Is it finally time to invest in marijuana stocks? There are many reasons to think so. Here’s why.
Humans and marijuana have a common history dating back thousands of years.
The UN World Drug Report claims that global marijuana use rose by 60% in the last decade and that roughly 200 million people consume it at least once a year.
From 2006-2016, the number of daily or near daily users rose by 96%.
In 2018, marijuana stocks exploded after Canada legalized recreational use. Investors rushed to buy shares and the marijuana index quickly reached all time highs.
Unfortunately, the investment high was short-lived, and reports of underwhelming sales and disappointing financial results sent the stock prices crashing.
Canadian company Tilray encapsulates the tragic story of marijuana stocks: In 2018, the stock skyrocketed 398% in less than 3 month; today, the stock trades for $8.56 and those who bought at the peak of the bull run are currently down 94%.
Thousands of investors who got badly burned may never invest in this sector again. One Forbes analyst summed up the general mood of the time and claimed that “pot stocks will never recover“.
Two years later, the grim prediction appears to have come true. The industry is struggling to turn a profit and stock prices remain low. Major companies are posting massive losses with no apparent path to profitability.
However, there is a silver lining.
The coronavirus lockdowns have given the legal weed industry a second renaissance. Sales rose considerably in Q1 2020 because the production and sale of marijuana were deemed essential services. In parallel, marijuana companies are restructuring their operations to rationalize and increase efficiency.
So is it finally time to invest in marijuana stocks? There are plenty of reasons to believe so.
1 – The Legal Marijuana Market Keeps Growing
A – Legalization is trending worldwide
By enacting the Compassionate Use Act of 1996, California became the first US state to legalize the use of medical marijuana. For the next two decades, legalization struggled to gain traction until 2012, when Colorado and Washington legalized recreational marijuana. In 2018, Canada became the second country in the world after Uruguay to fully legalize both medical and recreational marijuana.
In the US, marijuana is still illegal on a federal level but talks of legalization are now mainstream. Medical marijuana is legal in 33 states and 14 others have legalized medical marijuana with limited THC content. A recent Pew Research Poll found that 66% of Americans support legalization and the march towards legalization continues: Illinois legalized medical and recreational marijuana in January of this year, and New York Governor Andrew Cuomo stated his intention of doing the same by the end of 2020. Realistically, federal legalization could be less than a decade away.
Around the world, more and more countries are gradually legalizing marijuana for both medical and recreational purposes: the Netherlands tolerates recreational use since 1972; Uruguay legalized recreational marijuana in 2013; Portugal legalized medical marijuana in 2018; and medical marijuana use is being progressively legalized in Israel, Argentina, Brazil, Australia, Germany and Poland. This proves that mentalities are changing.
The legalization of medical marijuana – even when it’s very restrictive – is the first step in the long march towards full medical and recreational legalization because countries who adopt favorable legislation towards marijuana don’t return to repressive policies. This is the first reason why it may be time to invest in marijuana stocks – to enter before the legalization wave kicks in.
B – As Legalization Progresses, the Legal Market Grows
Legalization has created a booming marijuana economy.
The legal marijuana market, already worth $17 billion, is expected to grow at at CAGR of 30%+ for the next decade. Analysts believe that by 2028 the global market size could reach anywhere between $73.6 billion to $98 billion. This year alone, the Canadian Recreational Market is projected to triple from $1.6 billion to nearly $4 billion, despite slower than expected growth.
To understand this projection, we need to look at the four different sectors that make up the cannabis market: medical sector, recreational sector, the “Cannabis 2.0”sector and the home cultivation sector.
a. The medical sector
Currently, the medical segment generates 71% of all marijuana sales. Cannabis is increasingly used as a pharmaceutical product for treating Cancer, Arthritis, Parkinson’s, Alzheimer’s, and other neurological conditions. The medical CBD segment alone is projected to grow at a CAGR of 51.8% from now until 2028. As people in Western countries age, there will be increasing demand for disease treatments and chronic pain management therapy. The medical marijuana market will continue growing for the next decade as legalization progresses and more research is conducted.
b. The recreational sector
Today, recreational use represents less than 30% of the total market, but it will be the fastest growing segment. First, because recreational use will be legalized in a growing number of countries, and second, because governments who legalize will try to collect as many tax dollars as they can. The only way to maximize tax collection is to legalize recreational marijuana use.
c. Changes in consumption habits
Another factor that will increase revenues is the gradual shift from flower consumption to oils, tinctures, and edibles.
