The number of medical marijuana patients in Canada continues to grow rapidly. At the end of March 2017, the number stood at 167,764, an increase of 29.2% over the previous quarter. We suspect the number is bolstered by people accessing recreational marijuana by applying for medical marijuana licenses.
The sales and production data from the most recent quarter shows Canadians continue to show a strong preference for oils compared to smoking dried cannabis, as the following table demonstrates:
There is a large gap between the amount of medical marijuana approved for purchase by clients and the amount they are actually purchasing. For example, the latest quarter shows the 167,764 approved patients ordered .75 grams of medical marijuana per day. However, they are approved to order an average of 2.4 grams per day. This means if clients ordered the maximum amount they are approved to order, revenues of Licensed Producers (LPs) would more than triple. We think this may be caused by overprescribing on the part of doctors.
The number of licenses to grow that were issued in 2017 is on pace to reach around 25. We think, given Health Canada's streamlined approval process and their obvious desire to increase the number of LPs, there will be many more approvals in the second half. We have some concerns that with over 180 late-stage applicants in the system, there will be significant dilution to the value of a license, especially for the ones not yet approved.
Review of Recent Data
The latest data on cannabis production and sales from Health Canada confirm the significant trends in medical cannabis sales (see Health Canada Market Data report here) The data shows LPs continue to make gains and widen their advantage. The unhurried approach to approving the Cannabis Act means this group of companies will continue to advance their lead for another year or more (read my comments on what legalization means here)
Here is an analysis of what has been taking place in the Canadian marijuana industry, initially under Marijuana for Medical Purposes Regulations (MMPR) and currently under Access to Cannabis to Medical Purposes Regulations (ACMPR). All charts were created by me using the Health Canada data referenced above.
Sales of medical marijuana by Canadian LPs increased 24.5% in the three months ended March 31, 2017. At 11,509 kg, sales were up 213.9% over a year ago. These figures were slightly lower than recorded a quarter earlier, when growth was 28.5% and 282.2%, respectively.
Production in the quarter ended March 31, 2017, grew 28.3% to 10,972 kg and increased 122.6% over the previous twelve months. Production figures were depressed by the myclobutanil recalls in the previous quarter, when growth was -3.4% but still rose 204.1% over the year earlier. Please note Health Canada has replaced the term "production" with "amount released for sale," or ARFS.
Inventories of marijuana continued to rise in the March 31, 2017, quarter, increasing 7.0%. One explanation for the rise in inventory when sales exceeded ARRS is the approval of new LPs that likely come on-stream with inventory of product and little sales. Many are initially licensed as cultivation only. It can also result from "production" being replaced by ARFS.
The good news is inventory relative to sales and ARFS has been declining. Generally speaking, a lower inventory-to-sales and ARFS is probably a good thing. The previous quarter's data was likely upset by major recall issues. The trend toward lower levels resumed in the most recent quarter. Although an inventory-to-sales or ARFS ratio of around 2:1 is still probably a little high for a perishable product, the trend is in the right direction.
The best news in the data is the continued high growth in the number of medical marijuana patients approved by Health Canada. In the most recent quarter, there were 167,764 patients, an increase of 29.2% over the previous quarter and 212.7% over the preceding year. As we have expressed before, however, we think there are recreational users approved under the guise of medical patients, and the longer legalization is delayed, the greater this component will become. Health Canada's original estimate was that medical marijuana registrations would reach 425,000 by 2024, and we commented at the time that this could prove to be the most conservative estimate in history. Of course, the growth rates will slow down as we move ahead from here.
This chart shows that in the period under review, sales growth has far outstripped ARFS growth, and that is, in a general sense, a healthy indicator for the industry. Health Canada has expressed concern about the shortfall in production relative to sales and streamlined approval processes so the 180+ "late-stage" applicants under the ACMPR can be approved more quickly (see "Improving the Licensing of Production of Cannabis for Medical Purposes" here). Our concern about a shortfall in production is changing because there are major expansions underway among existing LPs. We are starting to worry that a large number of new LPs are approved, debasing the value of all LPs and, especially, the newly approved ones, and two or three years from now, the market will be swamped by new production (see "Expansion roundup: How Canada's LPs keep growing" here).
Here is the data isolating dried marijuana:
Sales of dried marijuana have risen steadily under ACMPR in Canada. In the 12 quarters for which data is available, sales by LPs have increased over 14-fold. In the most recent quarter, growth in sales of dried medical marijuana by Canadian LPs increased to 5,836 kilograms, a gain of 9.8% over sales reported for the quarter ended December 31, 2016. This was an increase of 89.4% over the same quarter a year earlier. Over the period for which data is available and shown in the graph below, sales have been growing at a compound quarterly growth rate (CQGR) of 27.4%. The 5,836 kilograms of production in the three months ended March 31, 2017, has a retail value of approximately C$43.7 million at $7.50 per gram.
