The Future Of Canadian Pot Stocks

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Includes: ACB, APHA, CGC, CRON, CTST, HEXO, MJ, OGRMF, TGODF, TLRY
by: D. H. Taylor
Summary

Canada is out of cannabis due to governmental shortages and mismanagement.

In the face of supply shocks, Canadian pot stocks are selling off.  This is misaligned with long-term future potential of what demand will be, what producers will provide and earnings.

Long-term, the industry stands to do well and will need to expand production by a significant percentage because of demand and what the major producers will supply.

Pot stocks have sold off lately and some of the selling has been sharp. Some of this selling I believe was well past due. But, in the face of all of that selling, there is a marijuana shortage in Canada, the country that has just legalized cannabis across the nation. One would be correct to think that in the face of overwhelming demand amidst a shortage of supply, the supplier's stock would move upward. That is not the case - but, it may be a buying opportunity for patient investors. Setting aside the transitory and temporary supply issues, while considering the demand side of things, where will pot stocks be in one year? Knowing this may give insight into what pot stocks to buy right now.

Here is a look at the recent activity on the cannabis ETF, the ETFMG Alternative Harvest ETF (MJ):

MJ Pot Stock ETF Anyone who has taken basic economics will know that if you want to figure out how much of a product is going to be sold, you need to know what the demand is going to be. As it turns out, in Canada, demand is quite large. The newly legalized adult-use cannabis has exceeded expectations. The country is out of pot supply.

Perhaps the euphoria was based upon pent up demand and the country embracing new legalization after 100 years of prohibition. It may be difficult to determine that one data point. But, if we look at Colorado, then we might be able to determine how much cannabis Canada will need on a regular basis outside of the celebration of the new legalization.

Colorado produced nearly 500 tons of cannabis in 2017. Both the state of Colorado and the country of Canada have run surveys to determine how much cannabis people intend on consuming over the course of a year. The numbers are fairly close with each other; both report nearly 15% of the general population will use cannabis on some level. So, the 500 tons is a good starting point to gauge how much will be necessary for Canada.

First, there are some 5.6 million individuals living in Colorado and there are 36.7 million people living in Canada. Since the percentage of potential usages for the populations of both demographics are about the same, then the math on this is simple. If 5.6 million people consumed 500 tons of cannabis in Colorado then, 36.7 million Canadians will need 3,275 tons, or thereabouts. That is a lot of cannabis.

But, here is a very big caution: Colorado has had legalization for a few years and had to build up to that level. Canada is already showing that while they may have grown some amount of cannabis, it never made it to the store shelf, so the product never got sold.

Eventually, given a linear relationship between Colorado and Canada, the numbers will correlate. However, this buildup process may take a few years for that to happen.

There is another issue at hand with Canadian cannabis producers: Most of them are still building their grow facilities. Just because the country has legalized cannabis, the lion's share of supply has yet to even be planted in a grow house. That will take time to ramp up as well.

In fact, there have been a few financial earnings releases that hit the wires just the past couple of days and weeks. I played a few of these stocks from a volatility aspect. I did well. However, I did not care about the actual numbers being released. I only cared that the numbers were likely to create stock movement in either an up or down direction. I was largely correct on that.

Until companies get their grow houses up and running, and until that product hits the shelves and sales start to hit the top and bottom lines of these companies, the earnings and revenues from these companies don't carry much weight at all.

But, eventually, there will be a market for this product and the suppliers will have their products flowing to the dispensaries. That translates into revenue and earnings for these companies. Given that, a patient investor may be able to ask some simple questions and determine where some stocks will be in the future based upon what they will be able to produce in the future.

First, 3,275 tons of cannabis translates into 2,934,742 kg. of cannabis. Now the question is: How much cannabis is the country of Canada about to produce based on each individual company's current projects?

Here is a listing of the top Canadian cannabis companies (predominantly) with the amount they will be capable of growing. Mostly, all of these companies will have their projects completed by the end of next year:

Company

Expected Capacity in Kg.

Canopy Growth 500,000
Tilray 145,000
Aurora Cannabis 433,000
Aphria 230,000
Cronos 110,000
Hexo 50,000
Green Organic Dutchman 195,000
Organigram 113,000
CannTrust Holdings 100,000

Source data: Company Filings

First, the list is generated by market capitalization and listed downwards. These are the biggest Canadian companies with the highest valuations. True, there are others out there, but their size hasn't gotten to the point where they would make this list. The total amount of cannabis these companies will be able to produce is 1,876,000 kg. of cannabis per year. This falls well short of the amount likely needed for Canada over the next several year's time. It took 4 years for Colorado's numbers to reach the 500 ton level. But, given the amounts these major producers will be able to produce, after 4 years in Canada, the country is still likely to be out of cannabis.

