The Silent Killer of Marijuana Stocks

Sean Williams, The Motley Fool

For years now, few if any industries have been growing more quickly or consistently than legal marijuana. ArcView, one of the leading cannabis research firms, suggests that North American legal weed sales could soar by 26% annually through 2021. That would put North American sales at nearly $22 billion by 2021.

We're also witnessing a major shift in the way consumers view cannabis. Back in 1995, the year before medicinal marijuana became legal in California for compassionate-use patients, only a quarter of respondents in Gallup's poll wanted to see the drug legalized nationally. As of October 2017, this support for legalization had hit an all-time high of 64%. This growing favorability, and strong projected sales growth, is a big reason marijuana stocks have doubled or tripled in value over the trailing year.

A cannabis plant growing in an outdoor commercial farm.

Image source: Getty Images.

Pot stocks aren't without risks

Of course, marijuana stocks aren't without risks. For example, political risks remain a crystal-clear concern for the industry. Within the U.S., Attorney General Jeff Sessions is practically waging war on the pot industry. On Jan. 4, Sessions announced that he'd be rescinding the Cole memo, which was a loose set of rules that legalized states followed in order to keep the federal government off their backs. Removing this memo, which Sessions believed overstepped its bounds, gives state-level prosecutors the discretion to bring cannabis charges against people or businesses, even in legal states. 

Marijuana stocks in the U.S. also face clear financial concerns. Since cannabis is a Schedule I substance -- meaning it's wholly illegal, is prone to abuse, and has no recognized medical benefits -- pot businesses are unable to take normal corporate income-tax deductions because of U.S. tax code 280E. That leaves profitable marijuana companies to pay an effective tax rate of 70% to 90%, thus cutting back on their ability to reinvest, expand, and hire.

Competition is a concern, too. For instance, Canadian marijuana growers are readying for the expected legalization of recreational cannabis by as soon as this coming July. Aphria (NASDAQOTH: APHQF) is aiming to complete its more than $100 million, four-phase flagship expansion project by January 2019. Spanning 1 million square feet, it'll be capable of 100,000 kilograms of dried cannabis production a year.

Likewise, Aurora Cannabis (NASDAQOTH: ACBFF) is slated to finish its flagship Aurora Sky project by mid-2018, with 800,000 square feet of production yielding in excess of 100,000 kilograms of dried cannabis. In fact, there are four Canadian growers expected to deliver more than 100,000 kilograms of dried cannabis in 2019, with perhaps three surpassing 200,000 kilograms. This could create supply issues that drag down margins, even with an influx of demand.

A worried investor looking at a plunging chart on his computer screen.

Image source: Getty Images.

The silent killer of cannabis stocks

However, all of these risks are well known and readily visible. There's one potentially silent killer which could wreck marijuana stocks that investors seem completely unaware of -- dilution.

The legal marijuana industry isn't particularly profitable, save for a handful of the larger players in the Canadian market that have managed marginal profits as a result of medicinal cannabis sales. This means cash flow for most pot stocks is either marginally positive or negative. For those that are rapidly expanding their growing capacity organically or through acquisitions, cash flow is most decidedly negative. Therefore, in order to generate the capital needed to expand growing capacity, marijuana stocks in Canada have been turning to bought-deal offerings.

A bought-deal offering is where a company sells common stock, debentures, warrants, or options, to an investor or institution prior to the release of a prospectus. It's very similar to a secondary offering in the United States, save for the fact that the deal is worked out prior to the prospectus being released.

Many of the newest bought-deal offerings aren't for common stock. Instead, they involve convertible debentures, options, or warrants, which can boost the immediate capital needs of a marijuana business. Unfortunately, these deals could come back to haunt unsuspecting investors within the coming months and years as investors convert their notes, warrants, or options to common stock. As the number of shares outstanding balloons, the value of existing shares held by investors dilutes. It also means a company would need to earn considerably more in profits just stay par for the course in terms of earnings per share.

An indoor commercial cannabis grow farm.

Image source: Getty Images.

Though there are no shortage of marijuana stocks guilty of diluting their shareholders now, or expected to in the future, Aurora Cannabis's case may be the most glaring. Its Aurora Sky project, as well as its $852 million acquisition of CanniMed Therapeutics, the largest weed deal in history, command quite a lot of capital. At one point recently, Aurora Cannabis had been sporting more than $400 million in cash and cash equivalents, mostly derived from bought-deal financings.

Yet between mid-2014 and the end of its 2018 fiscal first quarter, its share count ballooned more than 2,200% to 375.4 million. Keep in mind that this doesn't include more than $250 million in bought-deal financing undertaken since the last reported quarter that'll likely work its way into the outstanding share count in the coming years. For unaware investors, this dilution could silently destroy shareholder value.

If you're considering dipping your toes into marijuana stocks, or if they already have a spot in your portfolio, understand that delayed dilution by way of convertible debt offerings are a real concern, and they'll probably wind up hitting pot stock valuations when investors least expect it.

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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.