It is important to remember Health Canada's ARFS might be quite different from what we expect as production. As the previous two graphs show, the production of dried cannabis by the Canadian LPs started at a higher level than sales and maintained that edge, although it has lagged in the past two quarters. There appear to be some explanations for this trend:
- In the fourth quarter of 2016, there was a significant product recall related to the discovery of myclobutanil on marijuana. The two companies involved at that time were among the larger producers: Mettrum and Organigram. This likely caused the decline in production in the last quarter of last year (see "How The Myclobutanil Recall Affects The Outlook For Canopy Growth And Organigram" here).
- Sales, on the other hand, continued to grow rapidly. As the charts show, the result was sales of dried marijuana exceeded production for the first time in the fourth quarter 2016 and maintained a lead in the first quarter of this year.
- The third factor will be discussed in more detail below, and it relates to the even more rapid growth in cannabis oil products.
There is some controversy associated with expectations for dried cannabis production. Health Canada looks at the overall level of sales compared to production and concludes that there is a product shortage in the marketplace. Supporting this view is the fact that prices for marijuana have held up reasonably well. As a result, Health Canada recently adopted a streamlined approval process for new or expansion for existing growers referenced above.
On the other hand, the contrary view is given the aggressive expansion plans on the part of established growers, there will be a major increase in production over the next two years, and combined with newly approved LPs, we are headed for an oversupply condition. I refer to this prospect as "commoditization" that suggests marijuana will become a commodity, and to succeed as a grower, you will have to be a low-cost producer.
In any case, oversupply is not likely to be a problem in the next year or so.
Inventory of dried marijuana posted a fractional gain after the bubble in the previous quarter. At the end of the three months ended March 31, 2017, inventory level represented 3.1 times fourth-quarter sales and 3.2 times fourth-quarter production. Part of the explanation for the high inventory levels might be found in the approval of new LPs that probably come on-stream with inventory higher than sales because they must first grow crops before they can sell. If this is correct, inventory levels will likely remain at high levels for the foreseeable future. But inventory of 3+ times sales and production is likely high for a perishable product (see Marijuana Shelf Life here).
As the next chart shows, the level of inventory to both sales and ARFS has been improving, except in the most recent quarter that was impacted by the recall. Generally, lower inventory levels relative to sales and production are indicative of a healthier operating environment, except when inventories are so low it threatens ability to meet demand. We are not near that point in the marijuana industry yet, but we expect to see these ratios continue to decline over time.
This chart for dried marijuana is very revealing when compared to the same chart for total marijuana. In summary:
This indicates that although the expansion in the fundamentals for dried marijuana has been positive, it has been below average for marijuana in total. This means another part of the marijuana industry has grown even faster, and that is what we will examine next.
The other part of the marijuana industry is cannabis oil. The new data continues to show the demand for oil is outstripping the demand for dried cannabis. There is less data available for the oil segment, but it is still sufficient to reveal this important trend.
In the latest quarter, sales of cannabis oil increased 38.1% to 5,673 kg and were up 871.4% over the same quarter a year ago. This compares with 9.8% and 89.4% for dried cannabis. This confirms that smoking dried marijuana is on the decline.
The ARFS data shows a clear and continuing shift toward cannabis oil. The latest quarter recorded an increase of 33.3% in production to 5,298 kg and 493% over the same quarter a year ago. Currently, there is a limit of 30 mg/ml (3%) THC for bulk cannabis oil and 10 mg/ml (1%) for oil in capsule form. There is no cap on CBD levels. If this THC restriction is lifted, we believe the shift toward oils will widen even more. Underground market oil is manufactured without concern for such restrictions.
The data on inventory of cannabis oil shows a similar pattern. The inventory of cannabis oil rose 39.6% to 5,198 kg in the latest quarter and stood at 265.8% above a year earlier. In part, this reflects the LPs' desire to increase production of cannabis oil and a willingness to stock more inventory. The cannabis oil picture is hampered by the lack of data. But there are a couple of key points to be made:
There is not much data from Health Canada, but this chart still makes a couple of points. First, the ratio of inventory-to-production has stayed relatively flat. Second, the inventory-to-sales ratio is falling rapidly. Both of these trends suggest the LPs have been able to sell their oil production as fast as they can make it. In addition, if both ratios settle around a level of 1.0, it would point to a healthier condition than exists in the dried marijuana data. The growth summary table for cannabis oil is not meaningful, because the base figures are so low the ratios balloon out of sight.
