Cannabis Inc

All those big numbers are rather tantalising of course and one should always treat market research reports of this type with a degree of caution. But any fool can see that legalisation is opening up a huge new market for investors.

So, should you be investing right now, and which stocks are likely to offer the best returns? The answer to the first question is clearly yes – albeit there is a risk that the sector is overhyped and valuations already stretched – the answer to the second is a lot more complicated, not least because this is such a new market and even experienced stock-pickers are struggling to find where the real value lies. Here we look at cannabis investing, the key stocks to follow, and explore just how high the sector could go.

Regulatory overview: the war on drugs is lost

Canada has become the focus for investors since it became only the second country in the world – after Uruguay – to legalise recreational marijuana use. In the next few weeks Canadians will be able to legally buy cannabis and related products from licensed producers and outlets. The market for recreational cannabis use in Canada alone has been estimated at $5bn-$10bn, and it is here where investors have really displayed confidence that public companies can benefit, with Canadian cannabis firms attracting the lion’s share of equity investment. The land of the maple leaf is becoming the hemp leaf capital of the planet.

But it’s not just Canada. Despite the lack of nationwide liberalisation, the US market is already far larger. The regulations are more complex and at the Federal level we still have doubts about whether the market will be opened up entirely. But a majority of states – around 30 – have legalised marijuana use in some form or another and it looks as though more will follow. In the UK medicinal use of cannabis has been approved, while Germany legalised marijuana for medical uses in January 2017.

Of course, even in Canada the regulatory landscape varies state by state. Ontario will offer weed in only 40 state-run shops, while in Alberta over 200 private retailers will be able to sell marijuana products. In Newfoundland and Labrador, supermarket chain Loblaws – Canada’s version of Tesco – will offer marijuana. Pint of milk, loaf of bread, one eighth of cannabis... every little helps.

While the regulatory picture is complex and varied, there is a sense that the tide has turned and the ‘war on drugs’ has been lost. Or won, depending on your point of view. What is undeniable is that with legalisation comes the potential to invest in legitimate companies that are on the precipice of a brand new, largely untapped market. And even if there is not a wider liberalisation for recreational use, the medicinal market is growing rapidly. Stocks that have good relationships with healthcare providers may offer a more secure and sustainable revenue stream that is less dependent on countries completely opening up their markets to recreational cannabis use.

Picking stocks: who’s getting high?

As a guide for stock-pickers, marijuanaindex.com is a good starting point. It offers an overview of the largest stocks, share price performance and a comprehensive news feed for cannabis stocks. The North American Marijuana Index – probably the best overall guide to the sector – rose sharply through 2017 but has since retraced some of that move as the euphoria makes way for more hard-headed investment decisions.

So what stocks are worthy of our attention? Canopy Growth Corporation (Can:WEED), which through its Tweed brand and association with the rapper Snoop Dog is probably the best-known pot stock, was the first publicly traded and federally regulated cannabis company in North America. It’s listed on both the Toronto and New York stock exchanges – respectively under the tickers WEED and CGC. The latter listing in particular has helped to keep it in the limelight and may offer a bit more credibility than most. Indeed, with many pot stocks trading in over-the-counter markets, those that are publicly listed should attract greater investor demand and better liquidity as they are subject to tougher reporting and corporate governance criteria, making them able to attract interest from funds.

But this strong market presence is coming at a price. Higher admin costs and marketing expenses saw the company’s net loss last year rise to $0.40 per share from $0.06 a share the year before. Nevertheless, the outlook for the shares is encouraging, with revenues doubling and cash on hand up 247 per cent, leaving it in a good position to drive volume growth at this key phase. It has about 2.4m sq ft of growing space and more to come, so it has the capacity to ramp volumes easily as demand picks up.

If you think of pot stocks as a long-term value play then Canopy has the infrastructure and brand recognition in place already. And for it to be ramping up spending ahead of the big liberalisation day in Canada makes sense.

Product diversification is another area where investors should look. Constellation Brands, the alcoholic drinks company that, among other things, distributes Corona beer in the US, has a 10 per cent stake in Canopy. It has big plans for cannabis-based drinks, although it won’t roll these out in the key US market until it’s legalised nationally. It will, however, be ready to go in Canada next year.

Canopy also has more strings to its bow than just Canada, with international distribution and partnership agreements covering Spain, Australia, Denmark and Jamaica among others. In the most recent quarter it reported $2.3m in sales in Germany, thought to be the largest market in Europe, which is about a tenth of the group’s total revenues. International markets will be a key growth lever, with research suggesting that while North America will see by far the biggest spending over the next 10 years, the most rapid rate of growth will happen elsewhere, in places such as Australia and Europe.

