Part of cannabis and investing
The ragged, century-old storefronts that stretch along Broadview Avenue in Toronto’s eastern Chinatown have long been a shopping mecca for fresh meat, fish and vegetables. In the past couple of years, they’ve become a retail hub for another kind of produce: cannabis.
Kelly, a 68-year-old retiree, has come here with a friend on a Saturday afternoon to stock up. A laid-back hippie type who’s been smoking pot for 40 years, Kelly (not her real name) buys cannabis-infused chocolate and other edibles online, but prefers to shop for dried marijuana flower and hashish oil in person, so she can see and smell them. She doesn’t have a prescription—currently required by law to buy pot—but that hasn’t stopped dispensaries from selling her what she wants.
The pair rings the doorbell of Broadview Medicinals and are buzzed in. A staffer hands them a brief questionnaire, asks them for ID and then opens the door to a back room.
Two men in their 20s stand behind a small counter, keeping a wary eye on the feed from a camera above the front door. A whiteboard lists a dozen flower varieties, priced between $10 and $14 a gram, with playful names such as Charlotte’s Web and Kryptonite, while signs on the wall promote weekly specials: Happy Hash Wednesdays and Shatter Saturdays.
As is customary at dispensaries, the employees take open canisters filled with buds off the shelf and allow the customers to take a sniff. Kelly opts for three grams each of THC Snow and Hawaiian Snow. “I get a euphoria from these strains,” she says. She also buys a gram of hash for $25 and is intrigued by a tiny plastic container holding a gold-coloured chunk of “budder”—a potent, waxy extract—but finds the $60 price a bit too rich.
Come this fall, pot aficionados like Kelly won’t have to go to seedy parts of town or worry about cops busting in while they’re replenishing their supplies, because they’ll be able to buy cannabis legally, in licensed stores. If you believe Ottawa, the provinces and the CEOs of dozens of publicly traded pot companies, over the next few months, the black market in recreational weed will be magically transformed into a legitimate industry. Bruce Linton, CEO of Canopy Growth Corp., Canada’s largest medical cannabis producer, is pumped. He thinks there will be lineups at stores.
“Some people say they’ll go through their opening inventory in five weeks,” he says. “I’m going with five days.”
Investors are psyched too, forging a roaring bull market in pot stocks on the premise that legitimate producers will wrest most of the $5.7-billion marijuana market from the vast network of unlicensed purveyors. Those public companies’ combined market value is now close to $30 billion—almost three times the market cap of Canada’s TSX-listed engineering firms—despite minimal revenues and practically no profits.
But things might not turn out according to the hype. After years of study and consultation, politicians have constructed a highly regulated and typically Canadian Rube Goldberg market model. In each province, a cannabis authority will be the monopoly wholesaler, buying only from federally licensed growers. The wholesaler will then supply licensed storefronts and online sellers, or serve as the monopoly retailer. The merchandise will be tightly controlled and limited in the first year to a modest range of dried marijuana flower and low-concentrate ingestible oils. No touching or sniffing buds from heaping canisters. In many cases, you won’t even be able to see the actual product. And in some provinces, including Ontario, the number of outlets will be scant in the first year. Kelly says she will check one out, but the idea that she will only buy from the province is absurd. “Why would I do that?” she asks.
Why, indeed? Currently, about 90% of marijuana in Canada sells on the black market. Unless governments ease supply bottlenecks, loosen up marketing restrictions, and give legal growers and sellers of recreational cannabis a real chance to compete with unlicensed rivals, Canada’s great pot boom could be headed for a giant bust.
A MASSIVE POT GLUT
The Liberal government’s Bill C-45 set July 1 as the start of the legal market in recreational marijuana, though Senate delays will likely push it to this fall.
To meet the expected demand, licensed producers, which currently serve only the small medical marijuana market, have been frantically building or buying as much production capacity as they can.
In the past three years, Canopy has acquired two rivals, Bedrocan Canada and Mettrum Health, and now has 10 factories and greenhouses in four provinces. Linton says Canopy will have more than 200,000 kilograms of annual production capacity by this summer and could expand to 500,000. In May, Aurora Cannabis Inc. of Vancouver, the second-biggest player, agreed to buy Ontario-based competitor MedReleaf in a deal worth $3.2 billion. If shareholders approve the takeover, it would vault Aurora past Canopy into the top spot in terms of production capacity. Aphria Inc., the No. 3 producer, is also bulking up. Most of its marijuana comes from two giant greenhouses in Leamington, Ontario, plus a small factory on Vancouver Island. By January, says Aphria CEO Vic Neufeld, “we will be kicking out 20,000 kilos a month.”
There are now more than 100 federally licensed producers—roughly double the number a year ago—with facilities, either open or announced, capable of supplying about 1.8 million kilos of pot a year by 2020.
