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  1. Smaller LPs will have a hard time raising money as valuations drop.
  2. Some will restructure to focus on specific points in the value chain. Others will go bankrupt.
  3. There is a bifurcation in cannabis stocks between a small group of leaders and everyone else.

The next 24 months will see a wave of bankruptcies and fire sales across the Canadian cannabis industry as valuations drop and smaller licensed producers struggle to refinance, according to experts and deal makers watching M&A activity in the space.

“If you look at the retail numbers that have been released for the last three months since legalization, you would see that the top three players have captured almost 60 per cent market share. So what this tells me is over the next few months and years, we're going to see... more bankruptcy, a lot of these companies or smaller players are going to go out of business,” said Rami El-Cheikh, head of PwC’s National Pharmaceutical & Life Sciences Practice in Canada.

The large licensed producers (LPs) with cash in the bank and economies of scale should be able to ride out the cash burn that comes with scaling up, and survive lower margins when oversupply causes prices to drop. Small and mid-sized LPs may have a tough time doing this.

“I think we are going to have a shake out, because as valuations come down, companies are just not going to be able to finance, and they certainly can't borrow, so what do they do?” said Patricia Olasker, a partner with the law firm Davies Ward Phillips & Vineberg, who focuses on M&A.

“Those companies are going to be too small and too under-levered to actually restructure in a bankruptcy process. So they're just going to have to sell, and I think those will be kind of distress sales. I think these companies will be selling at prices that today they're thinking are unimaginable,” said Ms. Olasker.

Most cannabis companies continue to rely on equity investment to raise cash. This will get harder as the valuations of the smaller LPs stagnate or decline, said Steve Ottaway, head of investment banking at GMP Securities L.P. The cannabis capital markets are already dividing into haves and have nots, with the top five or six players trading at generous multiples compared to the mid- and lower-tier public companies.

“The bifurcation on the multiples is stunning. So Canopy, Cronos, Aurora, Tilray, Aphria... and Hexo, enjoy much higher multiples than TerrAscend, Organigram, CannTrust, Green Organic Dutchman, Zenabis, Supreme… And then the next tier down below that, the Vivo’s of the world, the Emerald’s, WeedMD, again another significant drop,” Mr. Ottaway said.

Patrick McBride, head of origination at Eight Capital, gave a similar assessment: “There's the haves and have nots, and that differentiation means number one, you're going to have some of the small guys tail off.”

“The smaller guys, they either need to partner up with somebody, or they need to have a few things that people would be looking for: near term production, cash on the balance sheet. And they need to go and make that transaction before it goes away. Because we fast forward a year or two, production doesn’t matter any more as much, because a lot more stuff comes online, and your cash, you’re going to have spent it,” Mr. McBride said.

"The guys that are kind of in this middle ground: can they figure out a way to leapfrog up? Or does that bifurcation continue and they get kind of sucked down by the guys below them? That’s really what’s left to be played out,” he added.

For the companies that can’t punch up into the top tier, the next phase of market development doesn’t necessarily mean bankruptcy, said Mr. El-Cheikh. But many will have to restructure and focus on specific segments of the value chain, instead of competing with the large vertically integrated LPs.

“We're going to start seeing some consolidation for midsize players and smaller players trying to gain more scale in an attempt to compete. I think all the others will probably change their business models in a way where they just go back to the basics, focus on core capabilities along the value chain, and become very good at it, and provide other services to other LPs," said Mr. El-Cheikh.

Industries often segment in this manner. Although, that may be little comfort to retail investors who bought into small LPs amid the market euphoria leading up to recreational legalization.

“It used to be that if you had a license, you were worth $70-million out of the gate, and [worth more] if you did anything, or you could hype that; these things were infinitely promotable, because you had no revenue, so you just stand there and tell people all kinds of bullshit, and the stock can go up. So that’s a wonderful world, and people were trying to buy different assets, and people were in the marketplace picking up assets because the big guys wanted to do that to get scale,” said Mr. Ottaway.

“And then all of a sudden [the large LPs] didn’t need to buy anybody else. And then if you don’t have the distribution channels... those companies’ valuations go stagnant and come off. And eventually … you’re in farming," Mr. Ottaway said.