The Blunt, Off-The-Cuff Truth About Marijuana Stocks

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Four days from now, Canada’s Senate is expected to make a game-changing judgment on bill C-45, which is better known as the Cannabis Act. If passed by the Senate, which is widely expected to happen, the Cannabis Act would be one step closer to becoming law and, in the process, legalizing adult-use marijuana for Canadians.

In becoming the first developed country in the world to legalize adult-use weed, Canada could be opening the door to $5 billion in added annual sales. This would come atop what the industry has already been generating from medical weed sales, as well as exports to countries where medical marijuana is legal.

The blunt truth about pot stocks

In response to this expected legalization, investors have pushed marijuana stock valuations into the stratosphere. But are these valuations warranted? While no one knows that answer with any certainty, I can offer a number of blunt, off-the-cuff truths about marijuana stocks that investors need to hear.

There is opportunity, but probably not where you’re looking

To begin with, I will agree with optimists that the legalization of recreational weed in Canada is an intriguing opportunity for investors to make money. However, I’d also contend that the period of “easy money” has already come and gone. While most investors have been laser-focused on cannabis growers and other steps of the supply chain that’ll be directly responsible for growing, processing, or selling the plant, they’ve ignored what could be the biggest no-brainer opportunity of legalization: the ancillary pot industry.

Think about all of the businesses working behind the scenes to make the legal cannabis industry tick. We’re talking about marketing and packaging companies, consultants, lenders, accountants, software developers, real estate partners, and so on. This untapped area of the cannabis economy is where investors still have a chance to make a significant amount of money.

One company that could be worth adding to your radar is Kush Bottles. This small-cap pot stock is responsible for manufacturing child-resistant and tamper-evident packaging for over 5,000 legally operating medical and recreational pot businesses throughout the world. Kush Bottles’ opportunity in Canada is as plain as day with Health Canada calling for very specific labeling requirements on legal cannabis packaging. While Kush Bottles won’t exactly have the flashiest business model, it’ll perhaps be one the steadiest growth stocks in the ancillary space.

You should be paying way more attention to CBD oil sales

If you still believe that owning growers is the best route to go, then you should take my suggestion to heart and stop focusing so much on aggregate cannabis production and instead pay a lot more attention to cannabidiol (CBD) oil and extract sales. CBD is the non-psychoactive component of the cannabis plant best known for its perceived medical benefits.

Why, you ask? The problem with traditional dried cannabis is that it’s expected to become commoditized in the years that lie ahead. By my own estimates, Canadian growers could be generating around 2.4 million kilograms of cannabis in 2020, which has the potential to create an oversupply that drives down dried cannabis prices on a per-gram basis.

The solution? Focus on growers that place more emphasis on cannabis oils and extracts as a percentage of their total sales. Even though oils and extracts are a niche product that narrows the potential pool of consumers, it’s a higher priced product that’s unlikely to face pricing pressures as a result of commoditization. This means it’s a significantly higher margin item as well.

If you want a marijuana stock to keep an eye on with a focus on oils and extracts, then I’d suggest CannTrust Holdings. According to CannTrust’s most recent quarterly report, more than half of its nearly $6.1 million in total sales were derived from oils. Though the company is in the process of expanding its Niagara Greenhouse facility, which should boost its traditional dried cannabis operations, CannTrust has a clear focus on the medical side of the business, as well as on oils and extracts.

Dilution is a multi-year problem

So often when I write articles about the cannabis industry, comments or emails stream in about how tired investors are of hearing about dilution. This dilution is the result of publicly traded marijuana companies selling common stock, convertible debentures, stock options, and/or warrants in order to raise capital to expand their growing capacity. These frustrated readers contend that acquisitions, partnerships, and even the capital being raised from bought-deal offerings are adding long-term value to pot stocks, negating any near-term effects of dilution.

The blunt truth? These folks are probably right in the near term. The combined value of adding two companies together, or putting $100 million in cash on a balance sheet, when combined with the upcoming euphoria of legalizing recreational marijuana, just might be enough to overcome any dilutive impact from an increase in a publicly trading company’s outstanding share count. But ignoring the impact of dilution over the longer term is not a smart move.

For 2018, 2019, and perhaps even 2020, sales growth for the largest marijuana growers is expected to reach triple-digits on a year-over-year basis. But when growth rates begin to slow in 2020 or 2021, investors are going to expect bottom-line results, and rising outstanding share counts will make that difficult. I say this because convertible debentures, stock options, and warrants, can vest months or years down the roads, continuing to add to already ballooning outstanding share counts.

Perhaps no company will be guiltier of drowning its investors in share dilution more than Aurora Cannabis. After finishing fiscal 2014 with just over 16 million shares outstanding, Aurora Cannabis ended the third quarter of fiscal 2018 with almost 565 million shares outstanding. Having recently announced an all-share acquisition of MedReleaf for what amounted to $2.5 billion at the time, Aurora Cannabis could have in excess of 1 billion shares outstanding by this time next year. Aurora would have to earn CA$100 million ($77 million) just to generate $0.10 in annual EPS. That’s insane, and it’s all the more reason to avoid it and a handful of dilution-happy pot stocks.

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