A slew of recent earnings reports across the cannabis sector, from Canopy Growth (NYSE:CGC) to Tilray (NASDAQ:TLRY), have confirmed an overwhelmingly bearish reality for cannabis companies: these companies are going to lose hundreds of millions, if not billions, of dollars before they ever net a profit. Tilray stock still is less than half of what it was at the beginning of the year.
Investors are finally starting to grasp this reality, and it’s making them second-guess the premium valuations they have been awarding pot stocks.
As such, over the past few months, all pot stocks have been killed. Canopy, Tilray, Aurora (NYSE:ACB), and Cronos (NASDAQ:CRON) all presently trade more than 40% off their 2019 highs.
But, this isn’t the end of the road for pot stocks. Instead, this is just a road-bump. Long term investors should consider strategically adding on this weakness. When doing so, the names to buy are sector giants CGC and ACB, and also rising cannabis star TLRY.
Here’s why.
Pot Stocks Will Bounce Back
In the big picture, the long term bull thesis underlying the cannabis sector and high-quality pot stocks remains intact. The cannabis sector promises to be huge one day.
Current consumption trends indicate that cannabis is nearly as widely used as alcohol, and far more widely used than tobacco and that recreational cannabis usage is on a secular uptrend, while alcohol and tobacco usage are on secular downtrends.
The implication is that once legal, the global cannabis market will be nearly as big as the global alcohol and tobacco markets. Those are several hundred billion- to trillion-dollar markets. Most estimates from research firms and cannabis companies put the global cannabis market at roughly $200 billion in size within the next 10 to 15 years. Thus, the revenue growth potential here is tremendous.
So is the profit growth potential. Sure, margins are getting killed across the whole industry today. But, that’s just what happens when you are less than a year into a new growth market. Everyone is expanding. Everyone is trying to win market share, grow reach, produce more supply, so on and so forth.
Essentially, that means no one is really concerned about margins today. Everyone is just investing big to position themselves optimally for long term growth.
In the long run, all this aggressive investment will simmer down. As it does, this industry will consolidate around a few large players, and start to look very much like the global alcohol industry. In that industry, the big players operate at around 25%-plus operating margins. That’s where cannabis companies will operate one day.
The math here is simple then. A 5% player in a $200 billion market operating at 25% operating margins should produce around $2 billion in net profits (assuming a 20% tax rate). A market average 16 forward multiple on that implies a long term valuation target of over $30 billion.
No pot stock today features a market cap above $10 billion. Thus, across the board, the long term upside potential in pot stocks from these depressed levels looks compelling.
Tilray Stock Has Turned into a Rising Star
One pot stock which has caught my eye recently is TLRY.
I’ve always written off Tilray stock as one that got way too hot back in late 2018 (it went from $20 to $300 seemingly overnight) and didn’t have enough size, growth, or backing to warrant its premium valuation.
That was true for a long time. Until recently when Tilray reported impressive second-quarter numbers that showed that this company is turning into a rising star in the Canadian cannabis market.
Here are the numbers. The Canadian cannabis market became legal in the last few months of 2018. In that quarter, Canopy sold over 10,000 kilograms of cannabis and Tilray sold just over 2,000 kilograms of cannabis.
Fast forward three quarters. Last quarter, Canopy sold just over 10,500 kilograms of cannabis, up a meager 4% from its late 2018 volume total. Tilray, on the other hand, sold over 5,500 kilograms of cannabis last quarter, up nearly three-fold from its late 2018 volume total.
In other words, while Tilray still isn’t the big fish in the Canadian cannabis market, its the fastest-growing fish. That alone makes Tilray stock interesting on this dip.
At the same time, Tilray’s gross margins have actually improved sequentially over the past three quarters, while gross margins at other cannabis companies have declined over the past three quarters. Thus, not only is Tilray the fastest-growing fish here, but it’s growing quickly while simultaneously improving margins.
Overall, then, Tilray stock is starting to look tasty on this dip. The stock is being sold off with the rest of the sector. But, the internals here are exceptionally favorable. That disconnect makes for a compelling “buy the dip” opportunity.
Bottom Line on Tilray Stock
Pot stocks will remain exceptionally volatile for the foreseeable future. But, in the long run, this volatility is ultimately just noise. Long term investors should look to strategically buy into major weakness.
One pot stock that looks particularly attractive amid the recent sell-off is TLRY. While other cannabis companies are struggling with growth or margins, Tilray is firing on all cylinders on both fronts. Thus, the recent sell-off in TLRY stock doesn’t make much sense relative to its internals. That disconnect is an opportunity.
As of this writing, Luke Lango was long CGC, ACB, and TLRY.
