Up in Smoke

There are sectors of speculation in every market that defy reasonable valuations. In the late 1990s, many Internet stocks with flimsy business models were bid up to stratospheric levels. One dozen years ago, speculation in the housing market reached historic proportions as the banks provided easy credit to risky borrowers. Housing prices in many markets are still way below the highs reached during the bubble. Last year, Bitcoin and other crypto currencies exploded higher only to deflate by 50% this year to date.

The latest craze is the cannabis market. Canada is legalizing the recreational use of marijuana starting on October 17th and the valuations of a few Canadian cannabis plays have exploded. One of these, Tilray, which first issued stock in July of this year, is now valued at $10.2 billion. This company had revenues of $20.5 million in 2017 and has sold $17.5 million worth of cannabis over the first half of this year. Year-to-date, the company has lost $18 million. For comparative purposes, Nordstrom has the exact same market capitalization. However, Nordstrom managed to produce $7.6 billion in sales and $250 million in earnings during the first two quarters of the year. Tilray may deserve a premium to a retailer such as Nordstrom, but we believe that its valuation is delusional.

To justify this valuation, Tilray, would have to grow its revenues at over 20% per year for decades to come. This outcome seems extremely unlikely. Marijuana consumption will probably increase as the substance becomes fully legalized, but there have not been many barriers to widespread use for the past 40 years. It’s also hard to believe that health conscious consumers who have drastically reduced their consumption of cigarettes and alcohol will go wild for weed as if it were a panacea with only benign impacts on health. In the 1950s and 1960s, 40-50% of adults in the US smoked cigarettes. Today the number is roughly 15%.

Aside from expanded overall consumption, analysts promoting the cannabis stocks expect that the black market of marijuana distribution will disappear soon after widespread legalization. This phenomenon is not happening. A Bloomberg story from June 28, 2018 noted that the black market for marijuana still represents most of the market in California after legalization. Legal dispensaries complain that they are competing at a disadvantage due to the taxes levied on their products. California charges marijuana growers $9.25 per ounce and retailers 15% of sales. These taxes cut into profit margins and are not born by black market participants.

In Cheech and Chong’s “classic” movie, Up in Smoke, two stoners manage to get signed to an improbable record contract after a series of misadventures between Tijuana and Los Angeles. Not able to live with their new-found prosperity, the record contract along with their new low rider goes “Up in Smoke” after Cheech drops hashish into Chong’s lap to start a raging fire while celebrating their good fortune. Similarly, we expect that the market valuations for today’s cannabis darlings will vaporize as revenues and profits eventually fall far short of expectations.