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HIGHLIGHTS
  1. Raymond James analysts foresee a 90 per cent downside for public Canadian cannabis companies
  2. Review of medical literature finds evidence for many medical marijuana claims “sparse at best”
  3. Analysts predict oversupply and rec market price declines of 8 to 12 per cent a year

U.S. investment bank Raymond James began coverage of the cannabis sector on Tuesday with a pessimistic report that expressed doubt about the future of medical cannabis and suggested that Canadian marijuana firms are in bubble territory.

Pointing to the Total Enterprise Value to Total Addressable Market ratio in the tobacco industry as a comparable, Raymond James analysts David Novak and Archit Kshetrapal suggest that publicly traded cannabis companies, taken together, could be overvalued by as much as 90 per cent.

“While there are always company specific exceptions, the industry performance as a whole draws striking resemblance to the tulip craze in 1634, railway mania in the 1840s, the US stock market bubble in the 1920s, the commodities hype during 2002-2008, the Canadian specialty pharmaceuticals frenzy in 2010-2014 and most recently, the cryptocurrency hype of 2017-2018,” write Mr. Novak and Mr. Kshetrapal in a wide ranging report.

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Here are some takeaways from the report:

Doubts about medical cannabis

After reportedly reviewing thousands of clinical and pre-clinical trials, the analysts came away with a skeptical view of medical cannabis and its ability to disrupt the traditional pharmaceutical industry.

“The list of medical indications being touted as targets for cannabis therapy is overwhelming, however, the scientific evidence supporting such claims is sparse at best,” they write.

Mr. Novak and Mr. Kshetrapal acknowledge that there is reasonably good evidence for cannabis treatment for several indications, including certain types of chronic pain, chemotherapy-induced nausea and muscle spasticity from multiple sclerosis. “However, efficacy in these potential indications is superseded by currently available therapeutics, and adverse effects ... indicate a poor risk-benefit ratio."

The analysts predict that the Canadian medical cannabis market will likely shrink from around $204-million in 2017 to $152-million by 2021, as medical users transition to the recreational market. In a parting shot, the analysts note that alcohol, during the prohibition era, was prescribed by doctors for a range of ailments.

“Naturally, the Rx market for alcohol all but disappeared once prohibition ended, despite some lingering “wellness benefits” associated with moderate alcohol use (such as cardiovascular protection perhaps being correlated with a single glass of red wine). In our view, a similar situation is likely to occur with Cannabis.”

Oversupply and price compression

Although the legal industry has been wracked by shortages since Oct. 17, the analysts suggest that this will soon be rectified, after which the problem will become oversupply.

“In our view, [current shortages] can largely be attributed to an underdeveloped retail model exacerbated by logistic failures on behalf of the LPs (packaging issues, stamp issues, etc.) rather than actual production capacity,” write Mr. Novak and Mr. Kshetrapal.

The analysts estimate that total annual cannabis consumption in Canada will peak at around 1,000 metric tonnes. Meanwhile, Canadian companies are on course to produce considerably more than that: “Based on production capacity disclosure from Canada’s 140+ LPs, cannabis supply is expected to reach 2,642 [metric tonnes] by 2021, eclipsing domestic demand by 2.5x."

This oversupply, along with competition from the black market, will lead to price compression to the tune of 8 to 12 per cent a year for the next three years, the analysts write: “We estimate a decline in the average recreational price/gram from $9.70 in 2018 to $7.01 by 2021. Notably, in the absence of excise tax and HST, we believe the illicit market will continue to out-compete the legal market on price with an estimated 2021 average price/gram of $5.58 down from $6.51 currently.

Canadian valuations are out of control

There is a real market out there for cannabis companies to capture. The analysts estimate that by 2021, the “All In” total addressable market in Canada could be $6.54-billion, with a legal recreational market worth $4.47-billion. Assuming widespread legalization at a state and federal level, the U.S. could have a total market of $35.5-billion.

The problem, the analysts say, is overvaluation. Canadian companies trade at an average of 31.9 times their 2019 EBITDA estimates (earnings before interest, taxes, depreciation, and amortization), and 7.4 times their 2019 sales estimates, the analysts note.

“Comparatively, global beer/wine and global tobacco currently trade at an average of 2.8x 2019E sales (12.7x 2019E EBITDA) and 3.9x 2019E sales (10.9x 2019E EBITDA), respectively."

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“While we cannot estimate if a return to fundamentals will occur this year or in five years’ time, it is our general view that the industry as a whole is poised to eventually experience further valuation compression,” the analysts write. “While there will certainly be case by case exceptions, we believe those investors looking to gain exposure to the cannabis space would be well advised to look for value beyond Canada.”

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