The United States and Canada have moved in different ways toward the legalization of marijuana in certain circumstances for years. Now, more than 20 states have legalized cannabis for medical or recreational purposes (or both), and Canada moved to legalize recreational cannabis use for adults in October of this year. Unsurprisingly, companies in the legal marijuana space and investors alike have been clamoring to take part in what many believe is a promising and fast-growing new industry. The result is that marijuana stocks have seen incredible gains over the past two years and in recent months in particular. However, there are reasons why investors should be cautious before diving into the legal cannabis market.
Canada's legalization of cannabis for recreational use has been seen as a game-changing move for the industry. Currently, medical marijuana remains a larger market than legal recreational cannabis. However, the dramatically larger potential consumer pool for recreational sales suggests to many investors that Canada's industry could develop into a major market in just a few years. Investors predicting a multi-billion-dollar space in the Canadian market and developing over a relatively short period of time have jumped in eagerly.
At the same time, marijuana companies have made aggressive plays to win dominance over competitors in a growing and complicated field. One of the ways that many companies have done this is through rapid expansion via acquisitions, according to a report by The Motley Fool. One reason for this approach is that these companies are aiming to set themselves apart from their competitors and to strengthen their long-term outlook. Companies including Aurora Cannabis (ACB), Canopy Growth Corp. (CGC) and Aphria (APHA) all made purchases of other companies for hundreds of millions of Canadian dollars this year. (See also: Who's Interested in Marijuana Stocks?)
It is in this practice of rapidly acquiring other companies, the Motley Fool report suggests, that these companies may inadvertently be priming their eager investors for failure.
Common Stock Deals
BNN Bloomberg reports that year to date, 69% of all cannabis sector deals where there’s a change of control have been financed entirely with stock. By comparison, across the global mergers and acquisitions space, more than 50% have been conducted using all cash in 2018.
Many of these acquisitions are for companies that may or may not emerge as victors as the legal cannabis space grows. The field is crowded, and it's likely that there will be many failures as certain companies win dominance over their peers. That some of the largest companies of today are buying up unproven and untested competitors for lots of money, and that they're using common shares to do it, could be disastrous for unwitting investors.
For each new share-based deal, the total outstanding share count for each of the acquiring companies gets larger. The process means that these stocks then have a more difficult time creating per-share profit. Particularly if some of the companies that have been acquired in these deals end up failing, these major player buyers could end up struggling to generate net incomes high enough to deliver strong price-to-earnings ratios.
The legal cannabis space is new, rapidly expanding, and facing a great deal of hype (and pressure) from investors around the world. It's clear that there will be many changes as the industry continues to grow. However, investors thinking that they are playing it relatively safe by buying into companies that have already emerged as big names in the nascent space may reconsider these moves, particularly when faced with the prospect of a major player getting overeager with its acquisitions and ending up setting itself and its investors up for failure. On the other hand, these bets could pay off in a significant way, and only time will tell.