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Why More Medical Marijuana IPOs Are Coming and Why You Should Avoid Them

Almost three months after the initial public offering (IPO) of MedReleaf Corp. (TSX:LEAF), shares have yet to do much in either direction. The company, which came to market in what was then described as a “botched IPO,” fell quickly out of the gate from its IPO price of $9.50 to close on the first day of trading at $7.40. Clearly priced too high, shares have settled into a trading pattern around the $8 mark.

MedReleaf is still finding its footing; the company is a fantastic example of entrepreneurship making it big. As most competitors in this industry are very new companies capitalized by private investors, the path most often chosen to monetize the investment is that of an IPO, creating liquidity in the process. MedReleaf is not the only company that has gone this route.

The biggest competitor in this space is Canopy Growth Corp. (TSX:WEED), which gained its size by acquiring companies such as Bedrocan Cannabis Corp in addition to Vert Medical, MedCann, and the well-known Mettrum Health. As the industry grew, so did the company’s ability to raise equity with the intent of creating economies of scale.

After a number of strategic buyouts, the appetite for M&A may now be coming to a close, which will lead more companies to opt for the only option available to them: going public. The challenge will, of course, be finding demand from investors as the tide has turned following the MedReleaf IPO. Under the current market structure, Canada’s big banks are not lining up to act as underwriters or to sell the shares into their client brokerage accounts. The supply/demand equation, which saw prices increase drastically, was a high amount of demand coming from the customer and not by the experts (the advisors) talking up the stock to the clients.

Given the first medical marijuana companies have been traded on the market for more than a year, data is now available for all investors to analyze. In the case of Canopy, the company has hemorrhaged cash in the amount of $27 million for the past fiscal year, which was almost double the cash burn from the year before. For the current fiscal year, it can be estimated that the company will spend $30 million more than will be taken in, assuming the company continues to increase the capacity to meet the needs of all Canadians.

Although the costs incurred to increase capacity are currently adding 80 cents per year to top-line revenues for every dollar spent, investors may not see any capital appreciation in their investments until the company is able to turn a profit. During fiscal 2016, Canopy committed an additional $33.9 million to working capital and spent another $12 million in long-term capital expenditures, which led to higher revenues, not higher profits.

Although higher revenues are similar to rising tides, investors still need to be diligent about the noise surrounding the industry. With potentially many more companies in the IPO pipeline, the entire income statement, including the bottom line, will need to be considered by investors. Eventually, the euphoria runs out, and investors will need to find investments with significantly better potential.

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Fool contributor Ryan Goldsman has no position in any stock mentioned.

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