Canadian Cannabis and the Goldrush

Delwin Graham - Mar 28, 2018
Its no secret that Canadian marijuana stocks performed quite well in 2017.

Its no secret that Canadian marijuana stocks performed quite well in 2017. As an indication, cannabis related companies raised over CDN$2.0 billion in Canada and the Canaccord Genuity Cannabis Index was up 277% over that period. And it looked like 2018 would follow in its footsteps. January saw approx. CDN$1.9 billion of capital raised and the Cannabis Index reach all time highs at mid-month. The sector began to retrace but still closed out the month with the Index up approx. 11% for the month.  However, February saw continued pressure in the sector with the Index declining 8% for the month, bringing YTD returns close to break even so far in 2018. 

 

Of course, the million-dollar question is - where to now? Perhaps the best analogy to use when considering the rapid development of the cannabis sector in Canada is a goldrush; of course, I’m not the first to make this suggestion. Canadians know a lot about goldrushes.  The first thing to do in a goldrush is to stake your claim. Then you work your claim to see if it is a bonanza or a bust. We might want to characterize 2017 as a period of claim staking following the announcement by the Federal Government in April 2017 that they will be opening up a large new consumer market – legal recreational marijuana – on July 1, 2018. Everyone is trying to gain a foothold. Some companies are recommissioning greenhouses to quickly ramp up marijuana supply and meet the anticipated demand.  Other companies are designing purpose-built facilities to maximize efficiencies, e.g., hydroponics and cheap energy, and become low cost producers.  Technology is also coming into play on the processing end, as various methods are being developed to extract cannabinoids that can be used in edible products (e.g., baked goods, various types of drinks), vapes and pills. Other companies are looking to lock-up retail distribution by developing branding and targeting retail store sites.  While there has been an explosion of companies looking to establish a business in these particular niches, other companies are working to vertically integrate production, processing and distribution.

 

In 2018, these companies will have to work their claims – what is potential will have to be made actual. Problems arise when the “rubber hits the road”. Already there are bottlenecks in rolling out such a large industry in such a short time. February saw a number of positive developments on this front, including: (1) an announcement by the Société des Alcools du Quebec (SAQ) for initial supply commitments to six Licensed Producers for recreational cannabis in Quebec; (2) the addition of medical cannabis into the benefits plan of a major Canadian insurance provider, i.e., Sunlife; and (3) the announcement of recreational retail store licenses by the province of Manitoba. But there were also reports of an expected delay in the Senate that could push Canada’s recreational start-date past July 1 and concerns surrounding firming up impaired driving laws prior to cannabis legalization. (Cf. MattBottomley, Cannabis Monthly, March 2018, www.canaccordgenuity.com). Two steps forward, one step back.

 

Given that the parameters of the cannabis market in Canada are not yet established, it is not hard to understand why cannabis companies are not trading on fundamentals. For example, the five largest marijuana stocks on the TSX (WEED; APH; ACB; CRON; LEAF) have an aggregate market cap exceeding CDN$18 billion, which is not far from the market cap of Molson Coors (TAP:NYSE) at US$17 billion.  Molson Coors has the largest share of Canada’s brewing market and generated approx. US$13.4 billion in revenue over the past twelve months.  The five cannabis companies generated approximately CDN$170 million in revenue and recorded only CDN$5.0 million in net earnings compared to over US$2 billion to the positive for Molson Coors.  Are those five cannabis companies really worth about the same as Molson Coors?  Many analysts think not.  (Cf. Ian Cooke, QV Update, January 19, 2018).  But it is difficult to determine the value of these companies because they are not trading on fundamentals and their potential market, i.e., the retail cannabis market, is continuing to develop. To this point, Matt Bottomley at Canaccord Genuity contends that sector multiple expansion should continue in the near term as we experience positive catalysts like the announcement of recreational cannabis purchase commitments from Ontario, further progress towards federal legalization, the potential for further consolidation and M&A, and the potential entrance of strategic partners in this space. (Cf., Bottomley, Cannabis Monthly, March 2018). According to Bottomley,

 

 “Its not until the rubber hits the road in the second half of the year with the roll-out of legal adult-use marijuana in Canada that we envision potential negative operational catalysts that could slow recent trends.” 

Where does that leave us?   As usual, we will consider opportunities in the cannabis sector as they arise, concentrating on how a stock is actually performing rather than how it should perform.

 

Please contact me (Delwin.graham@canaccord.com; (780) 408-1518) for more details and a few actionable ideas.