Right now, buds – also called flowers – are the largest product type by market share, generating close to 60% of revenues. Buds are popular because they are primary plant products which can be used without processing. Thus, they are affordable and easy to market. However, consumption trends are changing.
Smoking is banned in most public places. Thus, people are looking for more discreet ways of consuming marijuana. Vaping, dabbing, ingestible oils, tinctures, and edibles consumption is increasing rapidly. The advantage for cannabis companies is that these products have high profit margins and effective marketing can create strong consumer loyalty.
d. Is home cultivation under threat?
Every Canadian province and almost every U.S. state allow individuals to grow their own marijuana. However, some corporations are lobbying to ban home cultivation on the basis that homegrown products evades government taxation and can be dumped into the black market. They also argue that it’s impossible to control its quality which poses public health concerns.
In some cases, these lobbying efforts have been successful: In Illinois and New Jersey, marijuana cultivation is only legal for those who use it for medical purposes; program; in New York, some companies reportedly urged Governor Andrew Cuomo to include a ban on the home cultivation of recreational marijuana in his legalization proposal.
For now, states who ban home cultivation are exceptions to the rule, but companies try to convince states who are thinking of legalizing to prohibit home cultivations. That said, it must be noted that bans on homegrowing are not permanent. After initially prohibiting home cultivation, Washington State is in the process of passing a bill that will abolish the prohibition. Home cultivation poses a small threat to big corporate interests and it will be interesting to see who wins the war.
The growth of the legal market is a second reason why it may be time to invest in marijuana stocks – before the market reaches maturity.
C – Production is being scaled
In the early days of legalization, production was a huge problem. Young cannabis companies struggled to supply enough product to satisfy consumer demand. In Quebec, a day after legalization was announced, dispensaries were out of cannabis and had to close temporarily in order to reorganise.
- Aurora Cannabis’ produces 4.8 tons a year with a $0.85 per gram cost basis
- Canopy Growth is capable of producing up to 5 tons annually at similar cost
- Aphria’s facilities can grow 2.5 tons annually with a cost basis of less than $1/per gram
The resolution of production issues has resulted in more sales and insane revenue growth:
- Canopy Growth’s revenues for the year ended March 2020 increased 464% from 2018.
- Aurora’s 2019 revenues increased 349% from 2018 and 1272% from 2017.
- Aphria’s 2019 revenues increased 542% from 2018 and 1060% from 2017.
Almost every cannabis company posts similar Y/Y revenue growth.
If the legal cannabis market is growing and revenues are rising exponentially, why are cannabis stocks performing so badly? What’s holding the industry back?
The bad news is the legal cannabis industry is faced with several challenges that are preventing it from becoming profitable. The good news is these obstacles are being addressed and could be fixed within a few years.
Is it time to invest in marijuana stocks?
2 – The Issues Holding the Industry Back are Finally Being Addressed
A – High Revenues and Negative Profits…Forever?
As mentioned earlier, global cannabis sales are on the rise, and the spike in sales during the coronavirus crisis may be a sign of good things to come. Yet, investors are skeptical as to whether cannabis companies will successfully translate future sales growth into profits.
Indeed, quarter after quarter, marijuana companies are posting massive operating losses.
The numbers are scary:
- Canopy Growth posted a USD $1 billion loss for the fiscal year ended March 2020, which is a 161.8% increase from 2019’s operating loss of USD $553.6M.
- Aurora Cannabis’ 2019 operating loss of USD $297M is up 270% from $80M in 2018
- Aphria’s 2019 loss of USD $63.8M is up 782.5% from USD $7.2M in 2018.
Part of the reason why these companies are losing so much money is the lack of cost control.
First, their cost of goods sold is very high. Canopy’s 2020 cost of revenues is 107%, Aphria’s cost of revenues is 68%, and Aurora’s cost of revenues are a more reasonable 35%. Second, operating expenses (and particularly SG&A, which are mostly marketing costs) are too high. The cannabis market is highly competitive, so companies are spending big money on advertising to create brand recognition and consumer loyalty. For example, Canopy Growth has partnered with celebrities such as Drake, Seth Rogan, Martha Stewart, and Snoop Dogg to forge an economic moat based on celebrity brand recognition.
