Cannabis stocks after a stunning start to 2019 are struggling of late, with many of the emerging industry’s leading players declining sharply over the last month. This has occurred because of a range of headwinds facing the burgeoning industry, including sky-high valuations, doubts over the size of the global marijuana market, and rising environmental concerns.
Nonetheless, all the major players have still made massive gains since the start of 2019 and appear poised for another rally on the back of improving fundamentals. Industry leader Canopy Growth (TSX:WEED)(NYSE:CGC), which joined the S&P/TSX Index earlier this year and cut a $5 billion deal with liquor heavyweight Constellation Brands, is still up by 49% for the year to date with signs of further gains ahead.
Further market growth ahead
The looming legalization of pot edibles in Canada will act as a powerful tailwind for the major cannabis cultivators in a market where industry insiders are claiming that demand for dried flower is not being met. According to the Cannabis Act, the legalization of edibles, extracts, and topicals will occur by no later than October 17, 2019. This will be a powerful tailwind for greater domestic demand, which bodes well for companies like Canopy that can scale up production at a rapid clip.
The industry-leading cultivator reported for its fiscal third quarter 2019 that the volume of marijuana sold had grown four-fold to 10,102 kilograms compared to a year earlier, with 82% of that amount comprised of sales of recreational cannabis. While that can be attributed to the legalization of recreational marijuana domestically, it demonstrates Canopy’s ability to expand production.
According to Canopy’s latest investor presentation, it is expanding its cultivating facilities by over 1.3 million square feet and has become Canada’s market leader for recreational cannabis production. This has created considerable growth potential, particularly with the looming deadline for the domestic legalization of edibles and extracts. The massive investment made by Constellation, which has 37% interest in Canopy, gives the cultivator the ability to fund the expansion of its operations required to meet any significant increase in domestic demand. That means it could easily gain further market share at the expense of its competitors in coming months.
Industry analysts believe that cannabis edibles, extracts, topicals and infused products will generate better margins and more consistent sales than dried flower. This in part can be attributed to the social stigma in many parts of society associated with the consumption of marijuana, plus their longer shelf life. Those analysts have also forecast that the Canadian market for those products alone is worth somewhere up to $2.7 billion annually.
This represents a tremendous opportunity for Canopy, because it possesses much of the infrastructure required to expand its operations to meet that demand — even more so, when it is considered that analysts estimate that Canopy had captured around a third of the domestic legal marijuana market. Based on those rough numbers, if Canopy is capable of meeting demand, it could grow sales by an additional $900 million annually.
If that were to occur, it will give Canopy’s bottom line a solid boost and go a long way to addressing the valuation gap that exists, with the cultivator trading at 121 times the value of its sales. Canopy has demonstrated that it is particularly adept at expanding its bottom line. For the third quarter, it reported net income of $0.22 per share, which was its first truly profitable quarter and a significant improvement over the $0.01-per-share profit reported a year earlier.
Pulling it together for investors
While my views of the long-term prospects for cannabis stocks remain less than optimistic, the short-term prospects are particularly positive, especially after the latest pullback. It isn’t difficult seeing Canopy and its peers rallying strongly as Canada’s deadline for the legalization edibles, extracts, and topicals approaches.
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Fool contributor Matt Smith has no position in any of the stocks mentioned.