Who Will Get High Off the Marijuana Gold Rush?

Over the past few years, the perennial debate about the legalization of marijuana has become a permanent conversation held at the periphery of medicine, law, and investment. The dialog has been forced there because of THC’s status as a Schedule I drug under the Controlled Substances Act, but was brought into the spotlight when California passed the Compassionate Use Act of 1996.

In many ways, the act was an inflection point. It was the first time a state dodged around the federal position and recognized legitimate medical uses for marijuana. Since then, 20 states (including the District of Columbia) have either adopted medical marijuana provisions of their own or decriminalized the drug. Two of those states — Colorado and Washington — have legalized it at the state level. The drug remains illegal at the federal level.

The debate was given new life in 2005 when the U.S. Supreme Court heard a case (Gonzales v. Raich) that addressed the inevitable issue: what happens when the federal government decides to exercise its authority over a conflicting state law? The short answer is: the fed wins.

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“Today the regulatory environment is, I would say, highly ambiguous,” said Sterling Scott, CEO and chairman of Growlife (OTC:PHOT) in an interview. “You almost need to be a skilled lawyer to navigate a company through it.” Case in point, Scott is a former D.C.-based attorney who concentrated on federal regulatory issues affecting businesses.

This ambiguous regulatory environment has cast a pall over businesses that operate directly within or even at the edge of the budding marijuana industry. Investors seem to agree that at some yet-to-be-determined point in the future the floodgates will open and legal marijuana will be a multibillion-dollar industry. But the road there is still uncertain. The industry as it exists today is plagued with dubious actors, net losses, and micro caps — all red flags to anyone but the most risk-hungry investors.

That said, as the floodgates open, savvy businesses and their investors stand to make a tremendous amount of money.

First, some industry speculation:

“The medical marijuana industry has grown at a rate of 13.8 percent per year over the last five years to about $1.7 billion in 2013,” said Nima Samadi, a senior analyst at IBISWorld, in an interview with The Huffington Post. “Over the next five years, we’re going to see even stronger growth. It’s expected to grow 24.3 percent per year and approach about $5 billion [by 2018]. The majority of that revenue growth has come from the non-profit medical marijuana collectives.”

Samadi’s forecast includes just the medical marijuana industry. Specifically, it does not include growth up or downstream, or the recreational market. Recreational legalization at a large scale is farther down the regulatory road, but also promises a much larger market.

Jamen Shivley, a founder of Diego Pellicer, is one of the few people willing to throw out estimates on the current size of the black-and-gray marijuana market that, ostensibly, equates to the size of the hypothetical legal market. His pitch to investors values the marijuana industry at $100 billion, which will grow as large as $500 billion worldwide.

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This, of course, is a carrot on a stick. As it stands there’s no really good way to determine the potential size of the market, but it does seem safe to say that it will be large — large enough to warrant serious attention from investors. So the game to play for interested parties is: who can identify which company will be a winner when the market opens up?

Broadly, the field of viable investment candidates can be broken up into two categories: relatively new and relatively small industry-specific businesses — and older, more well-capitalized businesses that could easily branch into the marijuana industry in the event of practical legalization.

Here’s a quick overview of existing marijuana-industry players:

Company Market Cap Trailing twelve-months revenue TTM Price-to-sales ratio
Growlife, Inc. (OTC:PHOT) $21.3 million $1.45 million 14.37
Terra Tech Corp. (TRTC.OB) $13.86 million $552.58 thousand 27.22
Hemp, Inc. (HEMP.PK) $31.27 million $28.14 thousand 1,180.93
Cannabis Science, Inc. (CBIS.OB) $33.87 million $36.58 thousand 935.46
Medical Marijuana, Inc. (MJNA.PK) $126.67 million $11.36 million 11.33
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At a glance: low market caps, low revenue, and in most cases, high price-to-sales. These are penny stocks traded on the pink sheets or over-the-counter markets. Simply put, the risks are too high for most investors — but that’s a pretty vapid statement without some context. One risk already identified is the ambiguous regulatory environment. Active enforcement of the current federal regulatory position threatens to shutter some businesses and leave equity holders with nothing. At the very least, the specter of federal enforcement dissuades would-be customers.

