It’s just a few days until pot becomes legal, and the question on everyone’s mind is, “How high can cannabis stocks go?”
As the late summer rally showed us, cannabis stocks can go pretty high — like, $15 billion market cap high. But with most cannabis stocks cooling off in the past few weeks, we can see clearly that no rally is forever.
One of the culprits behind the cooling off’ we’ve seen in cannabis stocks recently is the profitability question. Put simply, very few cannabis companies are actually profitable in net income terms. If we exclude unrealized investment gains from the equation, almost none of them are. While the profitability issues in the cannabis sector mainly come from high investment costs that will presumably taper off at some point, it remains to be seen how profitable these companies will be when the earnings floodgates finally burst open.
Many are hoping that legalization will be the “saviour” of the cannabis industry that finally makes pot stocks profitable after years of growing losses. While this is certainly possible, I wouldn’t count on it. To understand why, we need to look at the cannabis industry as a whole.
A competitive landscape
The Canadian cannabis industry is a competitive space. There are over half a dozen publicly traded cannabis companies in Canada, all of them competing for the same recreational cannabis supply contracts and prescription cannabis sales. While these companies can differentiate themselves somewhat with their international strategies, on the domestic front they are basically interchangeable commodity suppliers.
This means that, in the long run, these companies are likely to start competing on price points, as happened in Colorado when cannabis was legalized there. Add into the equation even more price pressure from black market vendors, who will cut prices to remain relevant in the legal cannabis era, and you’ve got a recipe for falling prices.
Spiraling costs
While I think it’s likely that pot prices will fall when cannabis becomes legal this week, it’s not inevitable. What is inevitable is many cannabis companies’ expenses continuing to grow for the foreseeable future.
Take Canopy Growth (TSX:WEED)(NYSE:CGC) for example. Canopy wants to be the number one cannabis producer in all of the 11 international markets it operates in. This will require massive infrastructure investments, which the company is financing largely from the proceeds of the Constellation Brands (NYSE:STZ) deal.
The infrastructure involved in building up a globally dominant cannabis company is substantial, with grow sites, transportation, and storage infrastructure being only the tip of the iceberg. In order to become consistently profitable, Canopy will need to earn a significantly positive ROI on all of these infrastructure investments — and it’s not guaranteed that they will. Sudden government action against cannabis in any of the countries Canopy is investing in could make some of the company’s investments go to naught. For these and other reasons, pot companies like Canopy may have a rocky road to profitability ahead of them.
Fool contributor Andrew Button has no position in any of the stocks mentioned.