Cannabis Stocks Are Full Of Hot Air

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Cannabis plants grow at a craft grow operation in British Columbia, Canada. Photographer: Ben Nelms/Bloomberg<small class="article-photo-credit">&copy; 2018 Bloomberg Finance LP</small></p> </div> </div> </div> <p><span style="font-weight: 400">In the 1967 movie “The Graduate,&quot; a young Dustin Hoffman is unsure what career to pursue and advised to go into the plastics business because &quot;there’s a great future in plastics.&quot; If the movie&nbsp;were&nbsp;remade today, the&nbsp;advice would likely be &quot;there’s a great future in cannabis&quot;.&nbsp; </span></p> <p><span style="font-weight: 400">Use of cannabis is growing quickly in the US and&nbsp;more&nbsp;than half the states allow recreational or medicinal marijuana use. </span><span style="font-weight: 400">According to </span><a href="https://bdsanalytics.com/new-report-worldwide-legal-cannabis-spending-hits-12-2-billion-in-2018-projected-to-grow-38-to-16-9-billion-in-2019/" target="_blank" rel="nofollow noopener noreferrer" data-ga-track="ExternalLink:https://bdsanalytics.com/new-report-worldwide-legal-cannabis-spending-hits-12-2-billion-in-2018-projected-to-grow-38-to-16-9-billion-in-2019/"><span style="font-weight: 400" data-ga-track="ExternalLink:https://bdsanalytics.com/new-report-worldwide-legal-cannabis-spending-hits-12-2-billion-in-2018-projected-to-grow-38-to-16-9-billion-in-2019/">BDS Analytics</span></a><span style="font-weight: 400">, global sales of cannabis will expand to $146.4 billion in 2025 from $16.9 billion in 2019, a&nbsp;growth rate of 35% per year. With the sector poised for such strong growth, you might think the cannabis stocks are a great buy.</span></p> <p><span style="font-weight: 400">They are not. Incorporating even the most optimistic assumptions about future growth, the industry is trading at nosebleed valuations. The total market cap of marijuana stocks in the US and Canada is about $50 billion, despite sales of only $580 million. That translates to a price/sales multiple of 85x. To put that in perspective, the average S&amp;P&nbsp;500&nbsp;tech stock trades at a price/sales multiple of 4x. &nbsp;Highly valued and hyper growth tech stocks like Zscaler (ZS), Okta (OKTA) and Atlassian (TEAM) trade at 20 – 30x price/sales. None of the cannabis stocks have positive earnings or EBITDA. </span></p> <p> </p> <div id="attachment_74" class="wp-caption alignnone"> <div class="article-body-image"> <progressive-image class="size-full wp-image-74" src="https://blogs-images.forbes.com/robkoyfman/files/2019/03/pot-table.jpg" alt="" data-height="262" data-width="928"></progressive-image> </div> <div article-image-caption=""> <div class="caption-container" ng-class="caption_state"> <p class="wp-caption-text">Cannabis stocks by market cap&nbsp;and sales.&nbsp;<a href="https://www.koyfin.com/myd/5c485f36b277546dd91b6b8b" target="_blank" rel="nofollow noopener noreferrer" style=" display:inline" data-ga-track="ExternalLink:https://www.koyfin.com/myd/5c485f36b277546dd91b6b8b">Interactive dashboard</a><small class="article-photo-credit">Koyfin</small></p> </div> </div> </div> <p><span style="font-weight: 400">Things have gotten so frothy that even the company CEOs are warning about the frenzy. In a February 2019&nbsp;</span><a href="https://www.youtube.com/watch?v=nI0wzP9HL9w&amp;feature=youtu.be" target="_blank" rel="nofollow noopener noreferrer" data-ga-track="ExternalLink:https://www.youtube.com/watch?v=nI0wzP9HL9w&amp;feature=youtu.be"><span style="font-weight: 400" data-ga-track="ExternalLink:https://www.youtube.com/watch?v=nI0wzP9HL9w&amp;feature=youtu.be">int</span><span style="font-weight: 400" data-ga-track="ExternalLink:https://www.youtube.com/watch?v=nI0wzP9HL9w&amp;feature=youtu.be">e</span><span style="font-weight: 400" data-ga-track="ExternalLink:https://www.youtube.com/watch?v=nI0wzP9HL9w&amp;feature=youtu.be">rview</span></a><span style="font-weight: 400"> with Yahoo Finance, co-founder and CEO of Canopy Growth, Bruce Linton had a sobering assessment of the industry’s valuation.</span></p> <div class="vestpocket" vest-pocket=""></div> <blockquote> <p><span style="font-weight: 400">I think it’s entirely true that cannabis has become frothy and I’m not saying that necessarily specifically about our [stock] but you could list 85 or 90 names that are probably publicly listed that I as the operator of one of the first and most dominant [companies] have never heard of those companies.