Please note: All stocks and funds described herein trade on Canadian exchanges. Each has an OTC listing in the US, but I would encourage investors who are able to trade the underlying Canadian stocks to use those instead. Please be aware of liquidity issues when investing in OTC listings. All dollar figures herein are Canadian dollars unless otherwise noted.
Summary and Thesis
On July 1, 2018, recreational cannabis will be legalized across Canada. This was announced in March 2017, based on campaign promises made by the Liberal party during the October 2015 election. This legalization has led to a boom in cannabis stocks, as investors seek to pick a winner from this change of legislation.
I estimate total market size to be around $5.3 billion per year wholesale. Alternatively, I estimate the market size to be about $8 billion to 8.8 billion/year retail. It will take time for the market to mature and reach saturation levels, as it has in legalized US states.
I expect flowers and extracts to be priced as commodities. I do not expect consumers to purchase flowers based on brand, but instead on functional characteristics like price, strain, sativa/indica/hybrid, freshness, and THC content. However, markets like liquid vape refills could allow companies to build moats in a manner similar to Keurig's K-Cups.
The market looks richly valued to me. I don't plan to invest at this time, but if I was, I would invest in the Horizon Marijuana Life Sciences Index ETF, listed under HMMJ.TO in Canada and traded as a derivative under HMLSF on the grey market in the U.S. If others wish to invest, I would encourage them to dollar-cost-average their investments, to protect against possible short-term hiccups while allowing them exposure to possible gains.
Estimating Market Size
It is difficult to estimate the size of the Canadian recreational marijuana market. Estimates on the size of the Canadian recreational marijuana market vary widely.
|Source||Estimated annual market size|
|Deloitte||$4.9 to 8.7 billion/year (base retail)|
|Deloitte||$12.7 to $22.6 billion/year (ancillary)|
|CIBC World Markets||$10 billion/year|
One simple way to estimate the market size is to use estimates of past usage, and current retail prices in legal locations.
Estimate Markets Based on Past Usage
Statistics Canada estimated that Canadians consumed 697.5 tonnes of cannabis in 2015, worth ~ $6.2 billion. Canada's population is growing by about 1 to 1.2% per year, so this usage should be scaled up a bit to potential 2019 levels (the first full year that cannabis will be legal). This would imply about ~ 730,000 kg/yr usage in 2019, based on past illegal use rates.
Cannabis usage will increase when cannabis is legalized. Ease of access will increase the amount that is used by many users, who might otherwise find it difficult or cumbersome to purchase from illegal sources. Further, many people choose not to break the law to smoke cannabis, but would smoke legal cannabis.
Deloitte published a study in 2016 offering insights into the recreational marijuana market. In this study, Deloitte found that 22% of the adult population consume marijuana, and an additional 17% may try marijuana if it were legalized.
I would expect these figures to turn out to be underestimates as legalized cannabis becomes more normalized socially. For example, if cannabis were ever allowed to be sold in single joints at a bar, I would expect more people to try cannabis and some of those to turn into regular users. Thus, I suspect usage rates may increase over time and as the distribution channels for cannabis broaden.
However, taking Deloitte purely at its word, perhaps usage may increase 77% (17% / 22%). Only part of this increase would be due to new users. Those who "might try marijuana if legalized" are likely to use less marijuana per capita than current users. However, current users are likely to use more marijuana than they currently do, so perhaps a 77% increase is plausible. Adding a 77% increase to the ~ 730,000 kg/yr would result in ~ 1,300,000 kg/yr of recreational cannabis use.
Cannabis prices, when legalized, are also unclear. The best base for such an estimate may be prices in parts of the US with legalized cannabis. One study suggests that wholesale prices for cannabis in legal US states is around $1,500 USD/lb, varying by state and where the cannabis is grown. Indoor-grown cannabis is most expensive, with prices of ~$1,800, greenhouse prices of ~$1,300, and outdoor prices of ~$1,100.
Canada does not yet allow outdoor cannabis. However, the Canadian government published a Proposed Approach to the Regulation of Cannabis in November 2017, which appears to open the door for future outdoor growth. Outdoor growth would result in lower production costs, leading to lower cannabis costs for users. Lower prices would also lead to more cannabis usage, due to elasticity of demand.
With those factors in mind, I do not see strong evidence for altering the US wholesale price for cannabis for the Canadian market. I expect prices may begin higher than those prices, especially if supply is short, but will settle down to around the US price. When Washington state legalized cannabis, prices were initially very high due to short supply, but have now fallen more into line with other US states.
Canada may follow a similar path. Initially, prices may be very high, which will result in lost sales as people choose to abstain or choose to continue using unregulated cannabis. However, over time, I would expect prices to fall as supply rises to meet demand. I would also expect unregulated cannabis to decline to smaller levels, perhaps in line with illegal sales of cigarettes or alcohol, as regulated cannabis takes over the market.
