- LPs could face margin compression as they build out manufacturing and distribution capacity for Cannabis 2.0 products.
- New legal products may not be on the shelf until February.
- Demand for vaporizers may be affected by the vape-related health scare, while demand for legal edibles could be lessened by THC cap.
Cannabis 2.0 products will have better margins than flower over the long-run, but could put pressure on profitability in the coming quarters as companies struggle to bring new manufacturing and packaging equipment online and face the prospect of unsold product being returned to free up shelf space, Bank of Montreal analysts say.
In a report published on Monday, BMO’s Tamy Chen and Peter Sklar say that vape pens and edibles have the potential to generate gross margins in the 55 to 65 per cent range, compared to gross margins for flower products of around 50 per cent. Those margins, however, are achievable once manufacturing and distribution supply chains are “fully established” – and getting there will take time and a considerable amount of capital.
“Unlike Rec 1.0 products, which have been concentrated on ramping cultivation… Manufacturing costs (such as extraction, vape hardware, food manufacturing and packaging) will represent the majority of the [cost of goods sold] for Rec 2.0 products. As a result, we believe LP gross margins may be lower during the initial ramp period due to the learning curves associated with ramping these new manufacturing processes to scale,” Ms. Chen and Mr. Sklar wrote.
Actually getting these higher margin products on the shelf could also lead to short-term pain as older, unwanted products are sent back to producers, wrote Ms. Chen and Mr. Sklar.
“According to Health Canada data, inventory held by provinces has continued to increase. We believe some of this represents products with lower consumer demand relative to supply. If these products cannot be sold via price discounting, we believe provinces and retailers may ultimately need to return this inventory to LPs in order to establish sufficient warehouse and shelf space for Rec 2.0 products,” they wrote.
Moreover, with less than a month to go until edibles, vapes and topicals become legal, it’s still unclear when sales will actually begin.
New products have to go through a 60-day review period, suggesting that sales will begin in mid-December. However, as Ms. Chen and Mr. Sklar point out, “there is a possibility that review periods for some Rec 2.0 products could extend beyond 60 days as Health Canada may need to assess on a case-by-case a product spec’s compliance with regulations (i.e., whether it is appealing to youth or not).”
Speaking at a conference last week in Toronto hosted by Eight Capital and Cassels Brock, Everett Knight, executive vice president of strategy and investments at Valens GroWorks Corp., suggested that a December start-date may be optimistic.
"If you talk to the provincial retailers, I think expectations are shipping in January, and most of the products on the shelf February 1st," Mr. Knight said.
As with the start of legal flower sales last October, LPs will face a number of logistical challenges with the new products, said Navdeep Dhaliwal, CEO of The Supreme Cannabis Co., also speaking at the Eight Capital conference.
“For example: chocolate. Now you're going to require refrigerated transport, refrigerated storage, when companies are already across the country having huge challenges with secure storage,” Mr. Dhaliwal said.
“And then it’s going to be very difficult to differentiate yourself in that market… There’s a glut of high-THC distillate stored across this country because poor [cannabis] crops have all been extracted, and it’s just sitting there waiting to go into these products. So how are you going to differentiate when you can’t market and it’s all the same chocolate with all the same THC distillate oil?” Mr. Dhaliwal said.
The demand side of the equation is also unclear. The ongoing vape-related health crisis could dampen demand for new cannabis vaporizer products, wrote Ms. Chen and Mr. Sklar. Although it’s hard to assess the impact of the health scare, the analysts wrote that they “would not be surprised if there has been a modest decline [in demand].”
For edibles, the 10 mg THC cap could dampen enthusiasm for the new products, particularly among experienced users used to much more potent edibles from the illicit market. As for beverages, the uptake could be hampered by “limited shelf space and refrigeration infrastructure in provincial warehouses and retail stores,” wrote Ms. Chen and Mr. Sklar.
For all the uncertainty around the new product categories, they do present a major opportunity for companies that can figure out logistical challenges and muster the cash required for capital expenditure on new equipment.
Ms. Chen and Mr. Sklar’s analysis suggests that vape pens will sell for between $40 and $60 and have gross margins of 59 to 62 per cent, once manufacturing and logistics chains are fully operational. Edibles will sell for between $10 and $20, and have gross margins of 53 per cent to 61 per cent.