As a result of its aggressive marketing, Canopy’s SG&A costs represent a whopping 157% of their revenues. Not to be outdone, Canopy’s main competitors post similar numbers: 152% of Aurora’s 2019 revenues and 52% of Aphria’s 2019 revenues go towards SG&A.
When you combine the cost of goods sold with operational expenses, net losses are significant, and investors are understandably worried that these companies will struggle to turn a profit anytime soon.
However, some companies are bucking the trend:
- In Q1 2020, Aphria reported positive net income of USD $5.6M. This was the result of adjustments for fair value, but is still an encouraging sign.
- Curaleaf reported positive Normalized EBITDA for the past 3 consecutive quarters
- Green Thumb Industries also reported positive Normalized EBITDA for the past 3 consecutive quarters
- Organigram reported positive Normalized EBITDA for the past two quarters.
- Over the past year, HEXO’s Normalized EBITDA losses have gone from ($56.7M) to ($20.8M), which is encouraging.
The fact that plenty of marijuana companies are starting to report positive results is a very encouraging sign and suggests they are starting to scale and control costs. This is another reason why it may be time to invest in marijuana stocks.
B – High Taxes are not a Fatality
One of the main arguments the proponents of marijuana legalization put forth is the potential collection of tax dollars. Since the black market is so profitable, legalizing weed will result in massive tax collection. Governments are suckers for money, and this argument is very effective for convincing lawmakers to legalize.
Unfortunately, it seems that governments quickly forget that “Too much tax kills tax“. Laffer’s Curve – named after American economist Arthur Laffer – demonstrates what economic theory has postulated since Adam Smith: while no tax revenue is collected at the extreme tax rates of 0% and 100%, there is a tax rate between 0% and 100% that maximizes government tax revenue, and reducing or increasing tax rates beyond a certain point is counter-productive for raising further tax dollars.
In Canada for example, the federal government revealed that cannabis taxes are only generating two-thirds of the expected revenue. What’s going on?
The fact is that high tax rates on legal pot are pushing consumers towards the black market.
In California, for example, the various state, local excise, and wholesale taxes can add up to an aggregate tax rate of 45%. In Illinois, the various taxes can result in a 30% tax on the final product. Add to that the considerable sums spent on laboratory testing to ensure the products meet regulatory standards, and one gram of legal weed ends up costing at minimum twice as much as on the black market.
In Canada, the total tax rate varies from 18.5% (Alberta) to 28.5% (Eastern provinces). As a result, less than 1 in 2 Canadians buy their product exclusively from dispensaries. A Vancouver cannabis-focused reddit subforum sums it up perfectly: the general consensus is that the “government’s pot is too expensive“.
Proponents of marijuana legalization now realize they overplayed the high taxes argument. Fortunately, not all states (US) and provinces (Canada) apply the same tax rates.
Some US states have lower rates, and unsurprisingly, the black market’s presence is greatly reduced. Oregon, where simple regulations were implemented, has plenty of legal dispensaries, low prices, and little black market presence. The state initially implemented a 25% sales tax in 2016, but quickly lowered it to a much more reasonable 17%. The legal weed market attracts virtually all the buyers and tax collection is close to optimal.
In Canada, Alberta’s lower taxes results in 67% of consumers buying legal weed regularly, compared to neighboring province B.C. where higher taxes results in only 47% of consumers buying legal weed regularly.
Hopefully, this data will convince future states and provinces who legalize weed to adopt more reasonable taxation policies. This is another reason why it may be time to invest in marijuana stocks.
Taxes are a crucial issue, but they are not the only factor for explaining why marijuana companies have struggled. One big issue being tackled is the shortage of retail locations selling legal product.
C – Dispensaries are Finally Being Licensed
In North America, there aren’t enough dispensaries to satisfy demand and the big cannabis companies are sitting on millions of dollars worth of unsold inventory: As of March 2020, Canopy Growth is sitting on USD $289.5M worth of cannabis; Aurora recorded USD $185.8M of unsold product; and Aphria has USD $167M worth of cannabis on its books.
