An Inconvenient Truth About Cannabis Stocks

Legalization may increase sales in pot stocks like Canopy Growth Corp (TSX:WEED)(NYSE:CGC), but will it deliver value to shareholders?

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It’s almost October, and the smell of legal cannabis in the air. Legalization was one of the most hotly anticipated events of Trudeau’s government, and it’s almost upon us. In anticipation of the upcoming changes, the financial press has devoted a lot of attention to cannabis stocks. But amazingly, shares in Canopy Growth Corp/ (TSE:WEED)(NYSE:CGC) and Aurora Cannabis Inc. (TSE:ACB) have actually retreated in the past two months–and rather sharply in Aurora’s case.

On the surface, it seems like odd market behaviour. We’re two months away from a major event that should dramatically increase the revenues of both Canopy and Aurora. And yet investors react by either selling or holding, for the most part. Shouldn’t they be buying up as many shares as they can get?

Not necessarily. While I’m not a massive bear on cannabis stocks, I’m not bullish either. To explain what I mean by that, I need to discuss an inconvenient truth about Canada’s cannabis companies.

From negative earnings to… more negative earnings?

As most Canadians are aware, legalization is coming, which may mean increased revenue for Canopy and Aurora. Both companies specialize in medical cannabis now, but they should be able to adapt their medical products to the recreational market. If anything, the recreational cannabis market will be much less regulated than the medical one–at least initially. So both Canopy and Aurora have a path to increased revenues ahead.

The only problem is, that doesn’t mean much if the cost of revenue doesn’t come down.

Because for most recent quarters, both Canopy and Aurora had negative earnings. Despite strong revenue growth, Canopy had an EBITDA figure of $-58.9 million for 2017. In the most recent quarter alone the company lost $90 million. Aurora hasn’t fared much better, with diluted earnings per share of $-0.03 in a 12-month period.

Canopy’s $90 million loss in the quarter ended June 30 was attributed to increasing operating costs. Revenue was up, but with costs exceeding sales, that just means increased negative net income.  If that’s the case, then theoretically, legalization might just mean ever-mounting losses.

A silver lining

So far, the picture I’ve painted in this article seems like doom and gloom.

But there’s at least one silver lining that could come from legalization:

Increased sales in a less regulated market. Currently, Canopy and Aurora supply cannabis for the medical market. The medical cannabis market is heavily regulated under the Access to Cannabis for Medical Purposes laws. Any company selling legal cannabis in Canada has to abide by strict guidelines under these rules, including packaging, labelling and shipping rules. Compliance with these guidelines makes up part of any cannabis company’s operating costs.

Though it’s not clear what Canada’s recreational cannabis market will look like, it may be less regulated than the medical market. If that’s the case, then recreational sales may prove more lucrative than medical ones. This could improve the operating and profit margins of cannabis companies significantly.

Either way, there are interesting months ahead for the cannabis industry.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Andrew Button has no position in any of the stocks mentioned.

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