Say What? Someone Actually Upgraded This Pot Stock?
If you think the broad-based stock market is on fire, then you obviously haven't been paying close enough attention to the legal cannabis industry. This year alone, marijuana stocks have run circles around the S&P 500 in terms of total return, and marijuana's "Big Three" -- Canopy Growth, Aurora Cannabis, and Cronos Group -- have all delivered huge quadruple-digit-percentage gains since the beginning of 2016.
Wall Street is rightly skeptical about marijuana stocks
And yet despite this optimism and the expectation from Wall Street that worldwide sales of weed could hit between $50 billion and $75 billion by the end of the next decade, Wall Street remains notably hesitant on pot stocks.
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Even though analysts have bestowed a number of buy- and hold-equivalent ratings on major marijuana stocks, upgrades have been especially few and far between. Back in August 2018, Canaccord Genuity moved Cronos Group from sell to hold and Canopy Growth from hold to speculative buy. Then, on April 22, 2019, GMP Securities upgraded Canopy Growth to a buy following the announcement that it had secured the rights to acquire Acreage Holdings if the United States ever legalizes recreational marijuana. Until this month, these three upgrades were it for the entire industry.
At the other end of the spectrum, downgrades and sell ratings have freely flowed from Wall Street's faucet. Cronos Group is currently the only pot stock with four sell ratings, and it's received a number of downgrades to sell. Supply chain issues and ongoing losses have made skepticism sort of the standard approach for most investment firms.
The point being that Wall Street, while mostly optimistic on aggregate cannabis sales growth over the long run, remains leery of marijuana stocks and their valuations in the near term.
Wall Street actually upgraded a pot stock?
That's what makes what I'm about to say all the more shocking: Wall Street recently upgraded a pot stock...and it wasn't Canopy Growth, which is the typical go-to for most Wall Street investment banks.
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Two weeks ago, Owen Bennett at Jefferies, one of the first analysts to issue coverage on a number of leading marijuana stocks in the industry, upgraded Tilray (NASDAQ: TLRY) to hold from sell, all while lowering his price target modestly to $57 a share from $61.
Why the upgrade if Tilray's price target is being pushed lower? According to Bennett, who continues to remain cautious on Tilray in the short term because of supply chain issues impacting Canada's pot industry, Tilray's headwinds are now better understood. It's this added bit of clarity that suggests its valuation now makes sense.
Interestingly enough, Bennett isn't the only Wall Street analyst to feel this way. Aaron Grey at Alliance Global Partners initiated coverage on Tilray this week with a neutral rating (the equivalent of a hold), as noted by Barron's. Grey pointed out in a note to his clients that the company appeared fairly valued below $50 a share (as of last week) and that Tilray's "partnerships and management team warrants a premium to peers." Grey also contends that Tilray's Portugal production facility should help it close the international sales gap between itself and its larger peers.
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Does this upgrade make sense?
The big question is: Does it make sense to be more optimistic on Tilray now, especially after the company reported its first-quarter operating results on Tuesday, May 14?
On one hand, I can see where Bennett and Grey are coming from. After a protracted downtrend, Tilray has retreated about 85% from its September 2018 megarally to $300 on an intraday basis. But more than just retreating from its highs, Tilray has done an excellent job of finding brand-name partners for its product.
In December, the company announced that it was forming a $100 million joint venture with Anheuser-Busch InBev to develop nonalcoholic cannabis-infused beverages. Marijuana derivatives, such as beverages, edibles, vapes, and topicals, should be approved for sale in Canada by no later than this coming October, providing a high-margin sales channel for Tilray.
The company also expanded an existing distribution deal with Sandoz, the generic-drug arm of global pharmaceutical company Novartis. Having previously worked out an agreement to distribute noncombustible medical pot products in Canada, Tilray and Sandoz agreed to take this distribution relationship to the global level (in markets where medical cannabis is legalized).
Not to mention, Tilray's recently completed up to $310 million acquisition of Manitoba Harvest, a hemp foods company with product in more than 16,000 Canadian and U.S. retailers, gives the company a means to get its foot in the door in the United States.
Image source: Getty Images.
But on the other hand, if you really dig into Tilray's quarterly report, there's a lot to be concerned about. For example, Tilray's gross margin (23%) continued to underwhelm for a second straight quarter. Aside from capacity expansion costs, Tilray has had to purchase marijuana at wholesale costs from third-party providers to meet demand and supply agreements. That's definitely not the way to increase margins.
Additionally, Tilray's medical marijuana sales (its highest-margin operating segment) slowed to a crawl, with only 5% year-over-year improvement. The company chose not to address the minimal upward tick in domestic medical marijuana sales in its first-quarter press release, leaving investors to guess what's been going on. My personal guess is that medical cannabis competition has ramped up in Canada, and Tilray's supply is insufficient to address this still-growing market.
Most importantly, Tilray's net loss crested $30 million in the first quarter, up from $5.2 million in Q1 2018, suggesting that the company is nowhere near turning the corner. In fact, with Tilray announcing a complete change to its long-term strategy in March, there's no guarantee that it'll even be profitable on a recurring basis by next year.
It's for these reasons I feel that Jefferies' upgrade is a bit premature. Although Tilray's valuation is at least partially justifiable now, the company still has a lot of work to do to improve margins and narrow losses before it should be even remotely considered for investment.
More From The Motley Fool
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Sean Williams has no position in any of the stocks mentioned. The Motley Fool recommends Anheuser-Busch InBev NV. The Motley Fool has a disclosure policy.