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inside the market

Marijuana, seen in a licensed Smiths Falls, Ont., grow room in January of 2016.Dave Chan/The Globe and Mail

By next year, Canada's legal marijuana industry could transform from a multimillion-dollar market serving thousands to a multibillion-dollar market serving millions.

The Liberal government on Thursday unveiled its proposed legislation to legalize marijuana for recreational use, the latest chapter in its effort to dismantle the illegal market. Legalization, which Ottawa hopes will go into effect by July 1, 2018, would anoint Canada as a global leader in regulated cannabis consumption and thrust the country's production industry into high gear.

Already, a high-stakes battle is playing out as marijuana producers jockey for position ahead of the legalization date, with investors pouring hundreds of millions of dollars into various firms. Several companies have gone public and have seen their valuations multiply. Licensed producers, which are known as LPs and supply the medical market, are using the capital injection to build capacity to meet an expected surge in demand.

How big a surge? Canada's legalized recreational market could reach $6-billion in annual retail revenue by 2021, or almost $8-billion when including sales to medical patients, according to Canaccord Genuity. Today's medical-only market is pegged at about $400-million.

And Jason Zandberg, an analyst who covers the sector for PI Financial, forecasts that combined recreational and medical sales could reach $4.6-billion by 2019, if legalization starts in mid-2018. From there, he expects sales to grow by 10 per cent a year to $7.4-billion by 2024.

The customer base is substantial, too. A 2016 Deloitte survey shows 22 per cent of Canadian adults are occasional users of recreational pot and about 7 per cent use it daily. Another 17 per cent would be willing to try marijuana if it was legal.

Investors are buying into the industry's potential, but their enthusiasm is also raising concerns of a potential bubble.

"It's not a new product, but it's a new industry and it's going to develop very quickly," says Mark Whitmore, vice-chairman at Deloitte. "The risk is, it's hard to predict where it's going to go … There will be some winners, some losers and people have to be very careful about which way they want to get into this space."

With that in mind, here's what investors should know about this burgeoning industry.

The political background

One of the Liberals' most clear-cut promises in the 2015 federal election campaign was their plan to legalize marijuana.

Facing criticism this stance was soft on crime, Prime Minister Justin Trudeau repeatedly said the party's core priorities were not to create a new commercial market but to shut off an illicit source of money for organized crime groups and to lower cannabis consumption among Canada's young people, whom global drug surveys perennially list as smoking the most pot in the developed world.

Making marijuana legal by next summer could hit serious roadblocks as provinces and territories are expected to have different approaches to solving complicated policy issues such as where to sell cannabis and how much to tax the drug.

Most experts and industry insiders agree sales will likely become a reality before the next federal election.

In terms of taxation, the Office of the Parliamentary Budget Officer has recommended the best way to stamp out black-market operators is for Ottawa to tax recreational sales very lightly at first.

The watchdog has also forecast "modest" fiscal revenues to start, amounting to hundreds of millions of dollars, rather than billions. In a report last November, the PBO projected sales tax revenue could be as low as $356-million and as high as $959-million for the first full year of recreational sales, with a likely take of about $618-million based on legalized retail cannabis selling for $9 per gram – in line with current street prices.

The PBO's projections were based on a full year of sales after legalization goes into effect at the very start of next year, a timeline which is now widely considered at least six months too early.

The current market

Canada's medical-marijuana market has seen explosive growth over the past few years.

Retail revenues are estimated at roughly $400-million, according to Canaccord, based on estimates of 140,000 registered patients using 0.9 grams a day at an average price of about $8 a gram. Their projections are based on the latest data from Health Canada, which showed there were approximately 98,500 registered clients at the end of September, 2016, up from about 75,200 three months earlier.

There's a caveat with the Health Canada numbers, though. Some patients may be registered at more than one of the country's 43 licensed producers. Some also may not be active patients, either because a product didn't work for them, or they passed away.

"We aren't dealing with perfect information here," PI Financial's Mr. Zandberg says.

Still, production levels are soaring. More than 5,700 kilograms of dried marijuana were produced by licensed firms in the quarter ending Sept. 30, 2016, a 168-per-cent increase from a year earlier, Health Canada figures show. For the same period, nearly 4,800 kilograms were sold to clients, a gain of 155 per cent from the previous year.

When pot is legalized for recreational use, analysts expect growth in the medical market to slow as some users decide not to bother with a prescription.

However, growth could continue at a steady clip if there are tax breaks for medical use or cannabis is covered by employee or other types of medical plans.

Canaccord forecasts the number of medical patients to quadruple over the next five years to more 500,000, based on Health Canada's current data on registered patients as well as expected growth.