For the most part, market capitalization for these companies is way below where they should be, with at least one notable exception.

When I look at the valuations of these companies, I keep it simple. The above is their production capabilities with planned projects nearing completion. The wholesale going rate for Cannabis in Canada is $5.19 per gram. I multiply that by the production capacity. Then, I assume two things: 17.5% profit margin and 20-times earnings. From what I have seen in the industry from my research, the 17.5% seems to be in line. However, the 20-times earnings I feel is low. The number does provide a baseline, though.

Given all of this, here is where I believe the valuations for each individual company should be:

Canopy Growth (CGC):

This is the grand-daddy of them all, the company that wants to be the biggest. With this company, at 500 kg. and given the math above, their market valuation should be ~$9 billion. Their stock is fairly close to this, but I can see this stock heading higher. I have a few buy orders on this stock below the current market and have been a little surprised the stock continues to move lower. But, when you consider what they will be able to produce, they have a significant future ahead of them. First, however, they have to finish their facilities and then get their products to market

Tilray (TLRY):About the only thing I can say about Tilray that is nice is that their stock is significantly overvalued relative to what they can produce and it is easy to justify a short position. I have said this before and have shorted their stock and done well with it. But, the stock remains lofty. Given the math I have outlined, the market capitalization should be $2.63 billion. They are at ~$10 billion. I believe their day of reckoning is upon them, though.

Aurora (ACB):

Given the math above, Aurora should have a market capitalization of $7.865 billion. However, they are currently at $6 billion. Aurora is just behind Canopy Growth in size and I expect the two larger companies will be expanding even more over the course of the next few years. This is a company that while only slightly below market valuation, they are likely to continue to manage themselves well and expand with the industry.

Aphria (APHA):

I am long Aphria and have big expectations for the company. However, my expectations are a little short-sighted. Aphria is in talks with a major tobacco maker, Altria (MO). I expect some kind of deal to be announced and from that a spike higher in the stock price. My math tells me the company should be worth $4.17 billion; the are currently valued at $2.235 billion. I am likely to end up holding this stock position for a very long time based upon its undervaluation and its long-term potential.

Cronos (CRON):

I think Cronos will do well in the field over the longer period. Their valuation is reflective of the potential, however. The company, based upon how much they will be able to produce, should be worth $2 billion. They are currently valued at $1.56 billion. They can see some upside price movement, but on a percentage basis their stock is fairly closely priced when you consider this list.

Hexo (HYYDF):

Hexo gets the prize for coming in at almost dead on with their valuation based upon their future possibilities. The company could be worth $900 million, but are currently worth $880 million. I have not done a thorough analysis on this company; it has been on my list of things to do. Mostly, this is because when I took a cursory look at the company, nothing outstanding, such as undervaluation, grabbed my attention.

The Green Organic Dutchman (OTCQX:TGODF):

Here is a company that I feel is significantly undervalued based upon their ability to produce what they will be able to produce. Their market capitalization should be roughly $3.5 billion but are currently current $574 million. The company just inked a distribution deal with the biggest wine distributor in Canada, Velvet Management. I expect this will be a good marriage for both companies. But, I do have two big questions for the company going forward: How much of the market do they expect to grab being an organic producer and second, who will Velvet be distributing to? Once I get those answers, empirical answers with fact-based data, I will likely write something else up on the company.

Organigram (OTCQX:OGRMF):

Another organic company and another significantly undervalued company. Organigram should have a market capitalization of $2 billion but only manages a current cap of $535 million. When I look at both Organigram and Organic Green Dutchman, I notice a trend: Organic seems to equal significant undervaluation. But, maybe the market does not see what the industry does. Unfortunately, the state of Colorado does not produce any data on organic cannabis and how much consumers demand for us to determine market share. But, I am aware that there is a market share. I just don't know how much.

CannTrust Holdings (CNTTF):

CannTrust Holdings is another that is on my list of companies to take a close look at. This is the last of the bigger companies that I have yet to figure out if I want to put a long-term position on. Their market valuation should be $1.82 billion but, they are currently only $680 million. That is significant and that is motivational for me.

Takeaway

I see the future potential of the industry of pot stocks and am looking at this from a very long-term perspective. Given what demand is likely to be in Canada, there is a lot of room to grow in this industry. These stocks are likely to see the lion's share of that growth being that they are the bigger producers, er, will be the bigger producers.

But, you will have to be patient to get involved with these companies. A lot of them still have 6 - 9 months before their products make it to market. Then, you have a few more months until you see their earnings work their way into the financial reports. Then, you have even more time until the companies build up brand recognition. In other words, you need to be patient. But, that patience will pay off.

Disclosure: I am/we are long CGC. 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: I am long several of the stocks on this list with a timeframe of 10 - 15 years

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.