Top Factors To Consider Before Investing In Cannabis Shares

Cannabis Shares

Valuing a cannabis company is becoming an increasingly difficult task. Lately, the cannabis shares have been taking a beat in the domestic markets, falling from their respective all-time highs.

The table below provides you with the popular ASX-cannabis shares.

Source: ASX, 5 November 2019

It should be noted that cannabis companies have different business profiles. Moreover, cannabis sub-industry has numerous business lines, such as beauty and personal care, medicinal, and recreational.

Indirectly, some of the cannabis companies are engaged in many businesses through supplying cannabis to other companies which produce different products, including medicines, lotions, and maybe cannabis edibles.

Within the Cannabis industry there are wide spectrum of sub-industries. To a name few - agriculture technology, ancillary products and services, biotechnology, consulting services, consumption devices, cultivation and retail, cannabis products and extracts, industrial hemp, and organic farms.

There is now a range of cannabis companies in the ASX universe. Many of them are operating as a healthcare company, and some are classified in consumer staples, industrials, consumer discretionary as well.

Let’s discuss five factors:

Valuations

As the cannabis companies are largely operating in losses, it makes the valuation of the cannabis companies challenging. Moreover, the market usually prices the growth prospects of cannabis shares rather than earnings.

The cannabis shares are usually valued on other metrics such as revenue, or comparable valuations. Meanwhile, there are cannabis companies that are engaged in biotechnology, drug development etc.

The healthcare focused cannabis companies are more dependent on the success of clinical-trials, innovations, existing standard of care, commercialisation, drug-accessibility, addressable markets, legal barriers to entry etc.

The management of the cannabis companies proudly highlight the total addressable size, global market size, and opportunities. It should be noted that these numbers might include the illegal markets in the world wherein only handful of countries have the full-legalisation of cannabis at the national level.

Commodity

Let’s not forget that cannabis is an agricultural commodity. The products in the cannabis market could vary from places to places, in terms of use, and potency as well.

Cannabis is a commodity that could be exposed to supply and demand side risks in the markets, leading to possible price disruption in the market. Moreover, the increasing number of companies in cannabis cultivation only suggest an abundance of legal cannabis in the future.

Differentiated products by the companies might allow them to have monopoly, which is good for the business and valuations. Cannabis comes with so many varieties, and companies are involved in innovating with technologies to come up with efficient competitive advantages in order to sustain in the markets.

If the products become indistinguishable, it could lead to a uniform market and price, and possibly a publicly-traded commodity. Consequently, a publicly-traded cannabis commodity means weakened pricing power for producers.

As an example – In order to witness a price hike in iron ore markets, the supply-side disruption was necessary, which occurred with the suspension of production from a South-American company.

Therefore, the producers do not price the commodity they are producing in the markets, and it is priced by the market. Put another way, the companies cannot increase the price of the commodity without impacting the demand.

Management

Investors, particularly equity-investors, are the owner of the company. Investors could reach out to their company or management through e-mail, or phone calls in cases when more clarity is required. It would be interesting to note whether the management is considering the solve the query of an investor.

Moreover, active and effective management is a sign of a determined company looking to serve its customers, as well as its shareholders. Investors should also attend the conferences held by these companies, asking queries to management, discussing forward plans etc.

Companies convene general meetings and annual general meeting. Usually, the general meetings are convened for special purposes, and for annual performance review of the company in annual general meetings. Such events allow the investors asking required questions, and vote on the resolutions proposed by the company.

Capital & Dilution

As the cannabis-industry is developing and growing at a rapid pace, it needs sufficient capital in order to continue the growth trajectory. Although, the companies could hardly say no to the capital influx.

The argument that arises here is the route taken by the company to raise capital. In the meantime, there are pros and cons of each route, and it depends on the management of the company to consider the best possible way.

Issuing new shares in the company exposes the existing shareholders of the company to the dilution. As issuing new shares in the company increase the number of total shares outstanding with usually no material positive impact on the market capitalisation, rather it leads to EPS dilution.

As a result, the total number of shares outstanding increases, resulting in a decrease in the ownership of existing shareholder, and a potential fall in price as well for the short-term.

On the other side, if the company is looking for debt funding, it should avoid paying high-interest rates on credit. However, cannabis is a new industry, and the risk perceived by investors is relatively higher, leading to higher cost of capital.

Convertible notes have become a compelling investment route for investors. It allows the investor to remain a creditor and earn interest on the principal that would be repaid by the company, following the completion of the tenure.

In addition, the convertible note route allows the investors to convert the amount of debt into the equity share capital of the company as well, possibly resulting in more dilution if the investors chose to convert.

Expectations

Investors need to keep the expectations in-check with real-world scenarios. There would be additional development on the legal grounds for the cannabis business due to the relative age of the industry.

Recently, the Australian Capital Territory has legalised cannabis cultivation and possession to some extent. However, it contradicts with federal laws technically. So, there are ongoing developments in the industry that could have widespread ramifications.

Mostly, the cannabis companies are yet to report profits, and the visibility on the profitability of cannabis companies remains weak. Profitability or margins remain an important factor in the valuation of companies.

Cost structures of the cannabis companies remain higher, and it would continue to depict higher levels in capital expenditure and revenue expenditure as long as the company is pursuing growth prospects.

At the outset, the risks presented by investing in cannabis companies should not be ignored. There would be losers and winners in the industry like every other industry. Nonetheless, keen interest is being shown by growth seeking investors in this sector.

Disclaimer

This website is a service of Kalkine Media Pty. Ltd. A.C.N. 629 651 672. The website has been prepared for informational purposes only and is not intended to be used as a complete source of information on any particular company. Kalkine Media does not in any way endorse or recommend individuals, products or services that may be discussed on this site. Our publications are NOT a solicitation or recommendation to buy, sell or hold. We are neither licensed nor qualified to provide investment advice.