Can the cannabis industry turn growth into profits?
Summary: Find out more about the current state of the marijuana industry, the trading opportunities it presents and how you can gain exposure to it with Saxo.
High growth sparks opportunities
The cannabis industry offers great growth opportunities over the next five years – but they come with great risk.
The industry is bleeding on free cash flow generation, elevating the risks of refinancing its growth and operations. Recreational use is expected to become the main growth driver, but that comes with additional regulatory risks as cannabis was initially earmarked for medical use. The industry has also struggled in 2019 as market fundamentals have weakened, causing stocks to decline and bringing the possibility of bankruptcies sharply into view.
The key focus in 2020 will be whether the industry can show a path towards profitable growth.
All smoke and no fire?
As of January 2020, the publicly listed Cannabis industry, measured by the S&P/MX International Cannabis Index, had a combined market value $27.6bn, with the five largest companies being Canopy Growth, GW Pharmaceuticals, Cronos Group, Arena Pharmaceuticals and Aurora Cannabis. The index comprises 22 companies with a combined revenue in the last 12 months of $2.5bn – although this is largely concentrated among a few companies.
The industry’s biggest issue is the lack of profitability amid the high growth – the index’s 12 month free cash flow shows a combined loss of $3.2bn. Consensus is expecting goodwill impairments to accelerate in Q4 as past acquisition values no longer add up with the weak market fundamentals seen in Canada during the second half. Some companies have goodwill-to-assets ratios of more than 50%, and a few more stand at around 20%, making the industry vulnerable from a balance-sheet perspective.
Recreational use to fan the flames
The cannabis industry’s historical growth rate has been high and this is expected to continue in 2020. Canada’s legal cannabis market is set to increase by 50% to around $1.7bn*, driven by more retail stores carrying marijuana products, including edibles, beverages and vaping devices. The biggest growth driver in the coming years is likely to be recreational use rather than medical use, but this will have to battle against the increased risk of consumer regulation.
Still, here at Saxo we expect growth rates to remain high for the years to come based on the projections from Bloomberg Intelligence and restructurings to accelerate the weeding out of weak companies in the industry. There will be more pain before the industry consolidates into bigger players with operational moats that can improve operating margins. Regulation has so far been a friend for the industry but over the years this could change as recreational marijuana use increases. Our view on the industry is that it will be volatile for years.
* According to Kenneth Shea, senior analyst (Food & Beverage) for Bloomberg Intelligence
Growth rolled up in volatility and risk
Since the cannabis index’s launch in September 2018 it has had annualised volatility of 45.6%, which is three times that of the S&P 500 at 15.1%. The correlation to the S&P 500 is only 0.11, showing that the industry is not driven by general macro factors but many idiosyncratic risk factors. It also highlights the appeal of Saxo’s new cannabis index futures, as the S&P 500 or any other equity index would be an inadequate hedging instrument.
The idiosyncratic risk factors facing the cannabis industry include the high debt levels of some companies and new regulations arising from an increase in recreational use. Also, goodwill impairment and very high equity valuations cause sharp declines in share prices during earnings releases, which helps to explain the high levels of volatility that make long-term investing difficult.
Trade Cannabis volatility with Saxo
To complement Saxo´s existing cannabis-related product offering, we recently launched S&P/MX International Cannabis Index Futures (SMJ). This means you can now get exposure to the major global cannabis index with a multiplier of 50. Not only will this enable you to hedge against potential losses and enhance your risk management, but more importantly it will also provide you with an efficient way to short the entire industry.
For reference, GW Pharmaceuticals (GWPH:xnas) makes up 13% of the total S&P/MX International Cannabis Index market cap, and you can trade it as a CFD via SaxoTraderGO with an initial margin rate of 20%.
Trading in financial instruments carries various risks. This also applies to futures and CFDs, where the total loss you may incur may exceed the initial amount invested.