A View of Cannabis Investment Opportunities in Canada

Evan Eneman  |


This is the second article in a series exploring the Global Cannabis Market Expansion: Growth Trends and Considerations for the Future. See the first installment here.

In my first article, I covered a fairly broad overview of the cannabis market and various types of opportunities for those considering investing in this emerging industry. In this article, we’ll dig a bit deeper into the Canadian cannabis market, examining both the current state and growth forecasts, given their full adult-use market will go into effect on October 17th.

A Look Toward Canada

So what should we think about our friends to the North? As highlighted previously, Canada is the first G7 country to legalize cannabis, which will make it by far the biggest federally regulated market in the world. For comparison, Canada is a bit smaller than California population-wise, but given Canada’s free license to import/export and leverage capital markets, the nation has a strong advantage and market leading position. As such, there are no historical or industry comparisons that can be relied on. Canada will be forging new ground, making up the rules as they go … and the world will be watching.

Canada legalized medicinal cannabis in 2001 and the market has matured into a relative force in the ensuing years. Experts estimated that Canadians spent $4.63 billion on cannabis in 2017 alone, but 90% of that spend was “non-medical consumption,” in other words, black market sales.

Bullish prognosticators see ~$4B in existing market potential, with room for growth. But experienced industry investors know that uprooting entrenched black market operators is one of the largest questions facing a legal cannabis market. In the US, the black market has proven to be a difficult obstacle in every state that has legalized adult-use cannabis. In California, for example, black market operators – who don’t pay licensing fees or taxes or comply with regulations for safety and control – have been blamed for the slow development of the legal cannabis market. These “rogue operators” offer lower prices than their compliant competitors, and customers who have existing relationship with long-time dealers will often, ultimately, seek out the lowest prices. Canada’s large black market industry could slow growth as consumers may be reluctant to transition to a higher-priced legal market.

Legalization in Canada will help to both formalize controls around product quality and safety as well as provide economic stimulus from legal markets. There will also be a focused government and law enforcement initiative to convert black market operators into regulated businesses, or shut them down.

Ultimately, legalization on the Canadian scale is simply unprecedented and one of the few predictable factors is that there will be disruptions and difficulties as laws and regulations are rolled out and implemented. Growth in Canada’s cannabis industry is seemingly a likely outcome. The real question is how much, and how long will it take? And for the investment savvy, do current valuations of cannabis companies accurately capture this potential or currently overstate it?

Canadian Companies Riding the “Green Wave”

In recent years, Canada has become home to a growing number of public cannabis companies that are earning headlines with sky-high valuations, high-profile acquisitions and partnerships, and bold international growth strategies. But with these headlines may come a lot of empty hype, and it is essential to peek behind the glitz and glam to examine underlying operational and financial realities.

One reason Canadian cannabis companies have seen such growth is their unfettered access to capital markets. Since the cannabis markets are regulated at a federal level in Canada, companies compliant with Canadian law have been able to issue public offerings on major exchanges, including the Toronto Stock Exchange (TSX), TSX Venture Exchange (TSX-V), and the Canadian Securities Exchange (CSE).

The largest companies have used this access to capital to embark on ambitious operational expansions. For example: Canopy Growth has plans to add four million square feet of greenhouse space, has secured major distribution deals in numerous Canadian provinces, and is expanding globally with the launch of Latin American affiliate Canopy LATAM and the acquisition of Colombian based assets. Similarly, Aurora Cannabis has acquired another public cannabis company in MedReleaf, and has international ambitions of their own.

The deep field of public Canadian cannabis companies does not appear to be slowing momentum for companies seeking capital infusions, or for investors looking for the next big cannabis whale. Bucking the trend of listing on the Canadian exchanges, and forging new ground in the US, Tilray Inc.  (TLRY) recently became the first cannabis business to complete an initial public offering on a major US stock exchange, raising $153 million with its listing on NASDAQ. Initially priced at $17, the stock jumped in value to $22.44, up about one-third, by close of close business.

Impressive growth plans have fueled astronomical valuations. Currently, the three largest cannabis companies are Aurora Cannabis  (ACB:CA), GW Pharmaceuticals  (GWPH) and Canopy Growth  (CGC), which all trade on the TSX, currently have market caps of $3 billion, $4 billion and $5.3 billion, respectively. These valuations are currently hundreds of times higher than lifetime reported revenue. Further muddying the waters are talks of more “super-mergers” to come, following the precedent established by Aurora and MedReleaf.

