Canadian cannabis selloff overdone

Toronto-based Raymond James analysts Rahul Sarugaser and Michael Freeman say the strong cannabis stocks are beginning to separate from the weak. They pick two to buy.

Fundamentals are improving across the Canadian cannabis sector. The illicit market is slowly, steadily, converting to the legal market via the ‘deep-value segment’; the number of open retail locations is quickly increasing, primarily driven by Ontario; cannabis sector month-over-month revenues are growing large and accelerating; and the strongest players (in the cannabis game) are, finally, beginning to separate from the weak.

For strong ‘outperform’ cannabis operators such as Cronos Group Inc. (TSX—CRON; NASDAQ—CRON) and Village Farms International Inc. (TSX—VFF; NASDAQ—VFF), unhampered by capital concerns and/or weak operations in our view, a significant market opportunity is unfolding in that the cannabis selloff, with respect to these strong licensed producers, is overdone.

Conversely, we see the downtrend continuing for weak cannabis operators accelerating their capital concerns. That these companies continue to be propped up by protectionist public interests (specific provinces) and speculative private capital (super-high interest debt),we believe, diminishes the health of the Canadian cannabis market.

But, when the inevitable happens, and these sources of public/private capital become exhausted, and these larger, precariously-financed, unprofitable companies begin to die on the vine, we believe we will see a rapid downward spiral of these poor operators, causing them to finally relinquish their lingering grip on market share, leaving a significant vacuum for the quality operators to fill.

We see these quality operators as value buys (CRON is trading just above cash; VFF has a level of cost of goods sold) that provide for durable earnings margins. We believe that these players—and a subset of other quality players in the Canadian cannabis sector—should see a turnaround during the next six-to-12 months, once investors witness clear growth in revenues, but, more importantly, earnings.

The hype leading up to Canadian cannabis legalization—pre-Oct. 17, 2018—was founded on hopes and dreams for not only what the Canadian cannabis market would become, but what the global cannabis market could evolve toward, and how quickly. Since this hype and its valuation peak, however, Canadian cannabis stocks have had a tough couple of years.

From heyday to no-payday

A series of factors has hobbled the Canadian cannabis sector from the earliest days of its history as a legal adult-use market. First on the list is under-supply: Day 1 of legalization was met with severe under-supply (capacity constraints, crop failures), wide variations in quality, a high product return rate and a limited variety of available products (only cannabis flower and oil products to start).

Secondly, the retail segment of the supply chain was weak. For the first year, Ontario—representing 40 per cent of Canada’s population—only had online access to cannabis. Even when Ontario’s government started issuing retail licences, it was through a sluggish, flawed lottery system that further delayed the deployment of brick-and-mortar retail.

Thirdly, there was no international help. For example, the medicinal markets of Germany, UK, Portugal, Malta, Australia and Colombia were expected to buoy some Canadian trailblazers, but instead have been extremely slow-growing, barely contributing to revenues after expensive overseas build-outs.

Lastly, but not least, the massive pre-existing illicit market was probably most critical of all the factors hobbling Canadian cannabis publicly-listed companies. With its 75 per cent share in Ontario, for example, the illicit market continues to eviscerate the legal market with much lower pricing of quality product (illicit growers have decades of experience, and pay no tax), motivating, over the last six months, the creation of today’s largest legal cannabis category—deep-value segment (i.e. cannabis sold at large volumes for less than $5 a gram).

But, with 30 per cent margin going to retailers, 20 per cent to provincial buyers, and a $1 per gram excise tax, barely $1.50 a gram is left for the licensed producers (LPs). So, any LPs with ‘all-in’ COGS over $1.50—which, today, is still most LPs—yield negative margins, as we recently saw with Aurora Cannabis Inc.’s fiscal 2020 (period ending June) annual results (with a whopping EPS loss of -US$33.94).

With a steady conversion of Canada’s illicit cannabis market, there are currently too many operators supplying the sector, as 490 licences have been issued to supply a market of 35 million people. For context, Florida, which is the US market’s most profitable state, has only 14 operating producers supplying a population of 21 million people. We anticipate the implosion of several large, inefficient, tenuously financed Canadian operators during the next handful of quarters—a product of irrational capital expenditures, poorly managed core operations, and low-quality offerings—which would leave room for those strong companies with strong balance sheets (e.g. Cronos Group), industry-leading COGS, operational excellence and strong consumer followings.

