The “buy the next marijuana IPO” pitches are fast and furious these days, promising massive short-term gains as new companies go public (mostly in Canada) and try to capture the lightning in a bottle that generated bubblicious returns for speculators in past pot stock spikes (some of which have turned into hugely profitable — if volatile — investments like Canopy Growth, others of which have disappointed after an initial jolt).

And I don’t spend a lot of time writing about these stocks, because most of them are just wild stories cloaked in a ticker symbol, with no real financials on which I might base a decision, but I do get questions pretty much every day… so today we’re taking a look at one of those ads.

This one is from Money Map Press, in an ad for a service they’re calling Cannabis IPO Insider from their National Institute for Cannabis Investors, which was one of the higher-profile newsletter launches last year (they brought on several big names to sell memberships in their initial ad blitz, including retired Speaker of the House John Boehner). They charge $1,950/year for this IPO Insider, which basically provides “dossiers” on the new cannabis companies they recommend, along with regular updates, interviews and recommendations. As with most higher-cost newsletters, the refund policy is strict (it’s not as strict as the “no refund” policy that many have adopted, but they promise at least four of their 24 to-be-recommended IPOs will deliver 10X gains in the first year, and if that doesn’t happen you can call for a refund after the year is out.)

Their promise that you’ll see several marijuana IPOs generate massive returns over the next few weeks caught my eye, of course, partly because they dangle those tasty past returns that fortunate marijuana speculators could have gotten if they sold at the top of past price spikes, but what really grabbed my attention was their pitch about royalties.

I am, as I’ve probably made clear a few times, a fundamentally lazy dude. Royalties are my favorite investment, though it’s hard to find them at good prices — a royalty is basically a passive income stream that comes from intellectual property or a unique asset, and generates ongoing revenue without the need for additional investment. Like the royalty on a song, for example, that pays you a fraction of a cent each time that song is performed, or a royalty on a piece of land that gives you a portion of the gold or oil that is extracted from that land without obligating you to pay for finding and producing that resource.

This is a different kind of royalty we’re being teased with here, a royalty on some kind of extraction equipment that marijuana growers can use to make their own extracts (like CBD oil for use vape pens or edibles, for example).

Here’s a piece of the ad:

“They’ve created a proprietary extraction system for cannabis that’s unlike anything else in the world.

“But instead of spending tens of millions of dollars building grow houses and distribution channels… they license their technology to other cannabis companies.

“By doing that, they collect a sizeable royalty of 22 cents for every gram of product their equipment produces.

“Now here’s how the math works out if just a handful of companies are using their equipment:

“Aurora Cannabis is adding 128,000 kilograms of new capacity this year. That would be worth over $28 million.

“Tilray is adding 142,000 kilograms. That would be worth another $31 million.

“HEXO is adding 108,000 kilograms. That’d be an additional $23 million.

“Natura is adding 70,000 kilograms. That’s another $15 million.

“So you can see how easy it would be for this company to start raking in $97 million with just four clients. All with zero work.”

So who’s our “unlimited royalty machine” that’s about to go public? That’s very likely Xtraction Services, which is in the process of going public through a reverse merger with Caracara Silver (SILV.H on the venture in Canada as of last year, CARAF OTC in the US, currently in a trading halt pending the merger and movement to the CSE).

Xtraction and Caracara agreed to their merger last August and Caracara shares have been in a halt since then awaiting the consummation of the deal, with the most recent news being their “definitive agreement” signed last month. The terms of the agreement were filed on SEDAR on March 22 here if you’d like to see what limited info they make available.

Machines for extracting cannabis oils and other goodies from hemp and marijuana plants have been around for a while, and are not necessarily all that different from other extraction machines… though each company that makes or sells them, of course, believes it has a better product and an advantage (and marijuana is a tougher plant than, say, lavender or basil, so the hardware might be optimized a bit differently).

The interesting thing about Xtraction Services is not the machines themselves, though they’re probably just fine (I have no way of comparing them to the dozens of other extraction equipment packages that are being pushed now, and it seems like Xtraction is intending to work with multiple equipment manufacturers), but the financing plan — they’re essentially trying to place machines with customers and take a volume-based fee for offering up the machine and maintenance and trained operators, instead of a more standard leasing or purchasing agreement (though they will offer leases as well). Kind of like leasing a Xerox machine for your office, I suppose, with or without an operator who can man the machine and charge you per copy.