As cannabis becomes a more widely accepted medical therapy, Canaccord believes the number will reach a ceiling of about 800,000 patients by about 2026, or about 2 per cent of the estimated population at that time.

The next market

Under the proposed legislation, Canadians must be at least 18 years of age to purchase marijuana, though provinces can set a higher minimum age. Adults could possess up to 30 grams of dried cannabis in public and grow up to four plants per residence.

The bill calls for the federal government to license marijuana producers, leaving distribution and sales to the provinces.

Analysts expect each province and territory to use its existing infrastructure, such as pharmacy chains or stores operated by liquor-control boards (for instance, Ontario's LCBO) to distribute cannabis through regulated dispensaries. However, it's possible not all provinces will be ready to oversee the distribution and sale of marijuana when legalization goes into effect. Federal officials are preparing an "interim system" to deal with such a scenario, The Globe's Daniel Leblanc has reported.

How to dissect the earnings of marijuana producers The companies' results are more complex to assess than at first sight. David Milstead goes deep on the financials of a nascent industry.

Another hurdle is production capacity.

PI Financial forecasts Canadian LPs will need to cultivate a total of 610,000 kilograms of cannabis to meet domestic demand, as well as a growing export market, by 2019. For comparison, the firm pegs total 2016 production at 31,000 kilograms.

LPs have raised more than $700-million in capital in the past year and earmarked most of it for production expansion, Mr. Zandberg says. Still, he estimates a shortfall of just under 200,000 kilograms in the first year of legalization. Analysts believe the shortfall will eventually be covered as more producers are granted licenses and LPs continue scaling up their operations.

Until then, the illegal market will fill the void, Canaccord associate analyst Matt Bottomley says. "The shelves won't be empty when the legal market opens up," he says.

What the analysts are saying

Pot stocks have made some investors a lot of money – especially those who got into the market a year ago, when Ottawa said it planned to go ahead with legalization.

Since then, shares of Canopy Growth Corp., Canada's largest producer by market capitalization, have risen by about 300 per cent. Aurora Cannabis Inc. and Aphria Inc. are up more than 400 per cent, while Cronos Group Inc. has surged more than 1,000 per cent, to name a few of the largest publicly traded firms.

The frenzy has stoked some bubble fears. Analysts say valuations are high and they caution those investors looking to get into the sector to be selective.

"You have to really look and try to pick the winners. We think that the established licensed producers, quite honestly right now, are the only game in town," says Mr. Zandberg, who covers five companies including Canopy, Aphria, Cronos Group, OrganiGram Holdings Inc. and Emblem Corp., with a "buy" on each.

He says other newer companies with unique business models could also be good investments down the road, but warns about some of the smaller companies that don't have licences yet.

"You could be buying a lottery ticket on that," Mr. Zandberg says.

Marijuana bubble? The warnings signs are there Investors would be well served to gaze beyond the bullish haze on marijuana stocks, David Berman writes.

Echelon Wealth Partners analyst Russell Stanley says talk of a bubble doesn't take into account huge growth that will come with the recreational market. He points to Colorado, which did $1.3-billion (U.S.) in combined recreational and medical sales last year, its third year of legalization.

"If we follow the same growth path, then cannabis is an $8.6-billion industry in a few years," Mr. Stanley says, accounting for a Canadian population that is several times greater than Colorado's. "There is a much bigger market around the corner that isn't necessarily reflected in earnings estimates today, if you look at near-term valuations."

Canadian producers already up and running have a "significant first-mover advantage," but "don't overlook the risks," Canaccord's Mr. Bottomley and his colleague Neil Maruoka say. "There are a lot of things that need to happen before the recreational market comes online," Mr. Maruoka says, citing such factors as legislation, distribution, taxation and enforcement.

"While fundamentals remain strong, we believe that valuations may be stretched amongst the larger players," the analysts said in a recent note. They have a "hold" on Canopy and Aphria, and a "speculative buy" on Aurora, Emblem, OrganiGram and Supreme Pharmaceuticals Inc.

If legalization doesn't go into effect by mid-2018, as expected, stocks could sink, again. Pot stocks sold off in early March when Bill Blair, the former Toronto police chief leading Mr. Trudeau's marijuana reform effort, signalled legalization might take longer than expected. Stocks rallied a few weeks later when reports surfaced that legislation was coming before April 20, a celebratory day for cannabis culture.

Another potential risk is negative public sentiment around legalizing pot.

"We believe the industry is likely at the overall mercy of public sentiment, which has the potential to sour if issues like drug addiction, being able to detect and prevent impaired driving and youth access are not dealt with in a sufficient manner once the recreational rollout begins," Canaccord analysts said in a note last fall. "We believe that public perception is one of the key drivers that will allow for an expeditious legalization process – or perhaps delay it altogether."

