Looking at the performance of Canada’s marijuana companies over the past year, investors have had a lot to keep them excited. To begin with, share prices increased substantially, the industry was recognized as the next “it” growth industry, and the Canadian government has taken steps to legalize the product.
While the year began with a lot of potential, investors are beginning to realize the industry produces no more than a commodity, which will make competition very easy over the long term. There is no product differentiation. In addition to the ease of entry, the new Canadian regulations around the branding of the product will make it significantly more difficult for producers to differentiate themselves. Branded marijuana (or celebrity endorsements) will not be allowed. The result is that margins could remain thin for a long time.
Can dividends be paid?
As investors are aware, dividends are often paid out of excess cash. We know that growing companies will often need as much capital as possible to grow the operations of the business to increase production capacity. Increased capacity equals higher revenues. Higher revenues translate to higher profits. The relationship is pretty simple.
We also know that dividends will not be paid during the time an industry is in high-growth mode. Once the growth slows down to a more normalized level, however, investors will grumble for higher returns, and company management will be able to float the idea due to the increase in free cash. Let’s not forget, earnings and free cash are completely different things.
What is the current situation at Canopy Growth Corp.?
For the first nine months of the fiscal year, Canopy Growth Corp. (TSX:WEED) reported earnings per share (EPS) of $0.04, but cash from operations (CFO) was -$11 million. The difference between net income and CFO is the actual cash flowing in and out of the company during the period.
An example of the discrepancy between CFO and net income is the adding back of the depreciation expense, which is a non-cash expense. In the case of a marijuana producer, the capital expenditure of building a greenhouse to grow the marijuana is not recognized up front. Although the expense may be paid up front, the benefit from the greenhouse enjoyed by the company is realized over many years.
If we assume the expense is recognized over 20 years, then one-twentieth of the amount will be recognized each year. This depreciation expense must be recognized to arrive at net income, but not to arrive at CFO. Investors hoping to receive dividends need to consider both net income and CFO.
The marijuana industry is still expanding and growing, which translates to large capital expenditures in order to increase capacity. Only after legalization will producers know just how big the market really is and how much marijuana needs to be grown. After clearing this hurdle, investors may be able to begin think about a dividend. Until then, investors will have to content themselves with capital appreciation only.
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Fool contributor Ryan Goldsman has no position in any stocks mentioned.