I don’t know if it’s precisely 22 cents per gram that will be paid for these licenses, that doesn’t appear to be in the filings, or in the private placement presentation materials back when they were making their pitch in December (they raised $5 million, the deal closed a while ago).

The main thing that keeps me away from most marijuana stocks, other than the crazy valuations, is the fact that it’s a commodity business, and I have no idea what the margins or competitive advantages might be among any of the substantial players once (if) things normalize. Xtraction is set up, it appears to me, to provide services to smaller growers who want to build an extracting/CBD business, it’s not likely to be the preferred option for massive players like Aurora or Tilray, those big guys don’t need a deferred-cost lease option unless the technology or output is dramatically better, and Xtraction isn’t really claiming that their equipment is better — their pitch is all about financing and services.

I come in skeptical not because I’m an expert on the technology, but because breaking in to industries like this through some sort of technological advancement is rare and difficult. If the technology was markedly better, I assume, it wouldn’t be owned by a tiny company that’s trying to go public through a reverse merger with a failed silver miner, and it wouldn’t be raising money in preferred share offerings at $5 million a clip.

That’s a bias I have against tiny “better manufacturing tech” companies, but in my experience it’s been a profitable bias — little companies who develop better mousetraps do not take over markets from the established machine and equipment manufacturers and vendors. They might get bought out, if their technology is indeed better in some way, they might eventually grow little businesses on the periphery, but they don’t easily or quickly scale up and “own” these kinds of businesses. You can post extraordinary gains in sectors like software or retail, where some buzz and marketing can get you over the hump quickly to real revenue growth, but it’s not nearly so easy in capital-intensive processing industries like agriculture or food ingredient production. Not when there are also 40 other startup companies who are thinking they’ve also got a new and better system for CBD extraction.

So my biased outlook here is that there probably won’t be one “winner” in CBD production, but if there is one it will be either the low-cost volume leader or the company that develops a national brand in CBD that captures customer loyalty early through some kind of real and meaningful differentiation. It’s not going to be a company that has a new leasing model for extraction equipment.

Which doesn’t mean that Xtraction will be a bad company or is doomed to be a bad investment, that all depends on what their financial structure looks like and how big they have to grow (with all that growth being created by selling equity, at least to begin) in order to cover what are presumably relatively large overhead and selling costs.

If you’re going to be a leasing company, then a core part of the business that you need to master is raising money cheap — you have to buy the equipment that you’re placing with operators, after all, and even if the return is fairly high you need to be able to raise money at a cost that’s low enough for the returns to provide some leverage to shareholders, and keep in mind that you’re going to have massive depreciation as these machines get used for a few years and then returned for something newer and better. It’s a cycle of arbitrage that you have to master, though, as we saw with Xerox for a long time in the 1970s and 1980s, it can certainly be a profitable one if you have a unique product, can effectively refinance (cheaply) the lease debt that your customers are taking on, and can take meaningful market share and become a critical partner to your clients.

Xtraction almost certainly won’t be getting cheap debt financing at first, not unless the actual equipment manufacturers are backstopping them (and I don’t know why they would, unless Xtraction is a lot better at selling machines than the manufacturers are), so that means that in order to build this business they probably have to raise a huge amount of capital by selling lots of stock while buyers are excited, and it is probably going to take a long time, and some big deals with customers, to build up the cash flow enough for them to either get cheaper financing or self-finance (with the latter very unlikely unless the lease terms are insanely lucrative).

Management sounds knowledgeable, the CEO wrote this piece back in January about the specialty financing strategy… and the business does look crazy lucrative according to the pitch deck from their private placement, and they have raised money a few times (they had a $5 million investment back in late 2017, too), so most of my skepticism comes from that fact that it doesn’t make sense for a company to be this profitable in a competitive industry… which usually means there’s a “but wait” piece of information that we don’t have.

Here’s some of the summary from their pitch deck:

“The industry is capital constrained with limited access to traditional funding sources

“Cannabis and hemp extraction requires specialized equipment that is costly

“Extraction equipment is constantly evolving and requires updates

“Cannabis and hemp companies will need to adopt new technologies to remain competitive”

They do state in some places that their equipment is advanced, and can handle more than the first wave of extraction equipment that was originally developed for botanicals, but I have no idea whether they or their suppliers are genuinely cutting edge or have any kind of proprietary advantage. That’s not really the sales pitch, they’ve gotten away from talking up their unique equipment advantage in recent months and have talked more about the leasing/licensing/royalty angle. The pitch is that they have a turnkey leasing solution that comes with equipment and trained operators so you have very low startup costs and get an expert partner, and can trade that in for new equipment every few years, not that their machines are uniquely awesome.

