Generally speaking, growth for an industry doesn't just blossom overnight. However, that's exactly what's going to happen on Oct. 17, 2018, in Canada, when recreational marijuana officially becomes legal. After selling medical cannabis domestically and exporting some of this product to foreign markets where medical weed is legal, Canada will open its doors to adult consumers in less than three months. In dollar terms, we're talking about vaulting from a few hundred million dollars in yearly sales to perhaps $5 billion annually or more.
With triple-digit sales growth expected from practically all cannabis stocks in the near future, it's no surprise that Wall Street and investors have pushed pot stock valuations into the stratosphere. In many instances, investors could be looking at high double-digit, or even triple-digit, forward price-to-earnings ratios as a result of legalizing adult-use cannabis. While some of these pricey stocks may be able to hold their ground, others look downright dangerous and have found their way onto my "do not buy" list.
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To be crystal clear, no stock on my "do not buy" list is cast out forever. As investors, we have to remain objective and review our opinions and investment theses from time to time. But at this very moment, there are three very popular marijuana stocks that I have absolutely no desire to buy.
1. Aurora Cannabis
Though Aurora Cannabis (NASDAQOTH: ACBFF) has no shortage of supporters, and it's arguably done a marvelous job of increase its capacity since the year began, it's one very popular pot stock that I want nothing to do with.
As for positives, assuming it completes its acquisition of MedReleaf for $2.5 billion in an all-share deal, it'll bring an additional 140,000 kilograms of peak annual cannabis production under its wing. That'll bump its full capacity up to 570,000 kilograms per year, which might be good enough for first place in terms of annual production. Being the lead dog certainly has its perks, which often involve strong pricing power and the ability to forge strategic supply partnerships.
But the concerns I have with Aurora Cannabis are twofold. First, with the exception of its organically built Aurora Sky facility, an 800,000-square-foot facility designed to yield in excess of 100,000 kilograms per year, the company has grown predominantly through acquisitions and partnerships. Just as with any other industry, I worry that it's going to take longer than expected to integrate all of these new components into one cohesive company.
Along those same lines, Aurora's bought-deal offerings are an absolute eyesore for investors. A bought-deal offering is a means of selling common stock, convertible debentures, stock options, and/or warrants in order to raise capital. Aurora Cannabis turned to bought-deal offerings to raise cash a number of times since 2016. Though this capital was necessary for the company to build the production potential it has today, it also ballooned Aurora's outstanding share count.
Should the MedReleaf buyout go through, and taking into account all remaining convertible debentures, stock options, and warrants, Aurora Cannabis could have around 1 billion shares outstanding by this time next year, up from only 16 million shares at the end of fiscal 2014. It could be exceptionally difficult for this company to turn an annual profit of even $0.05 or $0.10 per share, making its lofty valuation nauseating to fundamentally focused investors.
2. GW Pharmaceuticals
Now, here's a bit of a head-scratcher: I don't actually dislike cannabinoid-based drug developer GW Pharmaceuticals (NASDAQ: GWPH). On June 25, GW Pharmaceuticals made history by becoming the first company ever to have a cannabis-derived drug (Epidiolex) approved by the Food and Drug Administration (FDA). Given its success in reducing seizure frequency relative to baseline and when compared to a placebo in two rare types of childhood-onset epilepsy, Epidiolex has a decent shot to launch strongly out of the gate.
But therein lay my two issues with GW Pharmaceuticals. First, there's the genuine possibility that the company has been priced for perfection. Even with Dravet syndrome having no previously approved FDA therapies, and it having been a while since any new drugs were approved to treat Lennox-Gastaut syndrome patients, GW Pharmaceuticals' $4.2 billion valuation is aggressive.
Generally speaking, recent biotech buyouts, which often involve reasonable-to-hefty premiums, are occurring at three to five times a drug developer's peak annual sales. While Epidiolex does have the potential to reach $1 billion in annual sales, it'll only be likely to do so with an expanded label. As it stands now, its peak sales potential for both indications combined might be closer to $500 million. That'd place it at a conservative eight times peak annual sales, which is expensive in my book.
The other issue here is that it's time as the lone dog in Dravet syndrome may prove short-lived. Last week, Zogenix (NASDAQ: ZGNX) reported outstanding data on ZX008 for Dravet syndrome patients in its second late-stage study. Zogenix's ZX008 easily met its primary endpoint, with a median reduction in monthly convulsive seizure frequency from baseline of 62.7%, compared to a measly 1.2% for the placebo. The experimental drug also found the mark in all secondary endpoints. In short, it looks as if Zogenix's Dravet syndrome therapy is marching its way toward approval and giving Epidiolex a run for its money.
I struggle to find any further upside in GW Pharmaceuticals at this point, which is why I wouldn't touch this stock.
3. MedMen Enterprises
Finally, MedMen Enterprises (NASDAQOTH: MMNFF), which became the largest U.S.-based pot stock to recently list its shares in Canada, is on the "do not buy" list.
Similar to GW Pharmaceuticals, MedMen's business model isn't one I dislike. The company is angling to normalize cannabis use in the U.S. market across its 16 locations in three states (eight of which are in California, and three of which are soon to be built in Nevada). Between rising favorability toward recreational and medicinal marijuana in the U.S. market, and the company's focus on a more affluent clientele, it looks to have a model for success in existing markets.
But one area of concern I have with MedMen is in the company's need to expand its reach. While I don't disagree with the need to open new stores in core markets in order to establish its brand, I do take offense to its $1.4 billion valuation when expansion costs are liable to be through the roof for the next year or two, at minimum.
Despite generating $8.4 million in sales in the six-month period ending Dec. 31, 2017, the company's prospectus also showed that it produced a $43 million net loss over the same time frame. Chances are high that MedMen Enterprises will continue to lose an exorbitant amount of money as it establishes new stores in select legalized states and makes its play for Canada via a partnership with Cronos Group. In my opinion, this increases the likelihood of a dilutive stock offering being needed at some point in the intermediate future.
There's also some degree of unpredictability associated with operating in the U.S. market. Remember, even though 30 states have given the green light to medical cannabis use in some capacity, the federal government still deems it to be an illicit drug. Even with sentiment favoring reform, investors are taking a risk by betting on a company with ties to the U.S. marijuana market.
For the time being, none of these three popular marijuana stocks are worth your green, in my opinion.
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Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
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