The cannabis industry has been growing at an unstoppable and rapid pace. Many of its most famous and biggest names enjoyed immense investment gains, driven by industry projections of aggressive growth. After BDS Analytics and Arcview Market logged $10.9 billion in cannabis sales globally last year, the worldwide forecast is likely to quadruple by 2024, especially with marijuana delivery service.
Forbes is also excited, citing $30 billion worth of legal sales by 2025. Wall Street believes annual sales will reach $200 billion by decade’s end. Of course, these figures hinge on open trade within the United States. So far so good. On paper, at least. Reality is proving markedly different. It is not meeting expectations, and has not been since the end of March already. Why?
Third Quarter Blues
Marijuana stocks are currently in a funk. A sizeable funk, at least six months old already, and in Canada’s newly legal marketplace, it appears to be worsening. During the third quarter, Horizons Marijuana Life Sciences ETF, the first cannabis-focused exchange fund, lost 34 percent of its worth, which includes all its dividends paid. Brand-name stocks are struggling, a beating really standing out the last three months.
Collectively, the industry’s “Big Four” shed nearly $14 billion of its market value during the third quarter alone. These companies have been investing huge sums of money for lucrative future gains. However, for the specific-minded, aggregate market cap losses for the third quarter of 2019 emerged with these rather depressing, even demoralizing, figures for the “Big Four:”
- Canopy Growth (NYSE: CGC): $6.05 billion.
- Aurora Cannabis (NYSE: ACB): $3.49 billion.
- Cronos Group (NASDAQ: CRON): $2.33 billion.
- Tilray (NASDAQ: TLRY): $1.77 billion.
The sheer scale of these losses is even more mindboggling when Canopy Growth and Cronos having the two highest cash balances on hand, with Aurora Cannabis so well capitalized it has a shelf offering of $750 million at its disposal, in case it should ever need it. In plain speak; cash on hand in the industry is not quite the protection against risk it offered just a mere six months ago. What is causing this?
Problems with Canadian Supply
Ever since the very first day of legalization back in October last year, the whole pot industry in Canada has been reeling. This is due to persistent issues in the supply chain, some self-inflicted by growers lagging behind in expansion projects. For example, the grow farm for Aurora Sun intends 230,000 kilograms of annual production for Aurora Cannabis, but only next year, somewhere around July.
Procedural issues are also causing problems. Health Canada, the country’s regulatory agency, is yet to issue many licenses, buried under a pile of waiting applications. Even with changes to license applications for growers, no quick fix exists for the supply issues facing these companies. In fact, this formed part of Aurora’s opening results for its fiscal fourth quarter.
Furthermore, in combination with delay issues at Health Canada, some provinces have also been very slow in licensing physical dispensaries, further disrupting the supply to already frustrated consumers. Despite huge demand for cannabis in the country, these kinds of problems are enriching the black market. Illegal sales are filling this shortage, at least for now.
Expanding on the supply problem is that being unable to provide product, and therefore not making enough sales, is turning many an income statement ugly. Canopy Growth only made a pitiful 15 percent gross margin in its first quarter, totaling an operating loss, without adjustments for fair value and once off costs and benefits, which should exceed CA$ 215 million, but appears stuck for two quarters now.
In the interim, Cronos has made some profit over two consecutive quarters, even with a huge asterisk. Its profit is the direct result of revaluing derivative liabilities from Altria, an equity investment firm. However, if investors focus solely on operations and remove all other fluff, Cronos still loses money where it most matters, and lots of it. Nobody looks even likely profitable in the 2020 fiscal year either.
Growing Risk of Writedowns
Increasing goodwill is another factor contributing to these problems for the Big Four. Goodwill refers to the most a buying company will pay for another business, over and above any tangible assets. Although some goodwill is normal during acquisitions, the figures accrued by some cannabis stocks suggest that some companies are overpaying grossly for the deal.
For example, over the last three years, Aurora Cannabis has made several acquisitions. In many of these cases, it recorded a massive chunk of these payments as goodwill, the biggest of which is the CA$2 billion paid from its CA$2.64 billion acquisition of MedReleaf in July last year. Its balance sheet now shows CA$3.17 billion in goodwill, amounting to 58 percent of its combined assets.
Recouping this goodwill is extremely unlikely for Aurora, in many an expert opinion. A future writedown seems imminent. After a slew of acquisitions, Canopy has CA$1.93 billion in goodwill, with Tilray now sporting CA$155 million in goodwill from its purchase of Manitoba Harvest. All of these amounts are potential writedowns in the very near future.
Rising Dilution of Stocks
Investors are also growing weary of the continual dilution associated with owning marijuana stocks. Since these stocks lack access to even basic financial services, such as banking, many are now issuing their own stocks to either finance acquisitions or otherwise raise capital. Where share offerings have been providing good results for cannabis stocks, they are also diluting shareholders to the minimum.
Aurora has been financing all of its acquisitions since 2016 with its own common stock. The abovementioned CA$2.64 billion price of MedReleaf was the result of financing from an all-stock deal. This ballooned its outstanding share count from June 2014, which stood at CA$16.2 million, to around CA$1.02 billion five years later, a one-billion share increase investors are having difficulty swallowing.
Aurora is not alone in this problem. Canopy Growth is responsible for similar dilution of its shareholders, financing most of its acquisitions with its own common stocks too. If its acquisition of contingent-rights Acreage Holdings ever comes to life, common stock will pay for most of the purchase price. Undoubtedly, investors are finding cannabis stocks displeasing so early in the industry.
The legal cannabis market is in its infancy. Companies like the Big Four are risking an entirely new industry, one that, despite its early hiccups, is still likely to reach unimaginably lucrative projections within the next decade of marijuana delivery service. Once Canada sorts out supply issues, companies will start profiting. Until then, consumers will continue to incentivize the country’s illegal black market.