</span></p> </blockquote> <p><span style="font-weight: 400">The&nbsp;shifting regulatory and tax&nbsp;landscape also adds to the uncertainty in the sector, with further concerns about how much taxes will eat into profits. In California for example, legal cannabis sales in 2018 were $3b, which is $0.5b lower than in 2017, as many consumers bought cheaper cannabis on the black market where taxes don’t add to the cost. Across the country, varying state regulations have led to wildly different prices. A pound of marijuana </span><a href="https://www.nytimes.com/2019/01/02/us/buying-legal-weed-in-california.html" target="_blank" rel="nofollow noopener noreferrer" data-ga-track="ExternalLink:https://www.nytimes.com/2019/01/02/us/buying-legal-weed-in-california.html"><span style="font-weight: 400" data-ga-track="ExternalLink:https://www.nytimes.com/2019/01/02/us/buying-legal-weed-in-california.html">costs</span></a><span style="font-weight: 400"> $1,183 in California (or $74 per ounce for those that buy in smaller lots), while in Illinois it costs $3,044.</span></p> <p><span style="font-weight: 400">The stretched valuations and regulatory uncertainty have resulted in a wild ride for cannabis stocks. Over the past 18 months, the MJ ETF has had three rallies more than 40% and two sell-offs more than 35%. &nbsp;Based on this pattern, the next move is likely down in the near term to the $25-$30 range.</span></p> <div id="attachment_76" class="wp-caption alignnone"> <div class="article-body-image"> <progressive-image class="size-large wp-image-76" src="https://blogs-images.forbes.com/robkoyfman/files/2019/03/mj-1200×614.jpg" alt="" data-height="614" data-width="1200"></progressive-image> </div> <div article-image-caption=""> <div class="caption-container" ng-class="caption_state"> <p class="wp-caption-text">MJ ETF wild ride. <a href="https://koyfin.com/s/g0AmN8136U" target="_blank" style=" display:inline" rel="nofollow noopener noreferrer" data-ga-track="ExternalLink:https://koyfin.com/s/g0AmN8136U">Interactive chart</a><small class="article-photo-credit">Koyfin</small></p> </div> </div> </div> <p><span style="font-weight: 400">Short interest in the ETF is around 9% of shares outstanding, which is near the high since inception. Also interestingly, short interest previously declined as the ETF made new highs. &nbsp;This time, the ETF has rallied 60% from its low in December but short interest has remained elevated. </span></p> <div id="attachment_77" class="wp-caption alignnone"> <div class="article-body-image"> <progressive-image class="size-large wp-image-77" src="https://blogs-images.forbes.com/robkoyfman/files/2019/03/mj-short-interet-1200×800.jpg" alt="" data-height="800" data-width="1200"></progressive-image> </div> <div article-image-caption=""> <div class="caption-container" ng-class="caption_state"> <p class="wp-caption-text">MJ ETF has elevated short interest as traders bet against it.&nbsp; <a href="https://koyfin.com/s/1zT40GhwaK" target="_blank" rel="nofollow noopener noreferrer" style=" display:inline" data-ga-track="ExternalLink:https://koyfin.com/s/1zT40GhwaK">Interactive chart</a><small class="article-photo-credit">Koyfin</small></p> </div> </div> </div> <p><span style="font-weight: 400">There are few reasonable options to buy cannabis stocks because valuations are too inflated. However there might be a better indirect play. Constellation Brands (STZ) is one of the largest beer and wine distributors in the world with brands such as Corona and Modelo. Recently, STZ planted its flag in the cannabis space with an equity investment in Canopy Growth (CGC). The dealmaking started in October 2017 when it paid $190 million for a 10% stake in CGC. In June 2018, STZ bought a $450 million convertible note and in October 2018, the company paid $3.8 billion to increase its stake to 38%, with optionality to increase its ownership to 50% in the future. STZ evidently has its sights on the cannabis industry with a large balance sheet. The stock is reasonably priced at 18.5x P/E, inline with its 10-year average.</span></p> <div id="attachment_73" class="wp-caption alignnone"> <div class="article-body-image"> <progressive-image class="size-large wp-image-73" src="https://blogs-images.forbes.com/robkoyfman/files/2019/03/STZ-pe-1200×800.jpg" alt="" data-height="800" data-width="1200"></progressive-image> </div> <div article-image-caption=""> <div class="caption-container" ng-class="caption_state"> <p class="wp-caption-text">STZ forward P/E. <a href="https://koyfin.com/s/tHp3PXtyoH" target="_blank" rel="nofollow noopener noreferrer" style=" display:inline" data-ga-track="ExternalLink:https://koyfin.com/s/tHp3PXtyoH">Interactive chart</a><small class="article-photo-credit">Koyfin</small></p> </div> </div> </div> <p><span style="font-weight: 400">It’s exciting to watch how the cannabis industry will develop over the next several years. The inflated valuation of the stocks makes for poor risk/reward of buying the traditional cannabis stocks. Until valuations come down for traditional cannabis stocks and there’s more certainty around regulation, investors should puff puff pass. </span></p>”>

