Beer vs Pot

This is a repost of an article we originally published on September 18, 2018.

With the pending legalization of marijuana for recreational consumption in Canada and a number of states in the US, a new industry is beginning to take shape.  With this, excitement has been building for well over a year now, and that excitement has been reflected in surging stock prices. Whenever there is a new industry like this, there is massive speculation on what the fortunes of the various companies will be.  With legalization in Canada just over a month away, it seems as though we might be reaching maximum speculation.  I thought it would be illustrative to put in perspective the prices people are willing to pay for some of these marijuana companies at the moment.

Within the marijuana space there are some small companies and some very large companies.  The companies range in market cap size of $100 million (depending on the day) to currently over $13 billion.  Profits are very hard to find, and a lot of the smaller and newer producers have very limited sales even.

National Access Cannabis Corp.

National Access Cannabis Corp (META) is a good example of a smaller company in this space.  Their business is in the retail end of the marijuana industry.  They plan to open lounges and stores to sell the product direct to consumers.  They have a partnership with Second Cup to open retail marijuana stores which will certainly help them expand rapidly.  META plans to open stores in Ontario, Manitoba, Alberta and BC to start as the legislation in these provinces allows for these types of stores. They plan to build 50-70 retail stores in the western provinces and plan to partner with Second Cup in Ontario which already has 130 locations in that province.

Sounds good right?  Well here's the cold water: Current sales are not reflective of what sales will be under legalization.  That much is obvious.  Nevertheless they do provide us with the closest thing to a method to value this company.  Current sales are about $1 million per year.  For a company whose market cap is now over $143 million dollars that is an astoundingly low sales figure (I'm sure some of our clients with businesses that have $1 million or more of revenue will be asking why their business is not worth $143 million).  It results in a price to sales ratio of about 143-1, which is astronomically expensive.

The company is currently unprofitable, which is not surprising for a company pursuing such an aggressive growth strategy.  Nevertheless we can't attribute any value to profitability because there isn't any profits yet. Any cash that is generated is being plowed back into the business so there is no dividend yield to speak of.  So we can't use dividend yield as a means to value it either. The company has assets of about $17 million, however about $4 million of that is goodwill and intangibles which would have questionable value in a liquidation scenario.

One positive is that META has no debt and not much in the way of liabilities at all.  The company has about $5 Million of cash, inventory, and receivables.  There is about $800,000 of property and equipment and the remaining assets are investments in subsidiary companies which would be fairly illiquid.  As a result, in a liquidation scenario, the value of the company you could expect to receive is probably not going to be much more than $9 - $10 Million, though that would obviously depend on a lot of things.  Nevertheless, no matter how you look at it, it is tough to justify a value of $143 million based on the assets.

Canopy Growth Corp.

Let's look at a much larger Marijuana company, Canopy Growth Corp. (WEED) which is currently the largest marijuana producer by market cap. It is a producer and retailer of marijuana and currently has a number of products in the medical marijuana space. Like META, there are no profits to speak of yet and the company does not pay a dividend.  This is not really surprising though.  As an investor I would actually question the quality of management of these companies if they were paying a dividend at this stage in their company's growth.

If we're valuing WEED based on their sales, the numbers are still very high.  Canopy is currently on pace to produce about $100 million of sales a year.  Given the current market cap of about $13.6 Billion that translates to an astronomical price to sales ratio of 136 to 1, almost as high as METAs above. WEED does have substantial assets of about $2.1 Billion (about $450 million of which is goodwill and intangibles) but again that hardly justifies a $13.6 billion sale price for the company.  WEED also has debt and other liabilities of about $800 million.  Sufficive to say, nobody is buying either of these two companies to sell their assets. Clearly growth is the story here.  

But do investors really have an idea as to how much growth is necessary to justify these valuations?

My guess is that most retail investors would be surprised to learn what amount of growth is required. I think it's a useful comparison to compare the budding new marijuana industry with that of the more established and mature beer industry, as I think there are clear similarities in the product, the industries, and in the types of companies.  In both you have a recreational consumable product.  You have a diversified group of producers and retailers.  Both industries are highly regulated.

In the beer industry, there is intense competition and thousands of competitors. Companies attempt to differentiate on taste, brand, and price primarily.  Brand is extremely important as the numerous beer commercials on TV and at sporting events would indicate, though brand is probably less important than it was 20 years ago with the proliferation of smaller craft beers. If we look at an established beermaker we might get a sense of what level of sales are necessary to justify either METAs $143 million dollar valuation or WEEDs $13.6 Billion valuation.  

Molson Coors

Molson Coors (TPX.A) is a very well known and established brewer.  Its current market cap is $20.3 Billion.  It pays a 2.22% dividend yield and it had profits in the last year of $2.2 Billion on sales of $10.7 Billion.  To put that in perspective, we already mentioned that Canopy's price to sales ratios was 143-1 and Meta's was 136-1 respectively, whereas Molson Coors has a ratio of price to sales of just under 2-1.  

In order to achieve a similar ratio, META would have to grow their annual sales from $1 million to $71 million and WEED would have to grow their sales from $100 millionto $6.68 Billion. That amount of growth would require WEED and META to more than double their sales each year for 5 years.  Now, that's not impossible if they hit the ground running, but we should not underestimate the difficulty of that task. Even if demand is strong, it takes time to ramp up sales, open stores, hire employees, establish supply lines, and invest in increased production capacity.  

Both of these companies are also going to need a lot more capital to execute on their strategies.  This capital will come from investors or banks by either borrowing or selling shares. If these needs for capital coincide with a downturn in the economy, the growth will stall, and the business might fail outright.  Mistakes are bound to happen, and competition will more than likely be fierce. This is all without mentioning that no one has any idea what the profit margin will actually be on these products.  

Molson Coors has annual profits of $2.2 Billion. Right now WEED and META have 0 profits. WEED and META will have projected margins that their management think they can get, but the truth is that no one can know for sure the size of the market, and the ultimate price point that consumers will accept.  Without knowing these two critical factors, along with a host of other factors, it is impossible to accurately predict what the profit margin will be.  Mistakes will be almost inevitable, and mistakes will eat into the margins, at least initially.  Profitability will ultimately determine what these companies are worth. Without profits, they are almost worthless.

Compare New to Old

When dealing with a new industry like Marijuana it is useful to compare the industry to an existing one.  Unfortunately for marijuana investors, the comparison to the beer industry only highlights the challenges marijuana startups face. I think it's far better to stick to companies and businesses that we understand and that we can properly value, rather than throwing our money into speculative investments which are more gambles than investments.

- Craig White, BA, LL.B., CIM

Craig White is an Investment Advisor at the award winning firm Endeavour Wealth Management with Industrial Alliance Securities Inc. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.

This information has been prepared by Craig White an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.