Recreational marijuana is "not currently a clear win" for the Liberal government, according to the Deloitte survey conducted last spring. It showed 40 per cent of the adult population is in favour of legalization, with 36 per cent opposed. The remaining respondents were undecided.

Five companies to watch

Canopy Growth Corp.

Smiths Falls, Ont.-based Canopy Growth was the first cannabis company to graduate to the Toronto Stock Exchange and be listed on the S&P/TSX composite index. Known for such brands as Tweed (which includes branding with musician Snoop Dogg) and Bedrocan, Canopy Growth also has export markets in Brazil and Germany. It recently bought rTrees Producers Ltd. in Saskatchewan and plans to rebrand it as Tweed Grasslands.

Market cap: $1.7-billion
The analyst's take: "We like this name for its size and speed," says Echelon Wealth Partners analyst Russell Stanley, who has a "buy" on the stock and $14 target.

Supreme Pharmaceuticals Inc. (SL-C)

Toronto-based Supreme is the only business-to-business cultivator in Canada, with a focus on the wholesale medical-cannabis market. It does business as 7 Acres and is waiting for approval from Health Canada to start sales. "We have a number of Canadian licensed producers under agreement to purchase our product when it becomes available," chief executive officer John Fowler says.

Market cap: $207-million
The analyst's take: "With six LOIs [letters of intent] already signed and over 2,000 plants harvested, the company is ready to commence sales once the puck drops on its sales authorization," Beacon Securities analyst Vahan Ajamian says. He has a "buy" on the stock and $2.25 target price.

Emblem Corp. (EMC-V)

The Toronto-based company, formed in 2014, has a focus on medical marijuana at premium prices. Analysts point to John Stewart, the head of its pharmaceutical division, as a differentiator. Mr. Stewart is an ex-CEO of Purdue Pharma, maker of the powerful painkiller OxyContin. The company has production facilities in Paris, Ont., and a network of GrowWise Clinics across the country.

Market cap: $151-million
The analyst's take: "We believe the company's medical focus and premium pricing support a higher multiple," say Canaccord Genuity analysts Neil Maruoka and Matt Bottomley, with a "speculative buy" and $3.75 target.

CanniMed Therapeutics Inc. (CMED-T)

CanniMed was the first government-licensed medical-marijuana producer (LP). It was the sole supplier to Health Canada under the former medical-marijuana system for 13 years. The Saskatoon-based company, which is focused on the pharmaceutical market, recently received two export permits from Health Canada and initial purchase orders for distribution to Australia and the Cayman Islands.

Market cap: $277-million
The analyst's take: "We expect many positive industry and company-specific catalysts to propel the shares higher over the next 12 months," says AltaCorp Capital analyst Keith Carpenter. He has an "outperform" rating and $19 target on the stock.

The Hydropothecary Corp. (THCX-X)

The Gatineau, Que.-based company is the only LP in Quebec and claims to be the only one with a dried cannabis pill on the market. Its operations are on a 65-acre farm along the Rivière des Outaouais. It promotes itself as offering "artisanal growing techniques" and medical cannabis that's grown without the use of synthetic pesticides. The company does not yet have analyst coverage.

Market cap: $159-million
What the CEO says: "We're not in this game for mergers and acquisitions and to go acquire other licensed producers. We're a team focused on operations and looking to the Canadian market first," says CEO Sebastien St-Louis.

Market caps as of April 6 close

The international market

Canadian producers are poised to expand their footprint on the global stage. They are already selling product to countries such as Germany, Australia and Brazil, where marijuana is cleared for medical use, and are laying the groundwork in various U.S. states. For instance, this past week, Aphria unveiled its strategy to expand in the United States, starting in Florida, while the Canadian Bioceutical Corp. said it was buying a 51-per-cent interest in a company active in Massachusetts, where residents voted in favour of legalization last November.

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Under federal rules, however, marijuana is banned for both medical and recreational use, and so these could be risky plays under the administration of U.S. President Donald Trump. While U.S. Attorney-General Jeff Sessions has acknowledged the benefits of medical marijuana, he has also been vocal about his opposition to recreational use. White House press secretary Sean Spicer has also warned of "greater enforcement" of federal laws, setting the stage for a potential battle with state governments that have seen an infusion of tax revenue from recreational sales.

The brewing conflict could distract industry growth there and become an advantage for Canadian producers as they look to boost exports of marijuana products worldwide.

"It's a big benefit to Canadian producers if the U.S. market is held in check," Mr. Zandberg says. "The longer they stay in limbo, the better it is for Canada."

With files from Mike Hager in Vancouver

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