Cannabis stocks will find their redemption

Laurentian analyst predicts that after a difficult 2019, troubled marijuana stocks will find their redemption, particularly his “preferred pick” selection, Aurora Cannabis Inc.

cannabis

The opening of more marijuana shops in Ontario and Quebec should spell relief for product manufacturers like Aurora Cannabis Inc.

Turnaround stories often coincide with the start of a new year as people attempt to cast away old bad habits and adopt new good ones; so too with cannabis stocks, suggests Laurentian Bank Securities equity research analyst Chris Blake.

Mr. Blake, a chartered financial analyst based in Toronto, covers cannabis and diversified industries on behalf of Laurentian. Prior to joining the bank and throughout a career that stretches back to the late 1990s, he has also covered infrastructure, energy services, industrials, and consumer-focused income trusts as an equity analyst.

The analyst predicts that after a difficult 2019, troubled cannabis stocks will find their redemption, particularly his “best buy” selection, (or “preferred pick” in Laurentian’s parlance), Aurora Cannabis Inc. (TSX—ACB; NYSE—ACB).

Aurora hit by slow retail rollout

Last year, Aurora, an Edmonton-headquartered licensed producer of medicinal and recreational cannabis products, performed significantly worse in terms of share price than the marijuana business as a whole.

Mr. Blake attributes the pummelling that Aurora took to several factors. These include a slower-than-expected rollout of retail stores in Canada (which led to the company missing its 2019 financial goals) as well as “an ambitious capital investment plan that was not fully funded, requiring additional funding”.

Meanwhile, on an industry-wide level, a few operators committed regulatory violations and valuation multiples for marijuana stocks in general became compressed, coinciding with a 30 per cent reduction to consensus sales forecasts for last year as well as this one. Mr. Blake says: “These headwinds are starting to diminish, with production better reflecting supply-and-demand fundamentals, stronger balance sheets following recent share issuances and construction curtailments, Ontario’s recent announcement to further expand the number of retail stores, and the introduction of higher-margin ‘Cannabis 2.0’ products launching in January.”

Key Ontario and Quebec markets under-served

As of December 2019, industry sales hovered at about $350 million per quarter, or just one-fifth of Laurentian’s estimated total market demand, according to the analyst, who blames the sluggish sales on too few retailers in Quebec and Ontario, Canada’s most populous provinces. Laurentian calculates that the two provinces would be able to support “at least another 1,100 stores and well above the combined total of 46 currently operating,” he adds.

Fortunately for Aurora, the analyst says, “Relief is on the way. The Ontario government will allow 20 new stores per month, starting in April 2020.”

“While we expected more stores would be allowed to open, this is a good first step and government officials did not rule out the possibility of raising the monthly limit at a later date.”

Mr. Blake says: “We expect the Ontario store count to reach 250 by the end of 2020. This is important because Ontario accounts for just 26 per cent of industry sales yet accounts for 40 per cent of Canada’s population. This announcement should help close this gap.”

Significant sales increases expected in Q3

The analyst predicts that the existing distribution bottleneck will continue to limit industry sales growth, possibly through the first half of 2020, then yield to a significant sales buildup in 2020’s second half, paving the way for even more industry sales growth in 2021, as the new stores open.

For its part, the Quebec government has committed to more than doubling its store count, to 48, by the first quarter of 2020.

Mr. Blake also looks forward to the second phase of cannabis legalization, Cannabis 2.0, when edibles and other alternative cannabis products (such as vapes and concentrates) will be allowed for sale in the Canadian market, as a significant profit-maker for the industry. The segment is worth an estimated $2.7 billion annually, he says.

Since such products enjoy higher margins than flower-based ones (80 per cent to 90 per cent in the former’s case; 40 per cent to 50 per cent for recreational flower), they should offset imminent lower prices for flower (expected to drop in the months ahead), the analyst adds.

“These products are quite popular as they are considered to be a more discreet way for consumers who are not interested in smoking cannabis or who wish to avoid the social stigma surrounding smoking it. As such, prevalence rates are expected to rise and thus provide a complementary revenue stream for licensed producers.

“We believe cannabis is rapidly becoming a consumer good just like any other product in the consumer packaged goods industry and we expect valuations will start to reflect this growing trend.” Mr. Blake argues that Aurora is well-positioned to take part in these growth opportunities, citing, for example, its top-three position in Ontario and upcoming initial suite of Cannabis 2.0 products, including edibles such as gummies and chocolates.

This is an edited version of an article that was originally published for subscribers in the January 24, 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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