- We are going to look into the economics of the cannabis industry.
- The stock we’re analyzing today is Canopy Growth.
- We’ll finish with what to do as a cannabis investor.
When the market is overvalued as it is now and the probabilities of a recession hitting the economy soon are high, one might look for alternative investments to see whether there are some better risk reward opportunities, or at least to find ways to take advantage of the trend.
Two such hot investment trends are marijuana stocks and lithium miners which we discussed yesterday. Today, I’ll touch on marijuana stocks to see whether they will ultimately be a fad that will burn investors or if there is some actual sector earning capacity.
The things to look at sector-wise are demand and supply, production costs, potential margins, and the inevitable investing trend and momentum that has been created. The sector’s revenue also has to be compared with the total market cap of the sector, and we have to look at whether there are some producers that have a business moat of some kind to differentiate between investments and speculations.
I’m going to discuss the sector by analyzing the largest player on the block, Canopy Growth (TSX: WEED), but let’s first look at the sector.
The Cannabis Industry
The exuberance surrounding the industry started in 2017 when the legalization of cannabis in Canada became a reality and stocks surged on the news.
However, since the start of this year, there has been an increase in volatility and marijuana stocks haven’t gone up. Let’s dig deeper to see whether it’s a trend or fad that will burn out just like a joint.
Canopy expects the weed market in Canada to be in a range from $5 to $10 billion soon.
So, they expect the weed market to be bigger than the beer market. To put things into perspective, 770,000 kilograms is 770 million grams sold from with which you can make 2.1 billion joints. If I divide that by Canada’s population of 36 million, it means each Canadian—from babies to the elderly—will smoke 58 joints per year. Of course, not all of the production will be used for smoking, but it’s an interesting perspective.
A note on usage, in the Netherlands, just 8% of the population smokes pot, so those who do consume would have to smoke 580 joints per year on average to consume all 770,000 kilograms produced.
Further, if the market grows to $10 billion as expected, it will mean that the total market capitalization of weed stocks could be around $20 billion. The company has sold weed for $8.3 which is higher than the $6.5 they expect in their best case scenario. Canopy’s market cap is already close to $5 billion, and that’s just one company.
Also, for selling wholesale, $8 is a bit high as the prices in the Netherlands—which is a mature weed market—are similar for retail.
We can see weed being retailing at less than 5 EUR, with a 150% markup, you get to prices of 2 for wholesale which is in line with Canopy’s production costs. Now, I know the customers are stoned, but the margins will come down to normal levels just as the tomato and vegetable industries did.
Don’t believe me? Look at this:
So, given the sector mechanics, I don’t see a business moat. What I do see is much lower prices as many new players come into the market. In the mature parts of the U.S. market with many private producers, wholesale cannabis prices are around $3.5 per gram, or $1,600 per pound.
Let’s look at Canopy’s financials, management, and corporate governance.
Revenue has more than doubled in the last quarter, but sales costs have tripled, administration costs have as well, and share-based compensation has increased 5 times as the management took home $17.8 million, or 82% of revenue for the quarter. Over the past 9 months, the management has awarded itself 52% of revenue in stocks. What a great business to own, at least as a manager!
Further, the company has burned 4 times as much cash as they did in the previous 9 months and has invested 10 times more.
So, operating cash usage for the first nine months of fiscal 2017 was $44 million on $55 million of revenue. This doesn’t include the $130 million spent in investing activities.
Further, there is much more dilution and the company has diluted shareholders by 50% over the last quarter.
Now, when investing in something like this, you need to have the management on your side and they have to have incredible integrity to deliver value to shareholders and not to themselves. Let’s check on what is going on with Canopy’s subsidiary.
Canopy Growth managed to dilute even its subsidiaries which is something you don’t want to see when you’re looking to own great businesses in sectors with stellar growth. Who controls the subsidiary doesn’t matter at all and if you look at figure 7, you can see that 90% of Canopy’s reported earnings are for non-controlling interests, not the mother company.
Let’s have a look at the CEO.
So, at this point in time, the CEO of Canopy is also the CEO of three other companies. I don’t think I have to dig deeper on the corporate issues this company is having, and I’m not going too far when I say that investors will have to be extremely lucky to see any kind of business returns from this stock.
To sum up, we have:
- A commoditized market with much lower prices.
- Management that is trying to make money in any way they can for themselves.
- Huge dilution in all forms and a perfect example of misaligned interest with shareholders.
- Unreasonable growth projections that may or may not happen.
Unfortunately, I must say that the cannabis market will resemble the difficult tomato market that is highly capital intensive with minimal margins where only those who talk to the plants all day long can make a good living for their family.
There is no moat, no competitive advantage, and nothing that would suggest these companies have an advantage over other competition that could well be you and me setting up a greenhouse and growing the week ourselves.
Perhaps if there is a positive end to this story, it’s that if you don’t sell the week, you can still remained stoned for life. But be careful not to stone your portfolio.
So what should you do? If you’ve made money on weed stocks, I would either smoke-up the gains or reduce my positions and diversify.