Numbers like those listed above have stoked fears of a “cannabis bubble,” threatening to burst with the first real bad news affecting the industry. And usually, such disparities in valuation and revenue or profit would send up red flags for investors. But for the cannabis industry, we truly just don’t know what these companies are worth now, or will be worth two, five or ten years down the line. We do know that growth prospects remain strong.

Why Was Growth Muted When Legalization Was Officially Announced?

Between November of 2017 and early January of 2018, the Global Cannabis Stock Index nearly tripled, largely fueled by anticipation of California’s massive adult-use market. The index has since dipped to 90 points, roughly half of its 180 point peak on January 3rd. Many expected a similar jump when Canada’s legalization was finally approved, but instead, growth has stalled and the index has dripped to its lowest level since December 2017.

A number of factors have contributed to the lack of investor enthusiasm around the announcement of Canadian legalization. Firstly, Canadian legalization was expected and has been hyped within the industry for over a year. When legalization was announced, the only real surprise was that it was to be implemented one to two months later than initially thought.

Secondly, in recent months the cannabis market has seen a number of significant offerings, including $52 million from Newstrike  (NWKRF); $100 million from CannTrust  (CNTTF); $153 million from Tilray; $259 million from Aphria; and $600 million from Canopy Growth. At the same time, the number of publicly-traded LPs has grown from 32 to over 40.

Finally, the realities of the Canadian market seem to have taken hold. The rush of optimism that fueled the early 2018 spike has been replaced with concern about limited inventory, slowly growing demand, limited retail operations, and other regulatory factors.

Less Risk, Safer Rewards?

Investors nervous about talk of “bubbles” and over valuation have sought profit in companies related, but not wholly committed, to the cannabis industry. One such company that earned headlines at the end of 2017 is Constellation Brands  (STZ), a leading beer and wine company that bought a 9.9% stake in Canopy Growth – and saw their investment triple in the following months when Canopy’s stock skyrocketed.

Constellation’s long-term plan is a hedge bet concerning how legal cannabis might affect the alcohol industry. They plan to sell cannabis-infused products themselves, and the additional exposure to the cannabis equity space has its own advantages. Investment in a diversified firm like Constellation are largely protected from the vagaries hounding the cannabis market, while should cannabis boom, Constellation and its investors will profit as well.

Similarly, lawn and garden care company Scotts Miracle-Gro  (SMG) represents another call option on cannabis legalization. The company has invested heavily in the hydroponics space, acquiring a number of hydroponics companies in recent years. Their strategy banks on increased demand among cannabis cultivators as operations expand. Investors enthusiastic about this play fueled a bump in stock value at the turn of 2018, but in recent months the stock price has dipped to lows not seen since mid-2016.

The variance in fortunes for the aforementioned companies establishing a stake in the cannabis industry are a microcosm of the severe variability that continues to confound investors.

In Conclusion

Canada will be the “canary in the coal mine” for cannabis legalization on an industrialized scale. Canadian companies in the cannabis space have been hard at work for many years developing cultivation and distribution operations in anticipation of legalization. With more and more pieces in place, the last and greatest variable will be consumer demand, in both the short and long-term. If demand fizzles, investors who heeded the red flags of aggressive valuations will be proved wise. Should demand explode (whether in six months or six years and domestically or internationally) today’s careful investors could be left out in the cold. As always, it comes down to risk appetite, investment portfolio theory and due diligence. Gaining a comprehensive understanding of both a company’s operations and leadership, and the regulatory framework they will be working within, is the only reliable information that differentiates safe investments from those likely to disappoint.

DISCLOSURE: None of the statements contained in this article should be misconstrued as investment advice.


The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
SMG Scotts Miracle-Gro Company (The) 64.69 1.18 1.86 297,564 Trade
CGC Canopy Growth Corporation 30.42 -0.50 -1.62 1,737,938 Trade
GWPH GW Pharmaceuticals Plc 121.47 1.94 1.62 261,738 Trade
weed:ca Canopy Growth Corporation
STZ Constellation Brands Inc. 181.37 0.10 0.06 626,701 Trade
TLRY Tilray Inc. 71.00 -4.13 -5.50 563,621 Trade

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