Catchy title, eh? This is my first article into a completely different area than I usually cover (Canadian O&G service companies) as I am starting to see a strong investment thesis forming. I hope it didn’t offend anyone, as that was not my intent. I wanted to write an article on the valuations of the cannabis industry in Canada, as it seems to have gotten quite out of hand over the last year.
Most of the experienced investors all remember the dot com crash of 1999. However, it wasn't the depth of the crash that is most memorable, it was the irrational exuberance that preceded the period that is most discussed. The prototypical story would involve some random company with a dot com name starting an online business, and eventually trading at unbelievable valuations- usually despite the company not only being unprofitable, but many didn't even have revenue! Investors dumped money into these companies on the belief that the internet was 'the next big thing', and thus internet based company valuations would soar. This led to more and more companies having IPOs, at more and more ludicrous valuations. Everyone wanted a piece of the pie, and nobody could deny that the internet was the future- thus internet companies, were the best investment.
However, despite the fact that people were very correct that the internet would drive our future, it did not drive most of these companies to profitability. As the market became crowded, eventually earnings starting to disappoint time and time again, ultimately resulting in a sharp and sudden correction, with hundreds of companies declaring bankruptcy. We have seen similar perspectives of 'not wanting to miss out' leading to irrational decision making in the past, as the real estate boom of the 2000's showed us more recently. Now, the same pattern has been starting to emerge a different industry: Canadian cannabis stocks.
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Okay, it's no secret. Two states are fully legal with respect to cannabis, and many more are likely to be joining them shortly. In Canada, the lower mainland and Vancouver Island have essentially legalized pot as there are now hundreds of cannabis dispensaries, and the police have stated that they have bigger priorities to deal with; furthermore, our Prime Minister has made it perfectly clear about his plans to legalize cannabis. The result? Many people view cannabis as the next explosive industry, and I think the big assumption is that eventually the billions of dollars of profits made on the black market will be replaced with legitimate companies, creating billion dollar cannabis companies. I actually agree with the first part of this belief somewhat.
The Black Market
One big variable that needs to be considered is how big will the black market be after legalization. I agree that much of the black market for cannabis will be destroyed in North America over the next few years, but the extent of this trend will be dependent upon a number of variables. The first major variable, is considering just how much tax will be added to the cost of marijuana. If the tax starts to become the majority of the cost of the product, there will still be a large black market to undercut the legal market.
Another big mystery that many of us wonder about in the future, is the absolute price that legal cannabis will sell for. If the licenses, taxes, and extra overhead cause prices to stay the same or possibly increase, then there would be an additional incentive for the black market. Then again, the legal producers have many advantages over illegal growers such as less likely to be robed, less capital spent on concealment, and better margins of scale due to size.
A third variable that should also be considered are the legal ramifications of growing and selling in the black market. I have read that they will likely increase the penalties for these crimes, which should help to squeeze out most of the black market. However, if the penalties stay the same or are even lowered, then I would argue that a very significant black market would exist. Ultimately, a combination of the new market price, cost of growing legally vs. illegally, and the consequences for growing in the black market will determine how much will remain.
So in conclusion, I am trying to demonstrate that it is not reasonable to look at the current black market value of cannabis being traded and assume that the same numbers will occur for the legitimate market. When considering overall sales of the legal marijuana market, we should at the very least expect some black market to remain. Another counter point to this, however, is that overall marijuana consumption may grow due to the legal status and less stigmatization.
The Flooding of the Market
So why would I not recommend buying into the industry at this point in time? I believe that we are going to see two things occur once legalization occurs across Canada. First, we are going to see most of the cannabis companies sell off enormous amounts of equity, diluting their shares significantly, to help pay for their production growth to meet the rising demand. Canopy Growth Corp. (TWMJF), for example, has already done a number of equity raises so far, however, they made many of these at great times when their company was clearly overvalued. Second, we are going to see countless new companies, both private and public, moving into the business to soak up the new demand. I hate to point out the obvious, but the barriers to entry for a marijuana producing company is low, which will incentive many new companies to join the space with minimal capital investments. I think that when this occurs, it would be a great time to invest in the industry, but until then, it seems like there is far too much downside.
However, there is one huge variable that will determine if the market will really be flooded: how many recreational grow marijuana licenses will Canada distribute? The answer to this question will be the most important when considering the future of the currently public companies. Fortunately, we already have a wealth of information on this topic that the market seems to have completely ignored. Not only has the Canadian government not once suggested that they would limit the number of licenses to a few companies despite making countless public comments, but they have made many statements that suggest the opposite. More recently, Ottawa announced plans to facilitate the process of getting a recreational marijuana license. When we consider that there are 42 current licensed producers, over 400 applications, and no sign of either of these numbers decreasing, I would argue that growing marijuana in the future has minimal barriers to entry. In Fact, Health Canada recently stated that they want to make obtaining the licenses easier to make sure that an adequate supply is available on the recreational market next year. Health Canada also stated that they want a large number of small producers to obtain the licenses so that the industry is not simply dominated by a small number of large companies, and they will be considering ways to make it easier for small producers to enter the market.
I decided to do some research into these cannabis companies, and the results were astonishing. Many companies are selling at multiple times their book value (without any real competitive edge) while producing negative cash flow and earnings. Now it is reasonable to believe that extra costs have been incurred in the last couple of years to get the company running, however, the valuation gaps are so extreme, they present a compelling short thesis. Why are pre-revenue companies selling for multiple times their book values in an industry that appears to have low barriers to entry, with minimal competitive advantages?
No Institutional Ownership?
