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Don’t Expect a Cannabis Comeback in 2020

The last year has been a grueling time for cannabis stocks with the industry pummeled by the market, as it was gripped by a plague of bad news. A lack of profitability coupled with regulatory investigations and growing concerns that the market for legal cannabis products may not be as large as anticipated fueled a market rout that saw the value of many stocks plunge to multi-year lows.

Industry leader Canopy Growth (TSX:WEED)(NYSE:CGC) has lost 38% since the start of 2019, while Aphria (TSX:APHA)(NYSE:APHA) is down by 24%. Other cultivators have fared even worse, with Canntrust plummeting 84% after a regulatory investigation found that it had breached a range of legal requirements, including using unlicensed grow rooms. This has sparked speculation that many are now attractively valued, and a recovery could be on its way, making it time to buy. There are signs, however, that a recovery could be a long way off with the legal cannabis industry swamped by a wide range of issues.

Weak outlook

One of the most pressing issues is a distinct lack of profitability coupled with nosebleed valuations. Canopy reported a whopping $375 million loss for its fiscal second quarter 2020 and a massive net loss of $1.7 billion for the six months ending September 30, 2019. Even after declining sharply in value, Canopy is still trading with a price that is 25 times greater than its sales per share. That indicates that Canopy’s revenue from the sale of cannabis and related products will need to grow by around five times if it were to have a comparable valuation to tobacco or packaged liquor companies.

Surprisingly, Aphria is profitable, and for its fiscal first quarter 2020 it reported net income of just over $16 million, although that was lower than the $21 million reported for the equivalent period in 2018. Aphria is also trading at a more reasonable valuation of four times sales, indicating it is appropriately valued when compared to companies in similar industries.

There is unlikely to be any significant sales growth any time soon. The global legal marijuana market was originally estimated to be worth up to US$66 billion by 2025, but many analysts have started to trim their projections, with it now projected to be worth around US$38 billion. There is a large volume of unknowns, which — when combined with the deep-rooted stigma surrounding marijuana use and the unwillingness of many legislators to legalize its recreational use — makes those numbers highly unreliable.

A growing supply glut in Canada, where the volume of legal cannabis harvested substantially exceeds sales, will weigh on profitability and has been responsible for a decline in the wholesale price of legal cannabis. Even the legalization of marijuana edibles and other derivative products in Canada in October 2019 failed to breathe life into cannabis stocks or trigger a notable increase in sales.

When that is considered along with the high production costs associated with indoor cultivation, it becomes difficult to see how the legal cannabis industry can grow as rapidly as anticipated or for sales to reach the projected values that many cultivators have relied upon. Aphria is one of the lowest-cost large-scale growers reporting all-in sustaining costs of $2.52 and cash costs of $1.35 per gram of flower produced.

Canopy is still struggling to reduce production costs to a profitable level, reporting an inventory production cost of $2.13 per gram. There is also the threat posed by cultivators operating outside Canada in far more favourable and lower-cost jurisdictions, such as Colombia, where PharmaCielo reported an all-in cost of $0.04 per gram for its third quarter 2019.

Foolish takeaway

There are no signs of a recovery among cannabis stocks emerging anytime soon. A combination of weak demand, lower-than-expected sales, and high costs are weighing on the profitability of cultivators. For these reasons, the fledgling industry is a very unappealing investment, particularly when the high valuations of many companies such as Canopy are considered. It appears that Aphria is the only reasonably priced and profitable company among the major cultivators, making it the most appealing option for investors seeking exposure to legal cannabis.

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Fool contributor Matt Smith has no position in any of the stocks mentioned.

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