How to analyse cannabis stocks: finding the value in the marijuana market

Finding the value in cannabis stocks

Cannabis stocks have exploded over the past year but it has not been a smooth ride for investors. Canadian companies have led the charge since the country became the first G7 nation to legalise recreational use of marijuana last year and many have already earnt multi-billion dollar valuations as investors fixate on the potential growth while ignoring the huge losses and cash burn that most are reporting.

Share prices in the likes of Canopy Growth, Aurora Cannabis and Tilray – often seen as the ‘big three’ – have soared over the last year but are all trading below their peaks seen in the run up to marijuana being legalised in Canada in October 2018.

Share prices are volatile and the valuations earnt by these early movers ultimately mismatch with the market fundamentals at present. The combined market value of six of the largest pure-plays alone – Canopy, Aurora, Tilray, Cronos, Aphria and HEXO - is over four times greater than all global sales of legalised cannabis in 2018. These bloated valuations and the volatility in share prices will be more welcomed by traders than investors.

The early movers in the market are overvalued and it is highly likely that we will see some major causalities in years to come, but they are also in the best position to capitalise. The largest cannabis stocks have managed to suck up vast amounts of capital from public and private markets early on and used this to expand rapidly. For them, it is ultimately a race to profitability before the money runs out. However, there are bigger concerns for the slew of newer entrants that continue to enter the market and their ability to compete with the first-movers and source the funding they need. Consolidation is already the favoured method of expansion with many smaller companies being swallowed up by larger rivals over the last year.

Things will only improve for the cannabis industry but it is far from clear who the winners and losers will be. We have a look at how to analyse cannabis stocks.

How to analyse cannabis stocks

It is rare to have the opportunity to invest and track a completely new industry from the start, but investors need to ensure they are paying attention to the right things when deciding where to deploy their funds. It may be the case that businesses have only scratched the surface of the potential for legal cannabis and marijuana-based products, but, as expected, the industry is experiencing growing pains in several areas.

The cannabis industry is unique but one that draws experience from many others. Cultivating cannabis is all about agriculture and yields. Operating a network of stores is requiring efficient logistics and retail strategies. Medicinal products fall at the feet of pharma and biotech companies. Recreational product development is seeking the help of consumer goods, packaging and food industries, and so on.

Investing in cannabis: medical vs recreational marijuana

Understanding the difference between medicinal marijuana and recreational cannabis is hugely important for investors currently trying to get their head around this emerging market. There are two key compounds that investors need to grapple with: CBD (cannabidiol) and THC (tetrahydrocannabinol). Both compounds have the exact same chemical makeup and the only difference is one has an atom arranged slightly differently to the other, but this is a major difference.

In a nutshell, CBD carries the medicinal properties of cannabis while THC carries the recreational high. It is often underappreciated that most CBD products being sold offer very low levels or no ‘high’ to the person using it: a medicinal CBD oil, for example, will not offer any psychoactive effects (although some do offer both CBD and THC).

This is why more than 40 countries around the world have legalised medicinal cannabis in one form or the other and why only two have formally given the green light for recreational use.

Although the medicinal market has got the head start it is widely accepted that the recreational market will be the bigger opportunity if more countries push ahead with legalisation. Firstly, introducing a new consumer good product, such as a cannabis-infused drink or brownie, for example, is considered to be a much quicker and cheaper endeavour than developing a new marijuana-based medicine that has to go through a much longer, more rigorous approval system. Secondly, if recreational use has been legalised then a medicinal user can gain access to the drug without the need for a prescription, which could shift some people from one market to the other. Many believe legalising recreational use actually undermines the medicinal market for this reason and there is evidence to back it up: for example in California – the heartland of legal marijuana in the US – sales of medicinal cannabis were running at over $3 billion per year but, when recreational use was approved, that sum plunged to less than $300 million as consumers bypassed their doctors and went straight to the shop. In fact, total medicinal sales in the US fell to $4.3 billion in 2018 from $5.9 billion in 2017 while recreational sales jumped from just $2.6 billion to $6.7 billion, according to BDS Analytics, which added significant tax breaks for medicinal users had also shifted many stores toward recreational sales.

