90.

In sharp contrast, investors could have acquired Canopy Growth shares in its first year (2014) for $2 each. Even if you had been fortunate enough to sell them last week at the peak, you’d have received $44 per  share.  Each dollar invested would have earned you $22.

That would have been sweet, to be sure.  But investors today should take comfort in knowing the exuberant spikes in marijuana stock shares still bear no relation to the fever that gripped Ottawa optical technology firms in 2000. This region is still paying for the aftermath when that bubble burst.