Canopy Growth: Sell Before Legalization On October 17th

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It’s time to have a serious talk about weed.

Investors have made impressive returns with pot stocks, particularly Canopy Growth (CGC), Tilray (TLRY), Cronos Group (CRON). But the growth story has reached its climax (for now at least), and the fun is about to end.

Introduction

What’s happening now reminds me of what happened with Bitcoin in late 2017. People seemed most optimistic when the price peaked around $20,000. Everyone was talking about the potential for Bitcoin and blockchain technology. Nobody was really talking about the actual value of the technology today.

Pot stock investors are overly optimistic about the upcoming legalization of recreational marijuana in Canada (Oct. 17th). And this optimism is reflected in the market price of pot stocks like CGC. To justify today’s prices, investors must believe there will be massive demand for recreational weed once it’s legal. If they’re right, pot stocks look fairly valued. But if they turn out to be wrong, prices could fall dramatically.

I’ll focus on CGC for this article, which is widely regarded as the strongest company in the industry. I’ll start with a review of the growth story we’re being sold, then provide 3 reasons why I think prices will fall.

The $4.2B-$8.7B market hidden in plain sight

Predictions for Canadian marijuana sales vary. Canada’s Parliamentary Budget Officer (PBO) forecast sales between CA$4.2B and $6.2B; Deloitte thinks it will be in the range of CA$4.9B to $8.7B.

But what’s most important is this: Constellation Brands (STZ) CEO Sands pointed out that CGC has won 35% of the supply contracts for recreational cannabis in Canada, and predicts sales in the country will reach US$5-7B, giving CGC first-year sales of about $2B (assuming a 1/3 share of the market).

We can take the company’s valuation and see how it matches up with these forecasts.

CGC had a market cap of $12.7B and price to sales ratio of about 192 as of October 15th. Now we have to make some assumptions. We’ll stick with generous assumptions to paint as nice a picture as possible.

Let’s say, once marijuana is legalized, CGC is able to achieve a 32% operating margin (the same as STZ). That would give CGC an annual profit of $640M, and a Forward P/E of 19.8, which is in the same ballpark as the Forward P/E ratios of a basket of companies that CGC aspires to be like (see table below), including British American Tobacco (NYSEMKT:BTI), Anheuser-Busch InBev (NYSE:BUD), Coca-Cola (NYSE:KO), PepsiCo (NYSE:PEP), and of course Constellation Brands.

Our aspirational P/E is quite a bit higher than BTI’s, and in line with beverage brands like KO, PEP, and CGC owner STZ.

This seems like a reasonable comparison because CGC aims to be more than a commodity producer – they want to own a diverse portfolio of marijuana brands. Today’s valuation seems to assume CGC will successfully market its suite of cannabis-infused edibles and beverages.

Is this realistic?

Probably not.

The forecasts above for the size of the recreational marijuana market are based on estimated black market sales, which are by no means guaranteed to transfer completely to legal sales. People will continue to buy from existing channels (especially if it’s cheaper) and some will just grow weed themselves (which is not very hard to do).

Also, to get first-year revenues of $2B, you have to assume CGC will execute flawlessly in the coming year and the government rollout plans will go smoothly. Today, on the brink of legalization, there are hardly any retail cannabis stores open. There’s one in B.C. and zero in Ontario, Canada’s most populated province. Ontarians will have to shop for weed online.

Basically, everything has to go right to justify the current valuation.

But if you ask CEO of Canopy Growth, that’s exactly what will happen. Everyone in Canada will want to start smoking weed once it’s legal:

Mr. Linton likes to compare his company to tech leaders like Amazon (NASDAQ:AMZN) and Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL). The comparison is a little bit silly. CGC and its competitors grow marijuana (a plant) and sell marijuana products (oils, tincture, and soon candy, snacks, drinks, etc.). It’s not a tech company. Just because they give employees stock options and have cool perks at work doesn’t make them like Amazon or Google.

This is just an example of how this industry is overhyped. Sure, the global market could turn out to be huge (some say $200B). But it’s not there yet.

Aside from the obvious regulatory uncertainty (including the fact that marijuana remains illegal in most markets), here are three reasons why pot stocks like CGC are overvalued.

1) Demand won’t exceed supply forever

Canadian cannabis producers seem to be sitting pretty, with demand for medical marijuana outstripping supply. This has led to strong margins for medical marijuana sales.

But with all the investment being shoveled into increasing production, this supply shortage can’t last forever. As weed sales become legal in more and more places, commoditization will take hold, competition will increase, and prices and margins will go down. The companies that are able to establish strong brands will succeed. Others will struggle.

CGC looks well-positioned, comparatively, but there are a lot of uncertainties involved. They’ll face stiff competition from beverage and maybe even tobacco companies that have a lot more experience building enduring brands.

2) For now, CGC and its competitors are in the commodity business

Marijuana is a commodity. The real profits, if and when they materialize, will come from companies that are able to establish strong brands. Whether CGC will be able to accomplish this remains to be seen. Granted, they’re taking steps towards this goal.

Of course, many investors see this as a near certainty in light of STZ’s recent $4B investment in CGC. But don’t get too excited about cannabis drinks and snacks just yet, because the company will have to wait at least another year to gain regulatory approval to sell these kinds of products.

Cannabis sales become legal on October 17th, but only in the form of dried cannabis, oil, and seeds. No edibles or concentrates (what you need to make a drink or to vape) will be allowed.

Health Canada specifically left these types of products out, saying they needed more time “for the development of specific regulations to address the unique risks posed by these product classes.” They’re reviewing things like quality control, packaging and labeling rules, allowable THC levels and portion sizes (most people know how hard it is to know when you’ve had “enough” when you’re eating cannabis-laced food since it takes a while to kick in).

Also, consider that there will be strict limitations on packaging in order to help prevent underage users from eating something that looks like candy. It might be hard to establish a brand – potentially much harder than it was for cigarette brands back in the day. We live in a much different world.

Health Canada expects to be ready to approve edibles and concentrates within one year of implementing the Cannabis Act (Bill C-45). I hope investors are patient.

So legalization after October 17th, I think, is going to be somewhat of a disappointment for investors who are expecting pot stocks to spike up even more. The real big day will be when edibles become legal sometime in 2019 or later.

3) Weed investors might be particularly prone to optimistic buying

The hype surrounding pot stocks seems to have attracted many new people to stock market investing. I’ve heard stories of people gaining 400% or more in a few months by putting all their savings into pot stocks. The most extreme story I heard is about a guy who placed a lien on his house to invest as much as possible. This person allegedly now owns more than $2M worth of pot stocks and is holding strong.

These people have incredibly high appetites for risk but not much experience. They believe in the growth story so strongly, they’re willing to put everything on the line. Right now these investors look like geniuses. But the really smart move might be to take some profits off the table before legalization.

Conclusion

Investors are understandably excited by potential deals and acquisitions on the horizon and recently inked deals like STZ’s $4B investment.

If these major beverage companies (and possible tobacco companies) are willing to invest billions into cannabis companies, shouldn’t individual investors also be willing to invest? Not necessarily.

As individual investors, we can choose to invest or not invest in any industry. STZ executives probably felt obligated to make a move and invest in cannabis because they A) are dealing with falling wine and spirits revenues, and B) are afraid to miss the opportunity to get in on the next big thing in the beverage industry. They want to be first to market. That’s why they’re willing to pay such a high price (a 50% premium at the time) to get their foot in the door.

But we don’t face such restrictions or competitive pressures. So we should avoid the temptation to buy pot stocks at this time.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.