Cannabis plants grow at a craft grow operation in British Columbia, Canada. Photographer: Ben Nelms/Bloomberg© 2018 Bloomberg Finance LP

In the 1967 movie “The Graduate,” a young Dustin Hoffman is unsure what career to pursue and advised to go into the plastics business because “there’s a great future in plastics.” If the movie were remade today, the advice would likely be “there’s a great future in cannabis“. 

Use of cannabis is growing quickly in the US and more than half the states allow recreational or medicinal marijuana use. According to BDS Analytics, global sales of cannabis will expand to $146.4 billion in 2025 from $16.9 billion in 2019, a growth rate of 35% per year. With the sector poised for such strong growth, you might think the cannabis stocks are a great buy.

They are not. Incorporating even the most optimistic assumptions about future growth, the industry is trading at nosebleed valuations. The total market cap of marijuana stocks in the US and Canada is about $50 billion, despite sales of only $580 million. That translates to a price/sales multiple of 85x. To put that in perspective, the average S&P 500 tech stock trades at a price/sales multiple of 4x.  Highly valued and hyper growth tech stocks like Zscaler (ZS), Okta (OKTA) and Atlassian (TEAM) trade at 20 – 30x price/sales. None of the cannabis stocks have positive earnings or EBITDA.

Things have gotten so frothy that even the company CEOs are warning about the frenzy. In a February 2019 interview with Yahoo Finance, co-founder and CEO of Canopy Growth, Bruce Linton had a sobering assessment of the industry’s valuation.

I think it’s entirely true that cannabis has become frothy and I’m not saying that necessarily specifically about our [stock] but you could list 85 or 90 names that are probably publicly listed that I as the operator of one of the first and most dominant [companies] have never heard of those companies.

The shifting regulatory and tax landscape also adds to the uncertainty in the sector, with further concerns about how much taxes will eat into profits. In California for example, legal cannabis sales in 2018 were $3b, which is $0.5b lower than in 2017, as many consumers bought cheaper cannabis on the black market where taxes don’t add to the cost. Across the country, varying state regulations have led to wildly different prices. A pound of marijuana costs $1,183 in California (or $74 per ounce for those that buy in smaller lots), while in Illinois it costs $3,044.

The stretched valuations and regulatory uncertainty have resulted in a wild ride for cannabis stocks. Over the past 18 months, the MJ ETF has had three rallies more than 40% and two sell-offs more than 35%.  Based on this pattern, the next move is likely down in the near term to the $25-$30 range.

Short interest in the ETF is around 9% of shares outstanding, which is near the high since inception. Also interestingly, short interest previously declined as the ETF made new highs.  This time, the ETF has rallied 60% from its low in December but short interest has remained elevated.

MJ ETF has elevated short interest as traders bet against it.  Interactive chartKoyfin

There are few reasonable options to buy cannabis stocks because valuations are too inflated. However there might be a better indirect play. Constellation Brands (STZ) is one of the largest beer and wine distributors in the world with brands such as Corona and Modelo. Recently, STZ planted its flag in the cannabis space with an equity investment in Canopy Growth (CGC). The dealmaking started in October 2017 when it paid $190 million for a 10% stake in CGC. In June 2018, STZ bought a $450 million convertible note and in October 2018, the company paid $3.8 billion to increase its stake to 38%, with optionality to increase its ownership to 50% in the future. STZ evidently has its sights on the cannabis industry with a large balance sheet. The stock is reasonably priced at 18.5x P/E, inline with its 10-year average.

It’s exciting to watch how the cannabis industry will develop over the next several years. The inflated valuation of the stocks makes for poor risk/reward of buying the traditional cannabis stocks. Until valuations come down for traditional cannabis stocks and there’s more certainty around regulation, investors should puff puff pass.

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