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Shelf Offerings Could Cripple These 2 Pot Stocks in the Near Term

Sean Williams, The Motley Fool

There's arguably no hotter than industry right now than legal marijuana, and the data proves it. Since the year began, the Horizons Marijuana Life Sciences ETF, the first-ever cannabis exchange-traded fund, which now holds about four dozen pot stocks of various weightings, has nearly tripled the performance of the broad-based S&P 500 (44% versus 16%). That's because Wall Street believes the marijuana industry could generate as much as $75 billion in sales by 2030, and both pot companies and investors want their piece of the pie.

Big-money industries require big-money investments

But with a rapidly growing industry also come fast-growing costs. We've witnessed an almost endless escalation in Canada among growers looking to secure market share and capacity. This has meant spending big bucks on cultivation farms, marketing and branding, production development and differentiation, and even acquisitions.

A businessman in a suit hiding a stack of hundred-dollar bills behind his back, with his fingers crossed.

Image source: Getty Images.

Some companies have been lucky enough to secure brand-name partnerships, thereby putting a boatload of cash in their pockets to make deals and execute on their long-term strategy. For instance, Modelo and Corona beer maker Constellation Brands (NYSE: STZ) made three separate investments in Canopy Growth (NYSE: CGC), including a $4 billion equity stake, which closed in November. By taking a 37% stake in Canopy Growth, Constellation has opened itself up to a new channel of growth. Not to mention that it'll be working with Canopy to develop a new line of nonalcoholic cannabis-infused beverages. As for Canopy Growth, it walks away with a lot of cash ($3.7 billion in cash and cash equivalents as of the end of 2018) that it can use to make acquisitions.

The same can be said for Altria dropping $1.8 billion into Cronos Group to gobble up a 45% nondiluted equity stake. Tobacco giant Altria has faced declining cigarette shipping volumes in the U.S. for years and plans to use the cannabis industry as a secondary source of growth. As for Cronos Group, the $1.8 billion it received shores up its cash position and should, presumably, allow it to make complementary acquisitions.

Shelf offerings could pester the shareholders of these two pot stocks

But most pot stocks aren't lucky enough to have an ample supply of cash at the ready to deploy, if needed. Rather, marijuana stocks often turn to the secondary market or bought-deal financings to raise capital. Although these cash raises do get the job done, they can ultimately be detrimental to shareholders for a period of time. That's because a bought-deal financing, secondary, or shelf offering can include any combination of common stock, convertible debentures, or warrants, and these are all dilutive to existing shareholders.

Over the past five weeks, two mammoth shelf offerings were announced by major marijuana stocks, and both companies could see their respective stocks struggle as the Wall Street and investors digest the potential for share-based dilution in the future.

An up-close look at flowering cannabis plants.

Image source: Getty Images.

Aurora Cannabis

Among marijuana growers, there's no company right now that's on track for more output per year at its peak than Aurora Cannabis (NYSE: ACB). Although Aurora's management team sticks to a rather conservative estimate of more than 500,000 kilos of peak production annually when operating at full capacity, yours truly foresees it to be more like 780,000 kilos annually by 2022, assuming ICC Labs' greenhouses are developed in South America.

But becoming the largest producer in Canada hasn't been cheap. Aurora Cannabis has acquired MedReleaf for about $2 billion, CanniMed Therapeutics for roughly $850 million, and ICC Labs for approximately $200 million. Not to mention that there are multiple smaller deals that Aurora has made along the way.

This is also a company that's looking to aggressively expand into overseas markets. The 24 countries Aurora currently has a production or distribution presence in is tops among Canadian growers. But laying the infrastructure for these overseas ventures is costing a pretty penny.

Perhaps it's not surprising, then, that Aurora Cannabis filed a shelf prospectus for up to $750 million in capital over the next 25 months at the beginning of April. While there's no guarantee that Aurora uses this shelf offering, all signs point to it being leaned on heavily. That's because, inclusive of a convertible senior note offering subsequent to the end of Aurora's fiscal second quarter, the company only has about $375 million in cash and cash equivalents. Given how liberally Aurora has been spending, this is a drop in the bucket.

However, if Aurora were to raise the maximum amount allowable under its shelf offering, its outstanding share count would be expected to balloon by another roughly 8%. Mind you, Aurora Cannabis has the dubious honor of having issued 1 billion shares over the past 4.5 years, so this is nothing new for this management team. But this continued onslaught of share issuances is a heavy weight to bear for the company's shareholders.

An indoor hydroponic cannabis grow farm.

Image source: Getty Images.

CannTrust Holdings

The other pot stock that could find tough sledding in the near term is CannTrust Holdings (NYSE: CTST).

On March 18, CannTrust announced that it had filed for a 700 million Canadian dollar ($522 million U.S.) shelf offering that could be of any combination of common stock, debt securities, or warrants over the next 25 months. Whereas Aurora's shelf offering represents about 8% of its current market value, CannTrust's shelf offering, if fully exercised, represents nearly 70% of its current market cap. In other words, it's at much greater risk than Aurora of being hit by the share-based dilution bug, depending on how much management leans on this new financing option.

Why the sudden need for an influx of cash, you ask? As of the end of 2018, CannTrust only had CA$72 million in cash, which is hardly enough to fund the aggressive capacity expansion tactics that were recently announced. Aside from beginning a 390,000-square-foot expansion of its flagship Niagara facility, CannTrust also intends to acquire 200 acres of land and use this land for outdoor growing purposes, effectively doubling or tripling its peak yearly output to between 200,000 and 300,000 kilos. It's probably unclear what the exact outdoor buildout will cost over the next year and change, but CannTrust needs a readily available source of cash to make it happen. 

On the flip side of this horrible dilution is a company that may offer below-average production costs due to its hydroponic growing method at Niagara. Cheap available sources of water and electricity, and the use of moving containerized benches that help create a perpetual harvesting system, should produce favorable per-gram production costs.

Ultimately, CannTrust looks like a bargain based on its production costs and output potential, but things could get ugly in the short term if the company leans heavily on its shelf offering.

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Sean Williams has no position in any of the stocks mentioned. The Motley Fool recommends CannTrust Holdings and Constellation Brands. The Motley Fool has a disclosure policy.