The trouble is, that vastly exceeds the projected demand. Canadians consumed about 773,000 kilograms of cannabis in 2017. The Marijuana Policy Group, a Denver-based consultancy that has conducted studies for several U.S. states and Health Canada, says the Canadian marijuana market might reach 900,000 kilos in the first year of legal sales, and that’s one of the higher forecasts. In short, the industry appears to be headed for a massive glut.
Initially, however, the problem is likely to be shortages. The provinces have been slow to set up their cannabis authorities and place product orders.
In April, Quebec’s Société québécoise du cannabis (SQC), one of the first movers, placed orders with six producers for a minimum of 62,000 kilos in the first year of legalization, an amount likely to significantly undershoot the demand. As of the end of May, the biggest provincial markets still had much to do. Neither British Columbia nor Ontario cannabis authorities had placed orders with producers, and both plan to open a limited number of legal outlets in the first year—just 40 in all of Ontario.
Even if those wholesalers step up preparations, Hamish Sutherland—an industry veteran who is now CEO of White Sheep Corp., a small producer that also invests in and advises other cannabis companies—expects many retailers to be stymied by federal regulations. Companies need licences from Health Canada to both grow and sell marijuana, and getting a sales licence is now an agonizingly slow process.
Sutherland’s previous company, Bedrocan, waited about five months for a licence for its Toronto factory. Now, wait times average about a year. Health Canada issued just nine first-time sales permits in 2017 and none in the first five months of this year.
The bottom line, says Sutherland: “There will be a supply crunch, and it will last a year to a year and a half.”
The combination of a production glut and a shortage of retail channels will have a punishing impact on producers, especially smaller ones, Sutherland predicts. As they wait for licences, they will accumulate inventory. “Much of it will ultimately not be sold or processed, and the companies will eventually run out of capital,” he says. Meanwhile, the black market will keep thriving, thanks to buyers frustrated by the lack of easy access to legal stores.
HIGH PRICES, POOR SELECTION
Elderly Ontarians may recall how dreary it once was to shop for alcohol. Until 1969, customers weren’t allowed to actually handle the merchandise at Liquor Control Board of Ontario (LCBO) outlets.
Names of wines and spirits were listed at the counters, and buyers wrote down order numbers and then handed slips to clerks, who brought bottles from the back and wrapped them in brown paper. Buying cigarettes today is a similarly grim experience, with products hidden behind store counters, and packages covered in gruesome images and warnings.
Combine the most restrictive elements from the history of Canadian booze and modern cigarette retailing, and you’ll get some idea of what shopping for recreational marijuana might be like in Ontario, where the LCBO will be the monopoly retailer. The constraints aim to address regulators’ overriding priorities: keeping pot away from minors, preventing impaired driving and combatting the black market.
Details of what consumers can expect remain murky. Bill Blair, the member of Parliament and former Toronto police chief who is now stickhandling pot legalization for the federal government, declined to answer questions about stores and online sales. Provincial liquor authorities also wouldn’t provide specifics. All LCBO communications manager Nicole Laoutaris would say is that each Ontario Cannabis Store location will have 10 to 16 retail staff who will be trained in “responsible sale practices, product expertise, understanding the new law and recognizing signs of intoxication.”
Alberta, which will rely on private stores, has been more forthcoming. Heather Holmen, communications manager for the Alberta Gaming and Liquor Commission, says stores will have to be physically separate from other businesses, and cannabis and accessories can’t be visible from outside.
All products can only be displayed in locked showcases in their original sealed packaging.
That packaging won’t offer much enticement, either.
Ottawa’s branding rules ban celebrity pitch artists; depictions of people, cartoon characters or animals; and graphics that might appeal to young people. Health Canada has released packaging prototypes: zip-top bags and envelopes, long health and safety warnings on the front and back, and two small spaces for company name and logo. “It’s basically a warning label and a container,” says Canopy’s Linton.
Ottawa has also severely limited the range of cannabis goods retailers can offer in the first year of legalization: dried flower and oils, and capsules and pre-rolled joints made with them. Aphria’s Neufeld figures that not being able to sell vape pens and infused foods, such as pot-laced chocolate bars, will eliminate one-third to half of potential sales. He estimates that vape pens alone account for 15% of illegal sales. Without a larger array of products, Neufeld believes the legal pot market may top out at $1 billion, or less than one-fifth of the total.
Then there’s the question of price. Since 2013, the cost of marijuana from both licensed providers and illegal dispensaries has fallen from around $10 a gram to $7.50. But the channel for recreational pot will add the provincial authorities as middlemen, along with an excise tax of $1 a gram or 10% of the retail price (whichever is higher). Meanwhile, new retailers will boost competition, putting downward pressure on prices. As a result, Neufeld is assuming that licensed producers will net less than $5 a gram on an average retail price of $9.
