Few would dispute that the marijuana industry in Canada will become a significant part of our capital markets. That means, once the froth comes out of share prices, advisors will be faced with trying to value individual shares on a fundamental basis.
Industry momentum has driven share prices of marijuana cultivators past their reasonably foreseeable fundamentals. Recreational legalization, mergers and acquisitions, and investment from outside the industry have pushed prices higher.
Even large players are trading at over 15 times their revenue estimates for 2019 (when a full year of recreational sales should be included). Two companies, Canopy and Aurora, have individual market caps that approximate the $5.7-billion medical and (currently illegal) recreational market in Canada, as estimated by StatsCan.
For current valuations to make sense, investors need to assume some smaller players will disappear, legal recreational uptake in Canada will be much stronger than current illegal use, and that Canadian companies can make considerable headway in penetrating international markets for both medical and recreational use.
This requires a long-term investment horizon. In that sense, advisors would be wise to avoid the Nortel-BlackBerry fallacy of assuming that Canadian frontrunners will not only capture significant global market share, but will also outpace fierce international competition.
Investing for the longer term will require valuing marijuana companies based on profitability. Most companies aren’t reporting income or positive cash flows on a normal basis, and the reason is twofold. First, the early stage of the market, lack of scale, and continued expansion of the industry all result in higher-than-normal costs. Second, obscure accounting rules cloud the financial picture.
IFRS accounting rules for biological assets allow companies to report large non-cash gains that offset normal cash operating expenses. This results in situations where companies are reporting gross margins that exceed 100%. One reason is that companies are adding back the estimated increase in fair value of their total inventory as an offset to their cost of goods sold during the period. Company executives are the first to admit that this doesn’t make sense from an investment perspective. As a result, they publish non-GAAP gross margin figures aimed at correcting some of the accounting haze. The further problem is that the non-GAAP metrics are calculated differently from company to company based on management preferences. Corporate disclosures on the composition of the calculations aren’t sufficient, and trying to identify accounting anomalies by comparing several companies is fruitless because of the fundamental differences between firms. This means corporate management teams are reporting margins to investors without the aid of external verification—which doesn’t happen in any other industry.
The challenge for investors is that margins are specific to the firm based on the strains of marijuana grown, the different products produced (e.g., dried, oil or capsules), the focus on medical versus recreational use, licensing fees, branding and packaging, varying stages of development and overall corporate strategies.
Compounding the challenge is the question of where the industry is headed with the shift to more recreational production in Canada, and whether producers can adapt costs and margins to address price-per-gram limitations. And this says nothing of market dynamics and varying regulatory structures outside of Canada. In short, investors are challenged enough without having bizarre accounting regulations that create a starting point of unregulated reporting as the basis for analysis.
Once the industry matures, production growth becomes more transparent and valuations reconnect to fundamentals, investors will still be left with an accounting mess. While companies have the option to provide reporting that fairly presents their financial picture, they currently lack support from the audit firms. The accounting industry is still looking at the matter, but history tells us that such a process is usually delayed and ultimately fails to meet investor needs.
In the interim, investors are left with the serious problem of how to assess value in the industry. Normally, when financial reporting is opaque and ranges widely, investors should discount valuations. Unfortunately, that’s the opposite of what is happening in the current environment, and it’s no surprise that many advisors are passing on the sector.
Al and Mark Rosen run Accountability Research Corp., providing independent equity research to investment advisors across Canada. Dr. Al Rosen is FCA, FCMA, FCPA, CFE, CIP, and Mark Rosen is MBA, CFA, CFE.