This chart for marijuana oil statistics compares it to total marijuana and dried marijuana. Because statistics on oil have not been available for as long, to provide a better perspective the data is for the most recent quarter compared to the previous quarter. The data for the number of patients is shown as the same, as there is no differentiation between dried and oil in the data provided.
The data shows that in growth in sales, production and inventory, marijuana oil outstripped dried marijuana by a wide margin.
The next chart reveals a somewhat puzzling trend in the Canadian cannabis industry. It shows the amount of cannabis approved per client is substantially higher than the amount of cannabis ordered per client. For example, the latest quarter shows the 167,764 approved patients ordered .75 grams of medical marijuana per day. However, they are approved to order an average of 2.4 grams per day. This means if clients were to order the maximum amount they are approved to order, Licensed Producers' revenues would more than triple.
We can see two reasons for this discrepancy. One is physicians might be over-prescribing medical marijuana due to lack of experience. The other is that clients might be requesting more than they need. If this is the case, however, we would expect the amounts ordered to be closer to the amounts prescribed, because it doesn't make sense to order more than you need and not order it. It seems more likely doctors are over-prescribing, and if that is the case, it will correct over time.
Finally, since Cannimed and Prairie Plant were the first LPs approved to grow medical marijuana legally in Canada on September 19, 2013, there has been a grand total of 50 LPs approved. Health Canada has streamlined the process so applicants can be approved more quickly. As there are some 180 applicants having "late-stage" status, we think it is important to monitor the rate of approvals. See earlier reference to "Improving the Licensing of Production of Cannabis for Medical Purposes."
The data shows the most approvals in any year were in 2014, when 17 new licenses were issued. The least were in 2015, when only 4 new licenses were issued. However, 2013 and 2017 are "short" years and are not fully comparable, so we examine the number of approvals per month.
The most approvals per month have been seen in 2017, when there have been 2.2 per month with six months to go. The slowest rate was 2015, when only 1 license every three months was issued (see Authorized Licensed Producers of Cannabis for Medical Purposes here). If we assume the rate of approvals continues in the second half of 2017, that would mean another 13 approvals will be made in the balance of the year, making 2017 a record-setting year. Given the number of applicants ready to go, the number could be even higher.
Health Canada has received 1,665 applications for licenses to grow and/or sell medical cannabis as of May 25, 2017. Of the total, 858 have been returned as incomplete, 265 were refused outright, 69 were withdrawn by the applicants and 428 are still in progress. Health Canada points out some applications might be double-counted. In May 2017, it reported 187 applicants were in the "review" stage. Applicants have equated "review" to "late-stage" applicants. So far, 50 licenses have been approved in total (see Application Process: Becoming a Licensed Producer of Cannabis for Medical Purposes here).
Our concern is shifting from approvals taking place at too slow a rate to the possibility that they will be done too rapidly. We estimate there are over 180 applications defined as "late-stage," as there have been five approvals since the 187 number was released. Combined with Health Canada's streamlined application process, too many applications will dilute the value of LPs. The dilution will be felt the most by those receiving new licenses.
Here are the highlights of the Licensed Producers market data this quarter:
(1) The number of medical marijuana patients in Canada continues to grow rapidly. At the end of March 2017, the number stood at 167,764, an increase of 29.2% over the previous quarter. We suspect the number is bolstered by people accessing recreational marijuana by applying for medical marijuana licenses.
(2) Sales and production data from the most recent quarter shows Canadians continue to show a strong preference for oils compared to smoking dried cannabis.
(3) There is a large gap between the amount of medical marijuana approved for purchase by clients and the amount they are actually purchasing. For example, the latest quarter shows the 167,764 approved patients ordered .75 grams of medical marijuana per day. However, they are approved to order an average of 2.4 grams per day. This means that if clients were to order the maximum amount they are approved to order, LPs' revenues would more than triple. We think this may be caused by over-prescribing on the part of doctors. If clients ordered the maximum amount of marijuana for which they are approved, sales would more than triple.
(4) The number of licenses to grow issued in 2017 is on pace to reach around 25. We think given Health Canada's streamlined approval process and their obvious desire to increase the number of LPs, there will be many more approvals in the second half. We have some concerns that with over 180 late-stage applicants in the system, there will be a significant dilution to the value of a license, especially for the ones not yet approved.
This data applies to the Licensed Producers in Canada, and the following is a list of the LPs that are publicly traded:
Our recommendations in the group have been Aphria, Canopy Growth and Organigram, and we are currently reviewing others to add to the list. In addition, we believe our smaller-cap recommendations, Lexaria Bioscience (OTCQX:LXRP), Namaste Technologies (OTCQB:NXTTF) and Radient Technologies (OTC:RDDTF), will also benefit from these trends.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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