Nearly two years have passed since Canada legalized adult-use cannabis. A lot has changed from those wobbly beginnings.

Turnaround starts now

Positives today include: Capacity issues have been resolved (then way overshot, resulting in today’s oversupply, inventory write-downs, asset sales, and layoffs); Derivative ‘Cannabis 2.0’ products such as cannabis vapes, edibles, beverages, topicals and concentrates have been allowed to be marketed in Canada; Cannabis retailers have begun to open their doors (though stifled by sluggish licensing practices in some of the country’s most important cannabis economies, such as Ontario and Quebec)—yielding material boosts in nationwide revenue—and the quality and variety of products in every category seems to be improving.

Now we see that, finally, monthly sector-wide revenues are beginning to escalate to levels comparable to original market expectations, and we are seeing an acceleration of these sales driven by an expansion of available products that meet consumer preferences, and an expansion in the number of routes by which consumers can buy them: e.g. brick-and-mortar retail stores, click and collect, delivery, enhanced online experiences. For example, there is the HiFyre-driven e-commerce SparkPerks loyalty program with Fire and Flower Holdings Corp. based out of Edmonton.

Looking solely at retail store numbers (being licensed to operate), the acceleration is clear: our updated count shows 1,168 stores across Canada now (175 stores in Ontario) versus 807 stores six months ago (40 stores in Ontario) and 555 stores one year ago (25 stores in Ontario). The real potential for acceleration toward market saturation is demonstrated in some of Canada’s most important cannabis economies’ ‘coming soon’ or ‘in process’ retail licence lists, which in Ontario and British Columbia amount to 672 and 35 respectively.

Ontario accelerating rate of store openings

To address this massive backlog of in-progress applications, the Alcohol and Gaming Commission of Ontario (AGCO) announced recently that it is doubling the weekly rate of retail store authorizations from five to 10, and will look to further increase this rate later this year. An estimated 250 stores are set to be open in Ontario by the close of 2020, with another potential 500 stores opening during 2021.

CRON is reliant on licences, authorizations, approvals and permits for its ability to grow, store and sell cannabis and other products derived therefrom. Such licences are subject to ongoing compliance, reporting and renewal requirements, including significant regulation under the Cannabis Act and other local legislation. CRON is subject to restrictions of the TSX that may constrain its ability to expand business internationally (especially in the US). The cannabis industry and markets are relatively new in Canada and in other jurisdictions, and this industry and market may not continue to exist or grow as anticipated. CRON must rely largely on its own market research to forecast sales and market demand, which may not materialize.

For example, under the 2018 Farm Bill, the US Food and Drug Administration (FDA) has retained authority over the Federal Food, Drug, and Cosmetic Act-regulated products (e.g., drugs, food, dietary supplements and cosmetic) containing hemp and hemp-derived ingredients, including cannabidiol (CBD—a non-psychoactive component of marijuana).The FDA or particular states may ultimately prohibit the sale of some or all dietary supplements or conventional foods containing hemp and hemp-derived ingredients (which have more than 0.3 per cent THC (the psychoactive component), including CBD products, which may impact CRON’s business and financial condition.

We view Village Farms as a high risk investment based on the volatility and risks inherent in the early cannabis market, as well as its exposure to risks inherent in the agricultural business. These risks include selling price fluctuations, high competition, labour availability, the changing legal status of cultivated products in different jurisdictions, frequent regulatory changes, marketing restrictions, changes in consumer preferences, supply and demand fluctuations and changes in the scientific understanding of cannabis’ active ingredients. Village Farms’ commercial prosperity will be fundamentally linked to continued demand for its fresh produce, its cannabis products and the continued acceptance of each as safe and lawful for human consumption.

Rahul Sarugaser and Michael Freeman are Raymond James Financial analysts based in Toronto.

This is an edited version of an article that was originally published for subscribers in the October 30, 2020, issue of Investor’s Digest of Canada. You can profit from the award-winning advice subscribers receive regularly in Investor’s Digest of Canada.

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