Hampered by marketing and product constraints, and an expensive distribution system that will dampen profitability, legal purveyors will have a tough time competing with the black market. What’s more, it’s hard to imagine consumers—particularly longtime pot enthusiasts like Kelly—travelling large distances just to buy the product legally. “For sure I’ll continue buying from the dispensaries and online,” says Kelly. “I like the varieties, and I love my edibles.”
A THRIVING BLACK MARKET
In 2012, Colorado and Washington became the first two U.S. states to legalize the recreational use of cannabis (there are now nine). Adam Orens, an economist and a founding partner of the Marijuana Policy Group, says those states’ experiences serve as “a cautionary tale” about marijuana legalization.
Washington took a regulated approach, similar to what Canada is pursuing, relying on its liquor board as the licensing authority for growers, processors and retailers, and tightly limiting product offerings. Growers could sell to only licensed processors or retailers, and growers and processors could not own stores. Colorado, on the other hand, allowed vertical integration and a wider range of products. It was also liberal in permitting former black-market growers and sellers to cross over into the legitimate trade. “They wouldn’t allow El Chapo to participate,” Orens jokes, “but if you had a few minor cannabis-related offences, you were allowed.”
In economic terms, Washington was less successful in its first year. With only 18 retail outlets, prices were very high—more than $20 (U.S.) a gram—and did little to divert buyers from the black market. But when the state expanded the retail network, prices dropped by half. There are now more than 200 stores, and about 80% of pot users buy from legal outlets.
Colorado, which has a smaller population than Washington, started with about 150 recreational retail outlets. Today, the state has more cannabis stores than Starbucks outlets—500-plus—and almost 100% of pot buyers have crossed over to the legal market. “It’s just like going down to the corner liquor store,” says Orens. There’s also a mix of producers: a handful of large suppliers that control less than half of the market and dozens of craft growers that are popular with enthusiasts.
Both states now have some of the lowest average prices in the country: less than $7 (U.S.) a gram. Their experiences suggest that, given competitive prices, consumers prefer to buy legally.
But they need to have easy access to stores. “God help the LCBO if they open 40 stores in the first year,” Orens says.
However, Washington and Colorado continue to battle black-market growers who export to states where weed is illegal or only permitted for medical use, and therefore commands much higher prices. The main black-market incentives in Canada will be the limited product range and the fact that what’s legal might not be the best. Ian Dawkins, acting president of the Cannabis Commerce Association of Canada, which represents small growers and dispensaries, estimates British Columbia produces about two-thirds of the marijuana in Canada. “And if you talk about quality [product], it’s 80% to 90%,” he says. If consumers can’t get access to that coveted B.C. bud legally, they will continue to buy it illegally.
This scenario is all the more likely because illegal Canadian growers and sellers who want to go legit face big obstacles and conflicting regulations. Mike Babins, who owns the Evergreen Cannabis Society dispensary in Vancouver’s laidback Kitsilano neighbourhood, has been struggling to operate legally since 2015. That’s when Vancouver announced it would license dispensaries of recreational pot, provided they conformed to municipal bylaws on location (such as maintaining a distance from schools), product display and other particulars. Babins paid $30,000 for a licence and is now one of 19 legal dispensaries in the city.
Yet Babins still gets his supply illegally, because the best B.C. product comes from craft growers who currently only have licences to grow medical marijuana for their own use or specific patients. “We have entire communities and full islands growing cannabis,” Babins says. “They’re some of the best people in the world doing it.” He sells just eight strains, all organic. He buys from only seasoned craft growers who have their pot tested by Health Canada–approved labs (in theory, for their personal use). Facing mountains of government red tape, many likely choose to stay in the black market.
Babins can relate: Under new B.C. legislation governing the sale of recreational marijuana, he will have to buy his product through the provincial wholesaler, introducing a bureaucratic layer into his dealings with suppliers. The province also requires retailers to black out their windows and put up bars. Vancouver’s current bylaws prohibit bars or blacking out. “We just paid a lot for secure clear windows,” says Babins.
Pot connoisseurs who can’t get their preferred product from Babins will have plenty of other options. He estimates there are more than 200 illegal pot stores in Vancouver alone.
The city issues tickets and pursues court cases, but shutting down illegals is tough. “They close the place down, it changes its name, and it reopens a week later,” says Babins.
Legal purveyors shouldn’t expect any renewed crackdown on the black market. Bill C-45 keeps in place many criminal penalties for illegal possession and sale of pot, but Yves Goupil, director of serious organized crime for the RCMP, says the enforcement focus won’t change: The RCMP goes after large criminal organizations for which marijuana is just one of several businesses. “We’re targeting groups, not the commodity,” he says.
Babins would love to operate completely above board. “If I didn’t have to meet someone once a week and pay them in cash, it would make my life a lot easier,” he says. But navigating the new rules might simply prove too onerous. “It will be a struggle if there’s red tape.”