When legalization was announced in Canada, plenty of illegal dispensaries were shut down. The licensed retail stores which were supposed to replace them were bogged down in the bureaucratic process and weren’t able to open in time for legalization. Health Canada struggled to process the hundreds of cultivation, processing, and sales licenses submitted by cannabis businesses so for a while, the only place customers could purchase legal cannabis was online. This created severe logistical issues as servers crashed, suppliers were overwhelmed and customers had to wait weeks to be delivered.
Today, certain Canadian provinces still do not have enough physical stores to meet demand. Ontario (Canada’s most populous province) has more than 240 licensed cannabis producers but less than 100 licensed retailers. In contrast, Alberta, who has just one-third of Ontario’s population, has issued more than 320 retail licenses.
Ontario officials are finally reacting to this anomaly and are abandoning the lottery system, which imposed a cap on the number of private cannabis stores, to adopt an open licensing system, which will result in the opening of 250 retail locations this year. The coronavirus may delay these openings but they will not prevent them. Further, additional stores will open over the next decade as the province’s population justifies at least 1,000 locations.
In the US, marijuana remains illegal on a federal level, so this creates unevenly applied policies. In California, for example, pot is legal but not all municipalities have provided authorizations for dispensaries: Only 161 of the 482 municipalities and 24 of the 58 counties have allowed commercial cannabis activity. The unfortunate news for cannabis companies is that 60% of the world’s largest cannabis market remains inaccessible. The good news is that legalization can only spread to an increasing number of counties over the next decade as mentalities change.
It’s difficult to sell a product when you don’t have the stores to sell it. Fortunately, authorities are implementing measures to speed up the licensing process and plenty of retail locations should open in the next few years. This ia very positive indicator that suggests it may be time to invest in marijuana stocks.
D – Will Cannabis 2.0 Save the Day?
In October 2019, Canada legalized cannabis-based vaping, edibles, beverages and snacks. These forms of consumption are dubbed “Cannabis 2.0”.
Although still in its early stages, Cannabis 2.0 consumption is growing rapidly. In the first three months of the year, Ontario consumers spent more than USD $14.8M on these products, and early projections claim the edibles market could reach USD $20 billion by 2021.
Health Canada delayed the commercialization of certain vaping products due to concerns over the effects of advertising on minors, but Ontario recently received the OK to sell them and, in one month, $3.3M worth of vaping products were sold. Similarly, Alberta authorized the sale of non-flavored vaping products in February and the provincial government expects to raise $2.9M in tax dollars for 2020-2021 and $5.8M in 2022. British Columbia, Quebec and the Eastern Provinces have strict anti-vaping laws but Alberta proves these laws can and ultimately are relaxed.
Investors should pay special attention to how these products sell because they might end up being the difference between losses and profits. Indeed, Cannabis 2.0 is expected to bring in more than $600M in revenues this year alone.
I believe Cannabis 2.0 will be a success because the big cannabis companies are backed by Fortune 500 companies with decades of expertise in the launching, branding, and mass marketing of beverages:
- Constellation Brands (who distributes Corona beer) owns 38.6% of Canopy Growth
- Molson Coors Light (US’ 2nd and world’s 5th largest brewer) has formed a joint venture with HEXO to explore non-alcohol hemp-derived beverages in Colorado
- Altria (tobacco behemoth who owns Marlboro) owns 45% of Cronos Group.
These partnerships are almost too big to fail.
Lastly, it’s important to mention that Cannabis 2.0 does not have black market competition. If the products are a hit, consumers will naturally go to dispensaries to buy them, and this may ultimately help retailers sell their buds. Consumers will eventually accept paying high taxes due to the convenience of being able to buy readily available products in the same way they buy alcohol and tobacco. Setting trends takes time, but Cannabis 2.0 could be a game changer in the long run.
The rapid growth of Cannabis 2.0 is an excellent reason to believe that it may be time to invest in marijuana stocks.
The global marijuana market is growing quickly, and companies are starting to post encouraging financial results. Patient investors with a long term focus should consider purchasing best of breed stocks now while prices are still low.
What are the best of breed stocks?
In my next article, I will analyze the companies I believe are well positioned to become the cannabis market leaders.
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DISCLAIMER: This article is the fruit of my personal analysis and is not professional investment advice. Knowledge is power so always do your own research before investing in an asset.