Cannabis in Canada: What Happened?

Delwin Graham - Nov 13, 2019
Scandals, sluggish earnings, and executive shakeups have replaced the soaring expectations of a year ago with caution, if not apathy.

The legalization of Cannabis in Canada was supposed to mark the beginning of a potent industry that would launch companies to new heights. It didn’t happen. Since recreational cannabis became legal on October 17, 2018, the share price of the three largest Canadian cannabis producers by market capitalization (Canopy, Aurora, and Tilray) have averaged a negative return of more than 69 percent for investors. The Canaccord Genuity Cannabis Index, which is comprised of a large number of key cannabis companies trading on the TSX, TSX-V, and CSE, was down about 59 percent over the same period. What went wrong? (Cf., Victor Ferreira, “Feeling Burned: The First Year of Legal Cannabis has Been a Complete Disaster for Investors”, www.financialpost.com, October 9, 2019)

Most of the top cannabis firms were trading near all-time highs on Oct. 17, 2108. Aurora and Tilray would hit their highest post-legalization levels one or two days later. But problems ensued. First, the industry’s producers didn’t appear ready to handle consumer demand. A lack of inventory quickly led to massive delays for even the simplest orders to be filled. Second, government agencies also seemed unprepared. For example, just weeks before legalization, Health Canada was dealing with a backlog of hundreds of applications for cultivation licenses. Third, concerns about expansion of supply soon turned to doubts about balance sheets and profitability. In early July, Canopy founder and co-CEO, Bruce Linton, was ousted just weeks after the CEO of US alcohol-giant Constellation Brands – which had made a US$5 billion investment – expressed disappointment with Canopy’s continued losses.

But perhaps the “straw that broke the camel’s back” was the CannTrust scandal. Health Canada found that the Vaughn, Ont.–based licensed producer was growing cannabis in unlicensed rooms, and as a result, it has had multiple licenses suspended. Its stock subsequently collapsed, and the industry seemed to be cast in an ill light.

The timing of the CannTrust news was not the best, given that it took place in the months leading up to “Cannabis 2.0”, the second wave of cannabis legalization that will introduce edibles, beverages, and extracts into the market. Scandals, sluggish earnings, and executive shakeups have replaced the soaring expectations of a year ago with caution, if not apathy. Hopes of a massive market disruption have fallen short. Government data shows that the legal market has only supplanted 14 percent of the black market since legalization, and some are concerned that any further inroads may be difficult to come by. (Cf., Vanmala Subramaniam, “Why Canada’s Cannabis Industry Didn’t Take Off the Way Everyone Expected”, www.calgaryherald.com, October 15, 2019)

There is no shortage of answers to the question of what went wrong in the cannabis industry’s disappointing first year – among them:  obsession on scale, heavy regulatory burden, and uncompetitive pricing. First, it seemed to be presumed that if the larger companies negotiated large-supply agreements and were first to market, they would capture much of the early market share and that would be a huge advantage for them in the future. The problem was turning capacity into profitable production – write-downs and mediocre sales growth were the result. To date, most major cannabis companies are still unprofitable. Promises of profitability are still being pushed back in favor of international expansion, major acquisitions, and partnerships with larger companies outside the cannabis space. Is it any wonder that scandals ensue? When the metric is growth, and you are being rewarded for it by capital markets, issues of governance don’t really apply until you are caught. (Cf., Subramaniam, “Canada’s Cannabis Industry”)

Also, excessive regulation is said to have hampered the industry’s ability to meet customer demand. For example, achieving profitability would be easier if there were more legal stores across the country to compete with the black market. Although it has been almost a year since cannabis has become legal, Canada’s biggest market, Ontario, still only has 25 brick-and-mortar stores and a government-run online store servicing a population of 14 million. Health Canada has also come into criticism due to the extensive rules that it has imposed on producers. But it should be kept in mind that the mandate of these provincial and federal agencies is to ensure that the cannabis that is sold to Canadians meets the highest safety standard – they are not incentivized to move faster. Their goal is to ensure that the product is safe.

Since legalization, the price disparity between legal and black-market cannabis has remained significant. The average price of legal cannabis was CDN$10.23 per gram for the third quarter of this year, compared to CDN$5.59 on the illegal market. In the quarter prior, legal weed cost CDN$10.65 per gram, and black-market weed cost about CDN$5.94. There is an economic incentive to stay with your black-market dealer. (Cf., Subramaniam, “Canada’s Cannabis Industry”)

But this price differential might be short-lived. According to calculations on Health Canada data by Craig Wiggins, an independent industry analyst, the industry scaled up so quickly that it is currently harvesting at a rate of 84 percent of total overall demand – both legal and illegal. He argues that unless we can sell all that product and can get almost the entire black market to purchase legal product soon, there is going to be a massive supply glut and a plunge in prices (Cf., Subramaniam, “Canada’s Cannabis Industry”). Perhaps we are seeing this now. Recently, Hexo Corp began selling a new product line called Original Stash, priced at just CDN$4.49 per gram, roughly 50 percent lower than the average per-gram price on the legal market. Hexo also announced that it was shutting down its Niagara greenhouse and suspending 200,000 square feet of licensed space for cultivation, firing 200 employees in the process.

The market will find a balance between supply and demand – often brutally. The trick is to build demand, and it looks like help is coming. October 17, 2019, saw the legal introduction of edibles (THC-infused foods and beverages), as well as topical creams, ointments, tinctures, and other cannabis products. This change will open up a consumer market worth an estimated $2.7 billion, according to Deloitte Management Services LP (Cf., Susan Goldberg, “One Year of Legal Cannabis”, Investor’s Edge, October 2019). Cannabis 2.0 is here. However, the rollout will be slow, piecemeal, and probably confusing. Health Canada has stipulated that there should be no elements in a product that could be associated with alcoholic beverages or brands and that edible products must not be “appealing to kids”. There goes the “hash brownie” market, and Constellation’s purchase of Canopy looks offside.

But perhaps the biggest potential market is in the United States. Based on population alone, the American market is 10 times that of Canada. But the rollout of legalization is state-by-state and can be torturous. However, there has been recent regulatory movement in the United States, where cannabis is now legal in 11 states and the District of Columbia. The 2018 U.S. Farm Bill, which allows for much broader hemp cultivation, and the Secure and Fair Enforcement (SAFE) Banking Act, which, if passed, would give cannabis companies access to federally controlled banking systems, are creating room for legitimate cannabis businesses. (Cf., Goldberg, “One Year”)

The real money, however, will probably be in the medical marketplace. Whereas the legalization of the recreational market has attracted investor attention because of the size of the potential market, the pharmaceutical market is attractive because of its potential margins. Medical products earn higher margins per gram than recreational products in Canada, as provincial corporations act as intermediaries between growers and producers. The aim is to build a true pharmaceutical market, that is, to sell prescription pharmaceuticals rather than medical cannabis to smoke. In its development, we would see partnerships between cannabis and pharmaceutical companies with access to patients and clinical trials. Pharmaceutical cannabis could be used for the treatment of anxiety, chronic pain, epilepsy, weight loss, and maybe male-patterned baldness.

We have come to see, maybe the hard way, that cannabis is like mining, oil and gas, and real estate – it is cyclical. As always, there will be greed at the top of the cycle and despair at the bottom. Please contact me (dgraham@cgf.com; 780-408-1518) for more details and a few actionable ideas.