Now there are many reasons that institutions don't invest in certain companies, and it typically has to do with the risk associated with it. Many will not invest in a company below a certain market cap, and so on. However, I believe that institutions are avoiding the industry for the same reason that I am. Going back to the dot com reference, much of the high valuations were due to retail investors betting on the industry. I believe that too many individual investors lack the experience to know that just because an industry will grow in the future, does not mean it is a good time to invest now, and does not mean that certain companies will be more valuable. After all, they were right about the Internet, but wrong about investing in anything that sounded like it involved the internet. I think that many intuitional investors are wanting to make a play in the trade (I know I am), however, are waiting patiently for the legalization and a flood of competition to happen first.
Canopy Growth Corp.
I wanted to highlight this company in this article specifically, because it is the biggest marijuana stock in the world, so I'm using it as an example. Before anybody criticizes me, I wanted to say right off the bat that I do not think Canopy Growth is a poorly managed company. In fact, management seems to be doing everything right, and I can’t see any glaring mistakes with their growth plan. The issue with Canopy, on the other hand, is the investors. They have pushed the valuation beyond anything close to reasonable. I think the reason for this is due to the disproportionate number of retail investors. I have read countless articles on mainstream publications citing the values of investing in the marijuana industry, even at peak valuations! Fortunately management has been intelligent and has been using these lofty valuations to raise equity, and is sitting on a large amount of cash which will be needed in the next couple of years.
After legalization occurs, there will be potentially hundreds of new competitors in the market. Currently Canopy is only competing with the limited medical market, and has no exposure to the recreational market which is currently a black market. I believe that Canopy will initially benefit during the legalization process, as will the other established medical growers, due to the delays in licensing and establishing the business of other competitors. Therefore, the first year after legalization will be a decent one for companies like Canopy as the lack of overall supply should keep prices reasonably high, and they may be able to obtain lower costs than competitors due to their scale. However, as time progresses, more licenses will be offered, and the lucrative marijuana industry will become one of near perfect competition, as eventually marijuana producers will be able to establish themselves with minimal capital requirements. Therefore Canopy has a small window to grow their market share to justify their current valuation, and I do not see it as possible in such a short time frame.
Returning to my original dot com example, if any company has the potential to be the Amazon of the dot com crash, it’s Canopy Growth. For those that need a history lesson, Amazon sold at high valuations during the dot com boom, but crashed hard when it eventually hit. Despite the difficulties, as we all know by now, Amazon went on to become one of the biggest companies in the world. Now I doubt Canopy will ever be in that category, but I see Canopy Growth as a company that even if you invested today, you would likely eventually make your money back years down the road. Despite this fact, I believe that there are much better entry points ahead, and that Canopy is still greatly overvalued at this time.
I also wanted to point out that although my research into this industry is limited (I reviewed a handful of companies, but certainly not all of them), it seems that Canopy’s valuation is much more reasonable than most competitors. The reason for this I believe is because due to the existence of Canopy on the Montreal options exchange, and the higher volume of the company, it is much easier to short. This allows the valuation to be somewhat kept in check, while the penny stocks do not have this property and thus have resulted in extreme overvaluations. It looks like short interest in Canopy Growth has increased significantly over the last few weeks, which makes sense as Canopy has under-performed peers.
Much of Canopy Growth’s market cap change has been driven by the election results which saw many states move closer to legalization. The theory was that Canopy Growth would have more exposure to the US markets, as there are no US equivalents that could compete in scale. Unfortunately, the market missed the fact that Trump was also elected, and has been talking tariffs non-stop. It would make no sense for the US to import high margin products like cannabis to the US as it would shut out US competition. I would argue that if anything, after the election, Canopy Growth was worse off than before as the NAFTA negotiation should easily more than offset any potential US growth in sales.
Another bull theory that I wanted to address was that Canopy is expected to obtain about 10% of market share of the $4 to $8 billion dollar a year marijuana industry is anticipated to become. Using this logic, Canopy Growth is fairly reasonably valued assuming that they can earn good margins off this revenue. The problem with this theory is that it makes no sense. I believe that investors are imagining a world where a handful of companies are producing all of the cannabis in Canada. There will be a handful of large companies, however, I believe that within a couple of years an enormous amount of market share will be taken by hundreds to thousands of small growers. Many of these growers will likely be former illicit growers that will try to adapt to the new market, and I believe a significant amount of black market product will still exist to lower the demand for the legal product.
If you wanted to consider making money off of this bubble, there seems to be enough shares available to short Canopy growth. The put options seem a bit expensive right now, but may offer a better entry to minimize potential losses. Unfortunately, I cannot find a way to capitalize off the more extreme valuations at this point in time.
The Canadian marijuana industry will explode after legalization next year. Despite this, however, the market capitalization's of the publicly traded marijuana stocks are currently greatly overvalued. Many of these companies are pre-revenue, and are trading at multiple times book value. Despite the fact that likely all of these companies will have huge improvements in revenue after legalization, I believe Canada will distribute large numbers of growing licenses which will dilute the market, resulting in lower prices and margins. I also believe that depending on certain variables, a significantly sized black market will still exist, which has also not been accounted for when looking at other models. I believe that in the future, quick access to licenses will erode most barriers to entry, and that much of the market share will be held by hundreds to thousands of small producers, rather than a handful of small companies. Canopy Growth Corporation, despite being a well ran company, is one of the least overvalued companies, but one of the only companies that can be shorted at this point in time. Avoid buying into this industry now as ongoing share dilution and missed expectations should result in a significant correction. If you have $1 million sitting around, don't buy into this industry yet; wait a year and start your own company where your investment equals the book value.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in TWMJF over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: If I initiate a position, it will be in the Canadian markets on the TSX or on the Montreal Options Exchange.