And that does sound like a compelling business model, but it’s not automatically a lucrative or successful one. Building and servicing the machines is presumably going to be expensive, as is staffing them, all of which will require building up some capacity before you have a lot of customers, and all we have to go on in their private placement presentation are some insanely profitable projections. The illustration they provide for their royalty financing includes a six-month payback of their investment, and a 300% internal rate of return for the three year term of the royalty deal.

Which, frankly, sounds crazy.

Unless their equipment and production is demonstrably better, there is no competition, and producers really are so financially constrained that they can’t possibly buy equipment or hire people before they generate CBD revenue, then those returns are just plain stupid and should be expected to shrink rapidly. And, of course, if producers are so financially constrained that they can’t buy a machine instead of paying a 300% premium for it over three years, then those customers are also likely to be really bad credit risks. I know much of the industry is financially constrained, without much access to credit, but relying too heavily on that current state of affairs for a massive profit margin is likely to be high risk.

The company says they have a lot of business lined up, so more power to them — they indicated that as of the end of 2018 they had $4.9 million in annual recurring revenue either in process or already coming in (meaning, I guess, that machines have either been placed or are being delivered), and that they have a pipeline of 118 more deals and 425 marketing contracts. If they can repeatedly do royalty deals that generate 300% returns over three years on relatively small investments, and they keep their recurring costs under control and can recycle the equipment on reasonable terms as leases expire, then I can see how the model would work great… I just don’t see how it can persist for long, particularly with any customers of larger size who have more options to finance this kind of equipment.

And, of course, they haven’t really filed any financial information that I’ve seen (I did skim through the SEDAR filings, but did not check every single one so I might have missed something), which means all we have is some promotional stuff to entice early private placement investors and customers. We don’t know what their operating costs are, or how much capital investment they’re required to make to place each machine, or what the corporate overhead or selling costs might be. Hopefully investors will see that information before the merger and re-listing takes place.

The regulatory environment is certainly a key risk area here, but it’s a risk in the way that it’s also risk for the only “pot stock” I own, Innovative Industrial Properties (IIPR), which is also a specialty finance company to the marijuana industry (real estate based finance through sale/leaseback deals for IIPR, not equipment finance): If we get to full and easy marijuana legalization in the US, the big banks and other finance firms come in and compete with the specialty finance companies, which means returns will shrink over time… though on the flip side, if marijuana stays a little bit in the “grey area,” then perhaps some finance companies still decide to stay away but the gradual improvement in legalization and regulatory reform makes the actual operators more profitable, which is good for the finance companies.

It’s a fairly small needle hole you have to thread to make these stocks work out spectacularly well — though I’d say IIPR has a much easier path than a little equipment financier, if only because they got a lot of cheap equity financing very early and have been able to add to that at good valuations because they’re the only “easy” US pot company that’s US listed and pays a dividend and actually owns some real assets. They’re richly valued, to be sure, but they’re not in as much danger of being competed away in a hurry as the little startups are (and on the flip side, they’re also not going to spike up in price by 1,000%).

There are a bunch of other extraction companies out there as well, of course — the ones I see mentioned most often are Neptune Wellness Solutions (NEPT), which is converting its krill oil production facility to cannabis oil extraction, and Valens Groworks (VGW.CX, VGWCF), though there are plenty of others that I’ve not looked at in any detail, like World Class Extractions (PUMP.CX), which says it has a proprietary flow-through extraction technology that’s also mobile, Quadron Cannatech (QCC.CX, QUDCF), and Radient Technologies (RDI.V, RDDTF), I’m sure you can come up with half a dozen more just by doing some browsing. They all say they’re the natural solution to the early CBD production shortages in Canada, and they all think they’re going to get rich.

So what to do for those who are itching to get in on the latest Canadian IPOs? Well, you can play in that sandbox if you want to, though I’d urge you to think of it not like investing in a company, but more like laying down your chips on a square at the roulette table.

Unless you really want to dive in and make yourself an expert on the marketplace, which means understanding which companies have the best margins and most honest management teams and likely revenue growth, at a start, then you’re just betting on a story getting investors fired up. If that’s the case, make sure you keep in mind that you have to not only be right about picking the stock that’s going to appeal to other speculators, but you also have to time it well as you sell at some point and take your winning bet off the table — the crazy spikes that they refer to from past speculative bubble stocks in marijuana have pretty much always come back down.

