Weed Stocks: A Further Analysis

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The euphoria that took the Canadian stock market by storm at the end of 2016 has subsided as marijuana stocks have traded essentially flat year-to-date. Investors paid heavy premiums (based on traditional valuation methods) to access the budding industry with the hopes of being part of the next big thing. Muted trading has given the market a breather and provides us a moment to analyze the shares. Are stock prices trading at a premium or a discount? Will investors make money or should they bail at break-even? Will this industry become as large as the rest? Here are some facts which we will use to provide you with both a bullish and bearish case.

In 2016, the state of Colorado reported total revenue of marijuana sales at $1.3 billion US. This equates to a total base of about $225 US per resident. The government projects sales will rise another 25% in 2017 which will generate $250 million in tax revenue for the state. This revenue projection would equate to about $280 US per resident.

National surveys done in the US showed a reduction in teen usage in the state of Colorado compared to the national average and a slight reduction in teen usage year-over-year within the state. Most international surveys also cannot prove or come to the conclusion that the legalization of marijuana increases total usage and some surveys draw the conclusion that total net consumption is reduced.

Canada projects total users (above the age of 15) to exceed 5 million if/when marijuana becomes legal in the country. However, total market consumption is undetermined.

When industries are newly forming and do not earn a profit, one metric used to measure a public company is by the price-to-sales ratio (PSR). This divides the stock price by its revenue per share or alternatively, divides the market capitalization of the company by its total revenue. The industry with the highest PSR is Internet software (6.66) and the lowest is auto parts (0.67). Click here for the full list.

Metrics

If we draw parallels from Colorado and apply it to Canada, and we expect that consumer trends remain similar, the expected size of Canada's weed industry should be $10 billion CDN assuming the average resident consumes $280 of weed per year (note we removed foreign exchange from the calculation as marijuana would most likely be unaffected by foreign exchange or futures markets).

The three most prominent stocks in Canada by market cap are Canopy Growth (WEED), Aphria (APH), and Aurora Cannabis (ACB) with a combined market capitalization of $3.15 billion CDN. Their 2016 revenues were $30.27 million, $15.07 million, and $4.51 million; a combined $49.85 million. This results in a PSR of 63.19.

Bullish Case

The legal weed industry is still in its infancy and the market has discounted its potential value. A $10 billion market could push stock prices higher. With a comparable PSR to tobacco of 5.66 (or 6 for simplified math), this would value the total industry at almost $60 billion in market capitalization, which is about 20 times more than the current value of the three companies mentioned above. Triple-digit growth proves that there is significant growth and it may not peak or plateau for years down the road.

Legalization could also increase tourism and it is estimated that an additional 900,000 Canadians would consider trying it after legalization according to a recent survey. The total market capitalization predictions also exclude the potential for expansion into the US which has a market ten times larger. There is a strong movement for legalizing in the remaining states to boost government tax revenue.

Bearish Case

Bears do not doubt that these businesses will grow, however, their shares may not. Current PSR show that the market is pricing the stocks almost ten times more than the highest industry. Its current PSR of 63 requires growth over 1,000% (or 11-fold) before its PSR matches the tobacco industry. A projected 20-times increase in revenue would only double the stock (at most) and this assumes Canopy, Aphria, and Aurora control more than 99% of the market share. The second assumption is that market capitalization does not grow due to increased float, which means the company issues shares and reduces the amount of ownership per unit.

The most recent quarter showed Canopy posting revenue up 180%, but the shares declined 8% on the news. Premiums are now catching up with fundamentals and the $10 billion projection could be an overstatement due to concentrated data from Colorado. In economics, the law of big numbers indicates that a company growing rapidly cannot maintain that level of growth forever because there are fewer new customers available. If this law applies to weed companies as well, it can be inferred that the following quarter will show less than 180% growth which results in an "asymptote-like" chart; a plateau or peak is an inevitable part of any business.

The $1.3 billion generated in Colorado includes tourism revenue. This is an important fact to dissect because it would provide evidence where revenue can plateau. If legalization hits all 50 states, would revenue specific to marijuana be reduced for Colorado on a resident-based average? The current projections assume $280 spent per individual, but in Canada, only 5 million (or about 15%) of Canada's population would be a regular consumer. This means that in a room of 7 people, the one individual would generate revenue of $2,000 directly to the producer.