But in reality, this is not what investors should be most worried about when looking at these companies.

Executives in the field are seasoned, and recognize where a slippery legal slope becomes a cliff. Companies like Growlife do not actually operate in opposition to the law, although some of its customers may. What this means is that the regulatory environment is more of a revenue roadblock than a threat of annihilation. The other side of this coin is that when the regulatory environment loosens up, the revenue stream should grow.

If anything, what investors should be worried about are company fundamentals, reporting history, and transparency.

As far as fundamentals are concerned, there are some obvious bad apples. According to its annual 10K filing, Cannabis Science has earned “limited revenues of $126,682″ since its inception in 2006, while incurring losses of $86,574,241 over the same period. The company’s assets totaled $713,240 at the end of 2012. There are also bad apples in the transparency and reporting-history buckets, such as Hemp. The company has no SEC filings and its financials are pretty much a mystery.

Medical Marijuana is interesting, because it is by far the largest company in the field right now, and its annual report reveals a multifaceted business strategy that promises to keep the company at the forefront of the industry. The company appears to have just had a great first quarter in 2013, earning $5.5 million on revenue of about $8.45 million.

Growlife is particularly interesting because of its fairly conservative approach to the industry and steadily increasing revenues. Through brands like Stealth Grow LED, SGsensors, and Phototron, the company is engaged in the business of providing would-be marijuana growers with the tools they need to thrive. This equipment falls under the umbrella of the urban gardening industry.

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Through these brands and other equipment-distribution channels, Growlife generated $674,620 in revenues in the fourth quarter of 2012. Annual revenues increased 43 percent in 2012, and the company’s gross profit margin increased 4 percentage points to 28 percent. Cost of revenue also increased dramatically — 44.7 percent in 2012 — but slower than revenue growth. Gross profit increased 78.6 percent.

And, perhaps most importantly, as CEO Sterling Scott points out, Growlife is “unlike most of the other public companies in this space. We are fully reporting.”

There are obviously risks associated with investing in marijuana-industry stocks, just as there are risks associated with any investment. One of the elephants in the room in this conversation are established, well-capitalized companies that could enter the market and challenge the value proposition of the smaller companies. Broadly, there seem to be two types of companies that would do this: those that operate in the tobacco industry, and those in healthcare.

There are a lot of intuitive reasons why Philip Morris (NYSE:PM) or Altria Group (NYSE:MO) would be interested in marijuana if it was legalized at a federal level — or even pragmatically at a state level. The companies are nothing short of legendary marketers and already sell to a demographic of smokers. Tobacco smokers are not necessarily marijuana smokers (just as marijuana smokers are not necessarily tobacco smokers) but there is no doubt some overlap that could be capitalized on. Brand-loyal tobacco smokers would likely become brand-loyal marijuana cigarette smokers.

Other positives include established distribution channels, regulatory experience and lobbying power, access to capital, and a history of success and shareholder returns that appeals to investors. What’s more, the cigarette market has been fighting against some slow but steady headwinds. Big tobacco may be eager to jump at the opportunity to enter a new market.

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On the other side of the equation, biopharmaceutical companies like Pfizer (NYSE:PFE) have a vested interest in the medical facets of the drug. The company is pretty much the reigning champ of dealing with the heavy regulation that surrounds controlled substances. With dozens of medical applications for cannabis on the books and more in the pipeline, there seems to be a lot of room for a company with a $1.7 billion R&D budget.

Pfizer’s most-recent earnings suggest that, like big tobacco, it could be looking for new revenue streams.

But whether or not these companies move into the space — and whether they’ll be successful — is uncertain. Many participants in the current medical and recreational marijuana industry suggest that consumers are specifically not interested in the big-brand presence of major corporations.

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