This article originally appeared on Fool.com
The marijuana industry is growing like a weed, and stock investors have really begun to take notice. According to a recent report from Marijuana Business Daily, U.S. legal weed sales are expected to grow by a blazing 30% in 2017 to a range of $5.1 billion to $6.1 billion, tack on another 45% growth in 2018, and march toward $17 billion in legal sales by 2021. Investors have struggled to find industries with a quicker compounded annual growth rate than marijuana stocks.
Favorability toward marijuana has also dramatically shifted in just two decades. Back in the mid-1990s, the federal War on Drugs was still underway, and a mere one in four respondents in Gallup’s survey on marijuana wanted to see it legalized nationally. As of 2016, when Gallup conducted its latest poll, 60% of respondents wanted to see recreational cannabis legalized, which represents an all-time high. This rapid change in pot’s perception has been critical to the legislative push we’ve witnessed in select states that have since legalized the drug. Today, 29 states have legalized medical cannabis and eight have OK’d the use of recreational, adult-use weed.
Burning green while producing green isn’t a good combination
However, marijuana stock investors face a number of unique challenges. As you’re probably aware, marijuana is a schedule I substance at the federal level, meaning it has no medical benefits and is wholly illegal. This leads to some challenges for weed-based businesses.
As an example, most cannabis companies have little or no access to basic banking services, which includes something as simple as a checking account. Having to operate an entirely cash business is both a security concern and a growth impediment.
Additionally, pot-based companies aren’t able to take corporate income-tax deductions like normal businesses because they’re selling a federally illicit substance. In short, it means handing over far more in taxes if they are profitable.
But there’s more to this story. Marijuana stocks are also generally money-losers. A vast majority of pot stocks, because of the mentioned disadvantages, law-based constraints, and their general “newness” to the industry, are burning green (i.e., cash) while they’re producing green. While I wouldn’t take anything away from the gains marijuana stocks have bestowed upon investors, we also have to recognize that fundamentally many of these companies probably aren’t worth anywhere near their current market caps based on their history of losses.
What few profitable pot stocks there are have absurd valuations
Even in instances where companies are profitable, their valuations remain astronomical. A good example of a fast-growing pot stock with an astronomical price-to-earnings (P/E) ratio is Canadian medical cannabis producer and retailer Aphria (NASDAQOTH:APHQF).
Aphria recently reported its fourth-quarter and full-year results for fiscal 2017, which included EBITDA growth of 962% year over year, a 25% reduction in its all-in production costs for dried cannabis, and net income of $3.34 million. The company even lifted its forecast for production capacity in phases 2, 3, and 4 of its ongoing expansion. Considering that Health Canada has seen medical patient growth average around 10% per month, and the Canadian parliament is reviewing legislation introduced by Prime Minister Justin Trudeau to possibly legalize recreational marijuana by July 1, 2018, the future for Aphria could be very bright — or should I say green?
Unfortunately, it’s a fundamental nightmare for more investors. At the closing bell on July 27, Aphria’s market cap was $644.4 million, and the $3.34 million it made, when divided into its outstanding share count, works out to just $0.024 in full-year EPS. That’s a trailing 12-month P/E of more than 210! Yes, it’s possible that Aphria’s P/E will move lower if it continues to hit on its goals, but for right now its valuation is exceptionally high.
Wow! A marijuana stock without an astronomical P/E ratio
However, there is one exception to the rule. A new front-runner in “value” among marijuana stocks, if we could call it that. And that title belongs to the newly public MedReleaf(NASDAQOTH:MEDFF), which is also a Canadian medical cannabis producer.
MedReleaf only went public a little over two months ago, so correlating its full-year earnings to its current share count isn’t easy for the average investor. In fact, MedReleaf makes curious investors dig into the System for Electric Document Analysis and Retrieval (SEDAR) just to find its net income statement for the latest fiscal year. The best you’ll find in the company’s fourth-quarter press release in June is an EBITDA growth statement, along with cash margin contribution figures and sales totals.
A quick review of the company’s financials on SEDAR shows that MedReleaf earned $8.72 million in net income in fiscal 2017, up substantially from the $2.02 million profit it recorded in 2016 and nominal loss it generated in 2015. Taking into account the number of shares outstanding, MedReleaf earned about $0.156 per share in full-year 2017, which works out to a trailing 12-month P/E of just under 41. OK, so 41 isn’t exactly value stock territory in the normal definition of the word, but it is when sales of the company more than doubled in fiscal 2017.
Why has MedReleaf so substantially outperformed its peers? I’d pinpoint two factors. First, MedReleaf tends to focus on a higher-price-point cannabis product, which implies that consumers (in Canada, at least) are willing to step up for a higher-quality product, just as food consumers are willing to pay more for organic and natural products given the perception of better nutritional value. Secondly, MedReleaf has a keen focus on cannabis oils, which have a higher price point and better margin than traditional dried cannabis products. As of the fourth quarter of 2016, MedReleaf had a 44.5% share of the Canadian cannabis oils market.
Though investors would be strongly encouraged by this Fool to wait for a decision from Canada’s parliament as to whether or not recreational marijuana will be legalized next year, I’d fully encourage interested marijuana stock investors to add MedReleaf to their watchlist so they can keep abreast on the latest news from the company. It’s profitable, its margins are heading in the right direction, and best of all, it’s not priced for perfection — at least not yet.
