Pot Stocks

I have wanted to do this for a while.

Let's look at pot stocks in Canada.

The Financials:

Aurora Cannabis.  This company had Operating Revenue of $55 Million for its last fiscal year ending June 1, 2018, and Operating Expenses of $122 Million, for an Operating Loss of about $67 Million.  For every dollar they received in revenue, they lost $1.21.

The company expects operating revenue of $50 - 55 Million for period from Oct 1, 2018 to Dec 31, 2018.  This would be a 327% jump.

With the Q2 financial report due February 11, 2019, this company just secured a loan of $250 Million.  They had $219 Million on hand in June, 2018.  One would think they have spent most of that trying to build new production facilities, and marketing in anticipation of the legalization of pot in Canada.

Canopy Growth.  This company announced it Q3 results on Jan 15, 2018. Unless you go to their website and read their report yourself, the company's propaganda will not tell you how they are doing - they claim an $11 Million "net profit" for the quarter.

If you go to their financial reports you see a whopping $214 Million LOSS in one quarter! Yes, their revenue was as they have announced in their relentless propaganda - $23.3 Million.  What they neglected to tell you about was the Operating Expenses of just over $180 Million! 

But it is not that bad. WEED issued $95 Million worth of options to its officers, directors and managers in the quarter, and booked them as operating expenses, so I think the Operating Loss for the three months was probably only something like $57 Million. If I owned this, I would be very worried about $95 Million in options being issued when revenues were only $23 Million or so.

Like Aurora, the company did raise over $200 Million, which is likely for expansion of production - or is because this what you have to do when you are losing tens of millions a quarter, and you want to stay in business? We will eventually find out.

WEED has acquired a number of small companies, and has started selling in Germany, showing an initial $1 Million in sales there. It has invested in a pot-based beverage business.

At this point, I can see no indication that these companies actually make money from the production and sale of pot. I see no path forward to profitability in the short run - 12 months. I expect their next results will show continuing operating losses. 

The 30 P/E Challenge:

Growth stocks are expected to expand production and profits rapidly over time, and therefore are generally given a bit of a pass regarding valuations in light of this supposed happy future.  While a Price to Earnings ration for a company like a chartered bank should be somewhere around 16, for a growth stock, having a P/E in the range of 30 is perfectly acceptable.

Canopy Growth is trading at about $63 a share today. There are about 343 Million shares out. To get to a P/E of 30, WEED would need profits of about $2.10 a share, or total profits of about $720 Million a year. Recall that their total revenues were only $23 Million in the last quarter.

How much revenue may WEED need to generate each year to justify a $63 share price with a 30 P/E?

To calculate this, we have to assume some level of net profit margin for this company - how much money will they make from every dollar of revenue received? 

The beer industry might be a good comparator, and a very quick Internet search reveals a net profit margin in that industry is likely close to 25%. Based on this, let's assume that WEED eventually gets to a profit margin of 25%, meaning that they make about twenty-five cents from every dollar worth of pot and pot derived products that they sell.....recall that they have a negative margin right now.... 

To get to a profit of $720 Million a year, with an assumed net profitability of 25%, WEED would need about $2.88 Billion in revenue per year. This would support today's share price at a 30 P/E.

Aurora is trading at about $9.00 today, with about 1 Billion shares out. To get to a P/E of 30, Aurora would need a profit of $0.30 per share, or about $300 Million a year.

Assuming that Aurora can also get to a net profit margin of 25% at some point, Aurora would need revenues of about $1.2 Billion a year in order to justify today's share price at a P/E of 30. 

Together, these companies will need, at a bare minimum, $4 Billion in sales a year to justify their present share price. 

Right now, WEED is projecting revenues of only about $1.2 Billion by the end of 2021. That is less than half way to the mark they may need to meet. In that year, they predict a P/E of, not 30, but 214. By way of comparison, I think that at the height of the Tech Boom madness, Nortel's highest P/E was 124.

Aurora's sales are projected to get to about $840 Million by the end of 2020. This is much closer than WEED will get to in order to meet the target noted above.  Aurora will have an expected P/E of not 30, but 130.

These are real companies that will survive and likely thrive, but they may be many years away from generating the type of profit they need to show to justify their present share prices.  

Will today's investors be willing to wait that long? 

Monkey Wrenches:

The above projections assume that many things will go well for these companies.  

While these are the two biggest companies in the space at the moment, there are at least eight other competitors out there that are worth over $500 Million already. For WEED and Aurora to succeed, this competition will have to be purchased, merged with, or beaten. 

The projected size of the market is also an issue. A quick search sees estimates for the size of the pot market in Canada ranging from a low of about $4 Billion a year to well over $10 Billion.  If it is the lower of the two, Aurora and WEED would essentially have to own the entire market for pot in Canada in order to justify their share price of today at a 30 P/E and a 25% net profitability - an impossibility.

The international markets may help, or they may not....no one knows. As pot is an agricultural product, it is worthwhile keeping in mind that agriculture is the most heavily subsizided and protected industrial sector on earth. If the world does legalize pot, will this be an opportunity for Canadian companies, or will countries subsidize their own growers and put up trade barriers just as they do with other agricultural products, effectively shutting our producers out? And what will happen when foreign companies demand access to the Canadian market?  

Finally, the existing black market has been around for decades. One would think that these people will fight to keep market share, with the probable effect being lower prices on the part of legal producers who will have to work to avoid being undersold. But this will cut directly into net profit margins, and with that, into share price levels.

Conclusion:

This ship has sailed...I'm not buying.