The shares have trebled in the last year to be worth around C$34 (£20), and it now boasts a market cap that is in excess of C$7bn. Of the half dozen or so analysts covering the stock, the consensus price target is just shy of C$40, offering an upside of about 15 per cent from the current levels.

Another well-known stock is Aphria (Can:APH), a medical-focused company that is looking to tap the nascent Canadian market for recreational use and expand internationally. After a spate of acquisitions, the valuation has suffered and profits remain elusive, but it’s undoubtedly got the scale to take advantage of global liberalisation efforts.

In its latest quarterly results there was some disappointment despite strong revenue growth and Ebitda in the core Canadian division rising for the 11th straight quarter – a feat unmatched by peers. Revenues doubled chiefly off the back of its acquisition of Broken Coast, while its international division reported an adjusted net loss of C$2.8m, leaving it with a group net loss of nearly C$5m, nearly twice that registered a year before. Cash on hand is dwindling, sliding from around C$173m at the end of the third quarter to C$105m in the fourth. But this remains a solid balance sheet that should leave it able to snap up smaller producers and make other ad-hoc acquisitions.

However, while Aphria looks set to ramp up production, there is a concern in the industry that supply will exceed demand pretty swiftly as companies scramble to take advantage of the new market. What probably matters more is driving international demand and, through its acquisition of Nuuvera among others, Aphria appears to have a way in to some important markets such as Italy and Germany. The challenge will be in driving expansion internationally while managing costs. The key question hanging over the investment case here – and indeed for most other cannabis stocks – is whether international sales can rise quickly enough to offset the capacity ramp up among Canadian producers.

Yet another company boosting production is Cronos (US:CRON). And like Aphria it’s seeing revenues rise substantially while the investments are hitting profits. In May the firm’s first-quarter report showed a 473 per cent increase in revenues but the net loss increased to about C$1m as production costs soared sevenfold from the prior year. Like Canopy it’s also investing heavily in marketing and admin to prepare for the Canadian legalisation date, which we assume to be a positive even if it hits earnings in the short term.

Deal-making is positive: the company recently inked a deal with MedMen – California’s largest cannabis retailer – to develop stores in Canada. Meanwhile, a distribution agreement with G.Pohl-Boskamp will enable it to deliver products to 12,000 pharmacies in Germany over the next five years. A new focus on the higher-margin cannabis oils market is starting to pay off with revenues from these accounting for nearly one in 10 sales.

Finally, we cannot ignore Aurora Cannabis (Can:ACB). It ticks all the boxes – it is ramping production from an already high level, has made a number of key strategic investments and acquisitions – its C$3.2bn all-stock acquisition of MedReleaf remains the biggest marijuana deal so far – and is building up its international footprint and distribution channels.

European cannabis market

Key takeaways

We’ve provided a brief snapshot here of a handful of the major players, but it’s clear that there are some consistent themes at work that investors should consider before stumping up cash to get a piece of the cannabis pie.

One, these stocks are already priced quite highly versus historic earnings – investors have already looked at this market and seen the potential. For example, Cronos trades at a trailing 12-month price/earnings ratio of about 1,000. Many stocks will likely fall as expectations for growth are so high and valuations do appear rather toppy. This makes old-fashioned stock-picking all the more important. On the plus side, cannabis stocks are not nearly as highly valued as they have been with the entire sector down by around a third since the peak in January, potentially offering an in for investors.

Two, a capacity glut is coming. Canadian production is expected to soar as every player positions for the growth opportunity. So, while revenues are going to rise with supply and demand increases, margins and profits are less certain. This makes the following two points vital.

Three, the importance of acquisitions and international deals to drive growth outside of Canada is becoming apparent. Those Canadian producers that can leverage distribution agreements with partners overseas will probably do better than those focused on just the North American market.

Four, balance sheets matter. Investors should always look for a healthy balance sheet, but it’s particularly important in the new cannabis sector as companies need to make bold investments to capture growth opportunities. The industry is highly fragmented and as the market matures it’s likely that companies with the healthiest balance sheets will win out as they snap up rivals and develop economies of scale.

Finally, five, don’t get overly carried away with the prospects for growth. Going back to the regulatory debate, while the market is growing it is highly uncertain just how large it will become in the coming years. In such a frontier market, poorly chosen investments could easily go up in smoke.