While there is widespread agreement that recreational cannabis will be the big opportunity in the future the argument that it will undermine the medicinal market is flawed. As smoking is not an acceptable delivery method for medicines, virtually all of the medicinal products currently available are in the form of oils. However, medicinal users – which are far more likely to try alternative, non-smoke based products than recreational users – will have a swathe of new products to choose from in the future as everything from eye drops to depositaries are brought to the market. There may be signs of medicinal users shifting to recreational cannabis once they can but, as the research behind medicinal cannabis advances and quality improves, many believe the medicinal market will be revived.

The biggest cannabis stocks at this early stage of development generate sales from selling both medicinal and recreational marijuana, but they boast very different mixes. For example, Aurora’s sales are balanced with 55% of revenue coming from the medicinal market versus 45% from recreational sales (Aphria also has a balanced mix with 60% medicinal: 40% recreational). Canopy Growth, on the other hand, is much more reliant on the recreational market, which accounts for nearly 80% of its revenue. Others like HEXO and OrganiGram Holdings generate over 90% of their revenue from the recreational market.

Management and corporate governance

With so much value being attributed to the growth potential, shareholders need to closely monitor management’s ability to deliver their outlook and promises. Companies always ensure that the board looks good on paper, so investors need to dig a bit deeper and consider whether management offers any relevant experience. While the cannabis market is evolving there are still huge hurdles to overcome and investors need to feel confident they are backing a team that is able to clear them when they need to.

Some cannabis stocks have also been criticised for poor corporate governance, whether that be their accounting practices or their engagement with filing with regulators and keeping investors up to date. The entrance of big, established brands from other industries – such as the huge $4 billion investment in Canopy by Corona beer maker Constellation Brands – is expected to get the industry in to shape and help introduce more stringent governance measures.

Scalability

Most of the largest cannabis stocks are reporting deeper losses and larger cash burns as they invest in building out their operations – whether that be through land to grow the drug, a plant to process it, a store to sell it or the logistics needed to bring it all together. At this early stage of the market, it is important that companies try to balance the need to preserve cash while capturing as much of the market as they can. In a nutshell, it is about analysing whether stocks are spending in the right area and how it not only expands the business but helps move it toward some of profitability further down the line.

Many are splashing huge sums by purchasing others. This is partly because it is quicker to buy land that already has the licenses and permits it needs in place than developing a new plot for cultivation and securing all the necessary permissions: applications have taken over a year to process in some cases in the US and Canada, which can make all the difference in this fast-moving market.

Cost of production and pricing

Gross margins among the largest cannabis stocks vary from as high as 87% to as low as 7.5%, but virtually all of them have seen margins deteriorate as they have grown. Most will publish the cost of production and the average price paid for their product, but you want to focus on the cost rather than the price. While prices will largely be dictated by external factors, costs are more under the control of the company itself. The lower the production costs, the more reward it can reap when prices are high and the more resilient it can be when prices are lower.

Cash, financing and shareholder dilution

Cannabis stocks are raising large sums to fund their ambitions and while debt is playing its role many are relying on issuing shares and convertibles. This is important for investors because it raises the threat of dilution considerably. In fact, many of the established players from other industries have used this as a way of potentially raising their exposure in the future: Constellation Brands bought a 37% stake in Canopy but has warrants that, if exercised, would give it a controlling stake of over 50%, and tobacco giant Altria has bought a 45% stake in Cronos Group but can take up that to 55% if chooses to.

While these major investments from established players is welcomed for several reasons, individual investors need to tread carefully to ensure they are not wiped out by the rampant need to raise equity. One example of this is MyDx, a firm that sells portable cannabis potency analysers, which has essentially seen its shares become worthless over the last three years as its share count exploded because so much equity was converted by its lenders.

R&D and product development

Hundreds if not thousands of new cannabis-based products will hit the shelves in the coming years, giving both medicinal and recreational users more choice. While medicinal cannabis has been legalised in some countries for a long time there are still stringent rules on how pharmaceutical companies and others can research the drug. This is opening up: the US has taken steps to allow cannabis-based medicinal research projects to access grants, for example, but there is a long way to go before the research that is desperately needed can start.

Branding and product development will be equally important for both recreational and medicinal markets. There will be both premium and discount brands, and companies that try to find unique strains that can be patented.