I spend a great deal of time researching the global consumer sector, and cannabis is a very popular topic. There are many questions and plenty of hype around this industry, which is in its infancy — at least from a legal investing perspective. I will begin with a conclusion. I believe we are at the peak of inflated expectations for cannabis investing.
Gaining the "social lubricant" market shareAnalysis around cannabis valuations is largely focused on the sheer size of the industry as it shifts from illicit to legal, and its potential to compete with alcoholic beverages. Proponents of cannabis products cite inherent benefits over alcohol, such as lower levels of carbs and calories, and no hangovers. To illustrate my views, I'll use Canopy Growth, one of the first publicly traded cannabis producers in North America and the largest by market capitalization (trading on the Toronto Stock Exchange as WEED).
Canopy is commanding a very high valuation in part because it is the first and largest company of its type. The "first mover" advantage for consumer product companies can be a challenge because consumers at this stage have yet to develop any brand awareness. An open question remains as to whether Canopy will be able to create the "Budweiser" equivalent of cannabis. Despite this lack of clarity, Canopy has a $15 billion valuation, with revenues of just $61 million for fiscal 2018, and $172 million expected for fiscal 2019. The market is currently valuing the company at nearly 100x expected revenues. If the company paid out as annual dividends all of next year's revenues (revenues, not profits), it would take nearly a century to break even on an investment today. It's safe to say that the market is assuming Canopy becomes a significantly bigger company in the future.
The global beverage market presents some formidable competition. Molson Coors, for example, is valued at $13 billion, but generates $11 billion in revenue and over $1 billion in free cash flow. Another important note: Cannabis is federally legal for recreational use in just one country, Canada. The estimated size of the Canadian recreational cannabis industry is roughly $8 billion. Canopy is being valued at two times the addressable market. Molson Coors, on the other hand, is a global beer company primarily competing in the $6 billion Canadian market, as well as the $35 billion U.S. market and the similarly sized pan-European market.
"Investors sometimes forget that it can take decades for an industry to establish itself and for winners to emerge."
What makes a winner?Ultimately, for Canopy to come close to the leaders in consumer packaged goods, it would need to generate comparable gross margins in the 40%-60% range. The question we ask is, what incremental value is a company bringing to the consumer above and beyond what it costs to make the product? It may be luxury brand status or superior product quality, but given that Canopy has only spent about $100 million in sales and marketing and less than $10 million in R&D since inception, it is much too early to make these determinations.
Flashback to 1999A look back to the late 1990s offers some perspective. The Internet hype had companies with zero revenue valued at billions of dollars. Of course, it all came crashing down, and from the ashes astute investors found some very lucrative investments. Even Amazon shares plunged from $100 to $6. But we must remember that the recovery took years. Investors sometimes forget that it can take even decades for an industry to establish itself and for winners to emerge. Today it makes sense to wait out the marijuana hype until there's more evidence that these cannabis producer business models can support their valuations.
As of 3/31/19, Canopy Growth and Molson Coors were not held in Putnam Global Equity Fund.