‘THEY WILL BE DECIMATED’
All of this does not bode well for licensed producers—particularly the smaller ones—and the investors who’ve been snapping up their shares. Pot stocks have seen an astonishing rise over the past two years.
As of early June, the Canadian Marijuana Index, which tracks two dozen companies with a combined market cap of $26 billion, had soared by more than 700% since the beginning of 2016. Canopy’s valuation has blown past $7 billion, even though it has just $70 million in annual revenue.
Cannabis company CEOs were once viewed as hustlers.
Now, they’re courted by Bay Street elites. A few years ago, Linton couldn’t get any of the bank-owned investment dealers to meet with him. In 2015, Royal Bank of Canada even cut off Canopy’s corporate account. Fast-forward to spring 2018, and Linton is very popular. Over the course of one week, he met with institutional investors in Frankfurt on Monday, Italy on Tuesday and London on Wednesday, and was back in his office in Smiths Falls, Ontario, on Thursday. At the end of May, Linton was one of the featured presenters at the first cannabis conference, held by BMO Nesbitt Burns, which coled Canopy’s $200-million share issue in January.
Linton has tried to ignore the recent swings in marijuana stocks between euphoria and panic, but that can be hard.
“Retail investors read headlines but don’t do the analysis,” he says. For example, Canopy’s share price shot up by more than 45% within days of its 2016 announcement of a marketing deal with rapper Snoop Dogg. Later that year, the company’s market cap climbed to more than $1 billion, making it Canada’s first marijuana unicorn, and then briefly shot past $2 billion five days later, before plunging by a third a week later.
There was a sobering decline in pot stock prices earlier this year when it became clear that Ottawa and the provinces would miss the July 1 target for legalization. The Canadian Marijuana Index dropped by 35%. But in early June, the index was still trading at more than double its value at the beginning of 2017. And there’s plenty of froth left in marijuana stocks. In February, The Green Organic Dutchman Holdings (TGOD) announced plans for an IPO. While the company is partly owned by Aurora, it has negligible revenues, and its prospectus says executives have discovered “a material weakness in our internal controls over financial reporting” that might require them to restate results. Yet investor demand was so strong that when the IPO closed in May, TGOD had raised $115 million and exercised an over-allotment option.
Investors are seduced by the image industry executives paint of a more liberal marijuana market in the future: a mainstream lifestyle product, clever and distinctive brands, a mix of large producers and craft operations and, perhaps most importantly, Canadian companies as global leaders. Several are establishing export markets in Europe and Latin America, and will hit the motherlode if the U.S. legalizes pot nationally.
Some of this vision may indeed materialize, but licensed producers and sellers will first have to survive a very rough ride over the next year, possibly much longer. It’s hard to see how more than a handful of the public companies will prosper.
“You can’t have all of them each getting 10% market share,” says Matt Bottomley, research analyst for alternative pharmaceuticals at Canaccord Genuity Inc.
At the start of June, five licensed producers (Canopy, Aurora, MedReleaf, Aphria and Cronos Group) each had a market cap of $1 billion or more. Meanwhile, dozens of companies are valued at $300 million or less. Bottomley believes only those with the biggest scale will survive a coming shakeout—and by scale, he doesn’t mean simply production capacity, market cap or capital. The best-positioned companies are already producing and selling at a low cost, have supply deals with provincial authorities and are establishing markets overseas.
“Scale doesn’t mean, ‘I just sent out a press release saying I raised $25 million and I’ll have this huge growing facility in 12 months,’” he says.
As for the rest, some will be acquired, which may prove profitable for shareholders, though both Linton and Neufeld suggest their companies aren’t looking for new deals. Even the top producers are hugely overpriced by conventional financial ratios, such as trailing or forecast price-to-earnings. Beyond the eight biggest companies in the Canadian Marijuana Index, none have had any earnings to date, and only Invictus MD Strategies and OrganiGram Holdings forecast a profit next year. Bottomley says investing in the sector is an exercise in finding “attractive relative valuation,” such as comparing ratios of enterprise value to forecast EBITDA for 2020. By that measure, and scale, he likes Aphria best.
Insiders and observers envision the industry becoming a typically awkward, regulated Canadian compromise, like the beer business. A few giants will succeed, but as for the smaller companies? “There will be a monster consolidation,” predicts Sutherland. Linton is more direct: “They will be decimated.”
Sutherland, a veteran entrepreneur who’s brought 17 companies to market since the 1980s, including Upper Canada Brewing Co., had to fight for more than a year to get his product into Ontario’s Beer Store monopoly. He hopes Ottawa and the provinces quickly carve out shelf space for craft cannabis growers. Otherwise, many will be swallowed up or go under.
Executives and investors in those vulnerable small and midsized licensed producers might want to savour a big fatty on the first day of legal recreational sales. The best of times may already be long gone.