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Trump’s Farm Bill Opens the Door for Hemp Cultivation Stocks

Last December, Congress voted to legalize hemp cultivation and the production of cannabidiol (CBD) oil in the US.
Aiming to identify the best income and growth stock opportunities in the market.
Aiming to identify the best income and growth stock opportunities in the market.

Trump’s Farm Bill Opens Doors for Hemp Cultivation Stocks

Last December, Congress voted to legalize hemp cultivation and the production of cannabidiol (CBD) oil in the United States. The bill displayed strong bipartisan support amongst lawmakers and effectively ended an 80-year ban on an overlooked miracle plant that has more than 25,000 recorded uses. Industrial hemp is a commodity that can be used to produce paper, cotton, biofuels, plastics, and many other sustainable consumer items. As a result, these efforts toward re-legalization have ignited massive potential for sales growth in a wide range of industries.

Despite the challenging legal and regulatory environments which were previously in place, the U.S. hemp industry grew by 16% in 2017 (hitting annual sales records of $820 million). Large portions of this growth were driven by demand for hemp-derived CBD products, which is a sales category that didn’t exist just half a decade ago.

These rising trends suggest that initial sales expectations of $1 billion in sales for 2018 should be attainable. But these estimates pale in comparison to the sales figure of $1.9 billion which is projected by industry analysts for 2022. As consumer education spreads and regulatory hurdles are removed, it may be more likely that these estimates err to the downside as they suggest a 5-year (2018-2022) CAGR of only 14.4%. Ultimately, investors with exposure to the sector could be positioned for greater market outperformance in the event U.S. hemp sales are able to match prior annual growth rates from 2017.

Individual segment sales will eventually determine the accuracy of the market’s growth projections, and most of the focus will likely be centered on hemp-derived CBD products. This segment accounted for roughly $190 million in sales in 2017, while personal care products accounted for $181 million and food products accounted for $137 million. Automotive sales led the totals in the industrial products category while sales of snack foods led sales results in the food products category.

These segment trends are expected to expand by 2022, with hemp-derived CBD products expected to generate 34% of all hemp-based product sales in the U.S. Current projections suggest that this segment will be followed by products with industrial applications (28%), personal care products (14%), food products (11%) and consumer textiles (10%).

This type of growth from an emerging industry is exciting for many investors and last year’s Farm Bill legislation has generated plenty of new interest for those looking to capitalize on the market’s long-term projections. But which stocks are most likely to be winners? Until now, mid-cap and large-cap cannabis stocks have dominated the discussion with names like Cronos Group CRON, Canopy Growth CGC, Aurora Cannabis ACB and Tilray TLRY rising in popularity. But there are several reasons why investors might consider small-cap alternatives, given their preferred valuations, a broader track record of attaining pofitability and a better likelihood that investors may benefit from a buyout in the future.

As a comparative example, consider the story of Canopy Growth. The stock currently trades at a market cap north of $15 billion despite the fact that the company lost over $300 million during the first nine months of fiscal 2019. Toward the end of last year, share price declines of 53.9% in CGC exposed vulnerabilities in the stock, and those downside moves were exacerbated by acknowledgments of error in its most recent quarterly earnings report.

Given the Canopy’s status in the industry, it is not surprising that the news weighed on many other stocks in the sector. Additional earnings disappointments from Constellation Brands STZ weakened profitability forecasts for 2019 and forced the company to rethink 40% of its position in its wine and spirits portfolio. After hitting record highs in October, shares of STZ have lost nearly 30% of their value and this leaves the door open to small-cap growth plays with direct exposure to the market’s rising expectations for long-term hemp sales.

Canopy Growth does not have any operations in the U.S. and isn’t considered a major player in its hemp-based CBD market. In contrast, GrowLife, Inc. PHOT specializes in offering cannabis cultivation solutions to commercial growers, and its stock trades at much lower valuations relative to its large-cap counterparts. As a supplier of the equipment necessary to cultivate hemp, GrowLife is uniquely positioned to capitalize on recent changes in federal legislation, and the company’s profitability trends remain supportive for this long-term outlook. In 2017, GrowLife generated annualized revenue growth of 99.19% (at $2.45 million). Additionally, the company has a sales base that includes over 12,000 established products, opened five new facilities across the U.S. and Canada in 2018 and launched a proof-of-concept study on a proprietary indoor vertical grow system last year, targeting a market launch in the second half of 2019. As a result, there is clear scope for the company’s upside growth trends to continue given last year’s favorable changes in U.S. hemp regulations.

In an industry that is undeniably ripe for long-term partnerships, it is still difficult to imagine that names like Cronos Group or Canopy Growth could be bought out any time soon. We did see Altria purchase a $1.8 billion stake in Cronos Group and Constellation Brands purchase a 38% equity stake in Canopy Growth. But it would be much easier for a party interested in gaining hemp cultivation asset exposure to consider one of the industry’s growth companies with a sub-$1 billion market cap. GrowLife recently acquired EZ-Clone enterprises, which manufactures commercial cloning systems designed for large scale hemp cultivation. The practice of cloning is well known in the marijuana cultivation industry as it guarantees the plant will be the right sex and maintains quality consistencies from season to season.

Hemp farmers will need to ramp up production quickly in order to meet new consumer demand, and cloning techniques can help growers produce 3-4 crops per year on a single plot of land. Hemp-based goods generally require substantial quantities of the plant in order to make a finished product, so GrowLife’s acquisition of additional cloning resources will enable the company to meet the market’s rising demand for mature hemp. Recently, GrowLife executives explained that some clients have expressed needs to clone 500,000 hemp plants per month, and this helps validate the rising level of demand the company will see from the hemp cultivation market.

When it comes to partnership opportunities, Cronos Group and Canopy Growth tend to attract most of the financial news headlines. But there are plenty of arguments which suggest small-cap alternatives may actually have the upper hand. With a presence in over a dozen overseas countries, Canopy Growth (and other similarly positioned large-caps) may have overextended their resources. Conversely, several names in the small-cap space might be better positioned to enact a strategic focus which is specifically geared toward these changing regulatory environments.

Moreover, small-cap alternatives still operate largely under the market’s radar and have considerably less premium built into share prices. As a clear example of this trend, PHOT stock is currently trading near three-year lows even after the recent launch of its Canadian e-commerce website, the retirement of over half a billion shares and new patents filed in both plant waste manufacturing and vertical grow room farming systems (which are associated with four-fold increases in production capacity).

With most of the market’s attention still squarely focused on the large-cap headliners, the smaller-cap alternatives have gone largely unnoticed. Industry-wide forecasts vary substantially, but it’s clear that significant investment opportunities still exist in this untapped industry. BDS Analytics and ArcView Market Research see global cannabis sales reaching $31.3 billion by 2022. Longer-term projections from Cowen Group suggest worldwide sales could reach $75 billion by 2030. These forecasts build substantially upon the initial sales estimates for 2018 (at $12.8 billion globally) and indicate growing potential for sustainability in the years ahead. Undoubtedly, the legalization of hemp has initiated a “green rush,” but the future of the industry may be defined by the lesser-known developers of ancillary products designed to serve the needs of retailers, manufacturers, farmers and distributors as they meet the rising demand levels present in the consumer markets.

This article was contributed by Dividend Investments, where we focus on dividend stocks and growth opportunities in the market.

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