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A leading debt-rating agency has issued a warning about the financial strength of Canadian cannabis companies, arguing that even the biggest among them should have “junk” ratings and that many licensed producers are likely to fail.

On Monday, coinciding with the worst day of trading this year for pot stocks, Toronto-based DBRS Ltd. released an analysis of the cannabis sector’s credit risk that provides a sober look at the industry – in contrast to the lofty expectations of equity investors in the lead-up to the legalization of recreational marijuana last week.

“Although the development of the sector may benefit all licensed producers [LPs], not all will perform equally and many will fail,” the agency wrote, adding that the sector’s credit quality is currently low. “At the outset, DBRS believes that the largest LPs in the cannabis sector exhibit characteristics consistent with the low, non-investment-grade [or “junk"] range of the credit ratings spectrum – in the B range.” A "B" rating is two notches below investment grade.

Cannabis stocks tumbled sharply Monday, extending a slide from last week amid long lineups at stores and dwindling supply. Excitement about legalization appears to have given way to questions about the industry’s supply chains and prospects for solid earnings and cash flow.

Aurora Cannabis Inc. shares sank 12.2 per cent, Canopy Growth Corp. dropped 11.2 per cent and Tilray Inc. fell 15.6 per cent Monday, while the Horizons Marijuana Life Sciences Index dropped 11.6 per cent.

DBRS acknowledges that the cannabis sector has a lot of room to expand, noting “there is considerable growth potential for the LPs.” The rating agency expects legal cannabis sales in Canada to reach between $4-billion and $6-billion annually.

However, DBRS also believes it is far too early to determine which companies will thrive.

“Much is to be determined regarding consumer reception, competitive behaviour, regulation, taxation and international market potential,” the agency wrote, adding that historical sales are only partly relevant because they reflect medical marijuana sales alone.

The agency’s cannabis sector analysis is a little unconventional for DBRS because, at the moment, very few companies have taken on debt. Banks have largely avoided lending money to the sector, partly to not run afoul of federal law in the United States. For this reason, DBRS did not provide debt ratings for specific companies, as it normally would.

However, Canadian banks are warming up to the sector as it matures, and earlier this year Bank of Montreal extended a $200-million credit line to Aurora Cannabis, secured by the company’s production facilities. Amid the sector’s expected growth, the rating agency’s assessment of its credit profile is noteworthy.

In its analysis, DBRS listed many of the variables that will influence success for licensed producers but have yet to be settled: the economies of scale that large producers may realize relative to smaller companies; the level of geographic diversification needed to sell all of the cannabis that is produced; and the nature of the industry, including whether cannabis is a discretionary product.

But the rating agency did put the sector in context relative to similar discretionary goods. In doing so, the cannabis market shapes up to be much smaller than a number of established industries, including alcohol. “Even with the most optimistic pricing and volume estimates post-legalization, the cannabis market will be relatively small when compared with other consumer product categories in Canada,” DBRS wrote.

In 2017, tobacco sales totalled $20.4-billion, while alcoholic beverage sales hit $22.5-billion. Cannabis sales last year – including black market sales – were an estimated $5.5-billion. With $6.2-billion in annual sales, the Canadian coffee industry is a much better comparison.

Despite so much being in flux, the rating agency stressed that debt ratings could change dramatically once the sector starts to mature. “DBRS believes the credit risk profile of the emerging leaders of the cannabis industry could improve significantly and rapidly as the industry settles and data becomes available and the behaviour of consumers, competitors and regulators is more known," the agency wrote.

People gathered at Toronto's Trinity Bellwoods Park and in Kensington Market to celebrate the first day of legalized cannabis.

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Tickers mentioned in this story

Study and track financial data on any traded entity: click to open the full quote page. Data updated as of 02/05/24 11:59pm EDT.

SymbolName% changeLast
WEED-T
Canopy Growth Corp
-0.08%12.52
ACB-T
Aurora Cannabis Inc
+2.71%9.08
TLRY-Q
Tilray Brands Inc
+1.09%1.85
HMMJ-U-T
GX Marijuana Life Sciences Index ETF USD
-2.9%8.36

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