Cannabis is finally coming of age, Brian Madden says

If you’ve dipped your toe in the cannabis market at anytime over the past few years you’ll know that volatility is the name of the game, making it a tough space for even the more adventurous of investors. But that might be changing, according to Goodreid Investment Counsel portfolio manager Brian Madden, who thinks indications are that the marijuana sector is finally growing up.

Cannabis stocks have been kicked around mostly through this year, with the sector hitting a high point somewhere around February before starting a protracted pullback which hasn’t shown much sign yet of stopping. The Horizons Marijuana Life Sciences ETF (Horizons Marijuana Life Sciences ETF Stock Quote, Charts, News, Analysts, Financials TSX:HMMJ), which attempts to track the sector as a whole, has by now given up all its gains achieved earlier this year and is about even, dropping from a high of $18.94 in mid-February to now a little above $8.00.

Many of the more established names in the Canadian and American markets have seen similar drops, with bellwethers like Canopy Growth (Canopy Growth Stock Quote, Charts, News, Analysts, Financials TSX:WEED) and Tilray (Tilray Stock Quote, Charts, News, Analysts, Financials TSX:TLRY) up north and Curaleaf (Curaleaf Stock Quote, Charts, News, Analysts, Financials CSE:CURA) and Trulieve (Trulieve Stock Quote, Charts, News, Analysts, Financials CSE:TRUL) in the States all falling over the past half-year.

But while cannabis companies still seem to be trading more or less as a group, Madden sees the mob mentality about to change as companies mature and investors are able to really dig into their financials.

“We think the cannabis industry really has come of age,” said Madden speaking on BNN Bloomberg on Friday. 

“We think the evolution of the industry has gotten to a stage where fundamentals matter and you can you can differentiate good companies from bad,” he said. “A lot of speculative froth that was in the market in the early days from circa 2015 until about 2018 has kind of blown off and a lot of speculators have found other shiny objects and things to trade like psychedelics and meme stocks and what have you.”

Madden says the Canadian market still has a lot of growth ahead of it, with predictions being that a full-scale cannabis industry will take in about $5-$8 billion in yearly revenue once fully established. That compares to last year’s take of about $2.6 billion, meaning the industry will likely at least double from here.

As far as the US goes, Madden says the legislative movement to legalize cannabis at the federal level along with the growing bag of individual states adopting legal weed are two trends for investors to watch.

“It’s been legalized at the state level in more than 30 states, and we’re at sort of a tipping point where the pressure is on more and more states to legalize it. The voters want it, there’s an excise tax opportunity and a legitimate job creation opportunity, as well, so we’re seeing states like New Jersey and New York and others that legalized in recent months,” Madden said.

“We think it’s going to be a big market, and we think we’ve identified what are going to be the key and critical success factors for companies that are going to become big and profitable companies in this emerging business,” he said.

Even with the legal adult-use market now a few years old in Canada, many pot co’s are still having trouble getting to positive earnings. Canopy Growth delivered quarterly numbers last month, showing an adjusted EBITDA loss of $64 million for its fiscal first quarter 2022 and a diluted earnings per share loss of $0.84. The company now predicts positive EBITDA won’t come until the end of the 2022 fiscal year. (All figures in Canadian dollars except where noted otherwise.)

In the US, many companies are still in expansion mod, leaving it a mixed bag in terms of earnings. Curaleaf, for example, delivered a net income loss of US$7.2 million for its latest quarter for a loss of $0.01 per share, while Trulieve had a positive net income of US$40.9 million.

Madden says in the US case, profitability will come once reforms get pushed through on banking in the sector. A federal marijuana reform bill was unveiled this summer by US Democrat Senator Chuck Schumer, while the Safe Banking Act, which would allow federally regulated financial institutions to do business with US cannabis companies, is now before the US Senate.

“Certainly for the US operators — which is where we think the opportunity is in US multi-state operators — cannabis remains illegal federally and so that creates an oddity whereby cannabis companies are not allowed to deduct for purposes of computing taxable income ordinary operating expenses like rent and wages. And so you have the odd situation where many of them pay more than 100 per cent effective tax rates, so they don’t earn money,” Madden said.

“Obviously, that’s untenable and unsustainable longer term and so there’s legislation in the works that is looking to address that,” he said.

Once there’s movement on the financial front, the sector will see more differentiation between companies in the space, Madden said.

“Right now, investors are valuing them on things like revenue and EBITDA or operating profit, understanding that the tax code is likely to change,” he said. “Eventually, we’ll be able to value these companies on things like price-to-earnings because they will be earning meaningful GAAP earnings. We’re not quite there yet but probably by 2023 I think we get to that point.”