If I were to invest more directly in a cannabis company, I would probably still stick with the big guys — and Canopy Growth (CGC), the only “real” marijuana stock I’ve been particularly tempted to buy in the past, would probably still be at the top of that list… mostly because they seem to me to be positioning themselves for entry into the US through their partnerships and options with Slang and MedMen and their forays into US hemp operations, and because I still think the companies with the best financial backing and the best brands and distribution are going to end up being the winners in five or ten years. But still, the prices and valuation of these companies is so ludicrous, including Canopy, that it’s hard to get on board (I don’t own Canopy shares, to be clear, it’s just the one that I’ve come closest to buying).

That doesn’t mean these speculations on new marijuana “IPOs” can’t work out, you can skim through lists like those provided by New Cannabis Ventures to get an idea of some of the companies that are coming public… just that I don’t tend to find them interesting, and these kinds of stocks are not the typical “buy and watch them build the company and compound earnings” stocks that most people like to find among young growth stocks — they’re entirely story-driven momentum stocks that, in the past, have almost all gone through crazy price spikes followed by equally dramatic collapses.

The pitch from the newsletter is partly based on their contention that the pot companies are trying to develop investor enthusiasm, so they “underprice” the IPOs to cause a pop in the price that draws investor attention, and that leads to a swarm of buying in the subsequent days or months — that’s true of most IPOs, they always have to balance the need to entice investors with an “exciting” IPO pop with the fact that the company going public actually needs to raise a lot of money, and the lower the price the less money they raise for each share they sell. Long term, you want a company that gets the most capital possible out of its IPO… short term, I guess you want a company that goes public at a price that’s “too low” to spur some manic buying, though I’d argue that no one is actually seriously looking at the financials or the valuations for these marijuana “IPOs” in the first place, so “too cheap” or “too expensive” are even more subjective terms than usual.

I use those quotation marks around “IPO” because, of course, most of these newer little pot stocks aren’t IPOs at all — they are companies that go public through a reverse merger with some kind of Canadian shell company, usually a failed miner, and there are a few reasons to do that: It’s cheaper and often faster than a traditional IPO, where you file for a new listing and get underwriting from an investment bank and go around presenting to folks and try to convince them to buy your shares; cynically speaking, it gives insiders and friends the chance to participate in private placements shortly before the public trading begins, perhaps generating warrant windfalls; and it avoids the scrutiny that is typically applied to the financials of companies that are going public through a traditional IPO.

That’s not an indictment of this particular company, but whenever your hear people talking up the story of a new company and the excitement of getting in early, pay attention to whether or not they’re talking about the actual financial results (or even financial projections)… how much revenue the company has, whether it makes a profit, how much money they’re going to raise, what they’ll spend it on, how that relates to their capitalization and the amount of money they’ve raised, that kind of thing. Those don’t get a lot of attention when it comes to “story” stocks in marijuana, but they will matter if you end up owning a piece of a company in the end.

There have been extraordinary gains in the pot industry, for sure, but there have also been extraordinary losses, particularly among the smallest stocks, for people who bought in on the way up, believed in the “story” that was churning through at the time (California legalization! Canadian legalization! CBD Shortage!) and didn’t sell before or during the collapses that have tended to follow those story-driven price spikes. Most pot stock teasers include lots of phenomenal looking charts, but if you look closely at the peak of the chart where the huge gains are recorded you’ll find that the date is not all that recent — that’s because the most compelling examples of gains for a lot of those companies were during previous spikes that have since collapsed. Go check a few of those tickers and imagine how different it would have been if you had sold anywhere other than right at the very top of the “bubble.”

Doesn’t mean you can’t win, but when you’re buying into an idea and a business plan without a lot of real info it does mean you’re taking a big chance — and the shares of this particular one are not actually trading yet anyway, so you’ve got time to think it over, look at their filings, research the industry, and see if you think you’re going to get a 1,000% pop in the first weeks after the shares start trading on the CSE. For me, being an old fuddy duddy, I’ll pass on this one — I love me some royalties, but I like to see the real numbers first, and their preliminary numbers in their presentations seem too good to be real or sustainable.

It’s your money, though, so you don’t have to listen to me — you can think for yourself. Interested in this CBD extraction “royalty” stock or in any similar companies? Enthused about pot IPOs in general, or have another favorite that you think we should consider? Hate the whole sector? let us know with a comment below.