This could lead to the following estimate of cannabis market size:
|Estimate of Potential 2019 Cannabis Market Size|
|2015 Cannabis Usage||697,500 kg|
|Canadian Population Growth Rate||1% to 1.2%|
|Implied 2019 Usage||~ 730,000 kg|
|Increase in Usage if legal||39%/22% (+77%)|
|Implied 2019 Legal Use||~1,300,000 kg|
|Price per lb, USD, wholesale||$1,500 USD/lb|
|lbs / kg||2.20462 kg/lb|
|CAD / USD||~1.24 CAD/USD|
|Implied price per kg||~ $4,100 CAD/kg|
|Estimated 2019 market, wholesale||~ $5.3 billion/year|
Other methods of estimating the market size can also be used.
Estimating Market Size Based on US Recreational Markets
As above, Deloitte estimates that 39% of Canadian consumers would at least try cannabis when it is legalized. Statistics Canada places Canada's population at 36.7 million, with 28.8 million who are 20 or over. This would imply a possible market of ~ 11 million consumers.
How much might each consumer spend? According to a Headset report from Washington state, most consumers spend $25-50 USD per trip to a marijuana store. The average age of customers is 37 years old.
On average, cannabis smokers spent $645 USD/yr (median), according to the report. Mean spending was not available in the report. I would conservatively estimate mean spending to be ~ $750-800 USD/user, based on the above chart. This estimate is based on using the average range for lower values, and well below the average for categories about $1,000.
To convert these figures to Canadian dollars, I use median household income in Washington state and in Canada. Median household income in Washington is ~ $63,000, while it is ~ $81,000 in Canada. Thus, a median Canadian household makes ~ 1.28x as much CAD as a Washington household does USD. This is roughly in line with the CAD/USD exchange rate, current ~ 1.24. Thus, I estimate that each consumer might spend ~ $925-$1,000 CAD/yr on cannabis.
However, I suspect that using 11 million users is too high of a figure for the Headset data. The Headset data is from customers at cannabis shops, but it is probably that many of the 17% of users would might try marijuana would not purchase their own marijuana in cannabis shops.
I expect that many users will use very infrequently, such as only using cannabis products with friends/family who purchased the cannabis, for example. Similarly, couples may count as only one cannabis store customer, even though both member may smoke. Thus, the 17% who might try cannabis in the Deloitte report should be discounted, as many of these users would never enter a cannabis store, and therefore would not be counted in the Headset report $645 median.
For this reason, I expect it is appropriate to count only ~ half of the 17% of users who would be willing to try cannabis if legal. This cuts the user base to 30% of Canadian adults, or ~ 8.5 million store purchasers. This would result in a market of around $8 billion-$8.8 billion/yr retail.
|Cannabis Market Size Estimate||Low||High|
|Number of Users||~8.5 mil||~8.5 mil|
|Spending per user||~$925/yr||~$1,000/yr|
|Total Canadian Cannabis Market||$8 bil/yr||$8.8 bil/yr|
I have two possible estimates for the cannabis market size. The market could be worth $5.3 billion/yr wholesale. Alternatively, the market may be worth $8-8.8 billion/yr retail.
Both of these estimates are rough, back-of-the-envelope calculations. Despite that, they help paint a bit of a picture of what Canada's potential cannabis market might look like.
Markets Will Not Mature Immediately
Recreational cannabis markets will take time to mature.
Distribution issues will limit the initial size of the Canadian cannabis market. Each province is putting their own regulation and sales scheme into place, and those plans will proceed at different speeds. Some provinces will begin with too few locations to purchase legal cannabis, which will result in long commutes to legal locations and perhaps long lines and higher prices. Because of that, many existing cannabis users will continue to use their current unregulated cannabis suppliers, reducing scale for legal, commercial sellers.
Supply issues may limit the size of the Canadian cannabis market. When Washington state launched recreational cannabis in 2014, demand exceeded supply. Many stores were forced to close early, or even close for days or weeks, as they simply ran out of supply of cannabis due to high demand. These problems smoothed out over the next 6-12 months, but hurt sales initially. Similar issues could also happen in Canada. For example, regulators may not approve enough growers in time to provide the volume of cannabis demanded by consumers. This may lead to supply shortages and higher prices. Again, this may result in existing cannabis users continuing to rely on their current unregulated suppliers.
I expect it will take a few years before the recreational cannabis market in Canada matures. It will take time for provinces to expand their distribution networks for cannabis, and for consumers to switch from unregulated recreational cannabis to legal cannabis. Ultimately, I expect that legal cannabis will command a dominant share of the market, like the share commanded by legal cigarettes and alcohol. (This is less than 100%.)
Flowers and Extracts Will Be Commoditized
In my view, cannabis flowers and extracts will be commoditized, and customers will not choose cannabis based on brand. I have been to medical marijuana shops in British Columbia and to recreational shops in Washington state. In both cases, brand of cannabis flower is barely advertised, if at all.
In my opinion and experience, customers do not purchase, e.g., Opal OG Kush based on its production at Nine Point Growth Industries, but because they want OG Kush, which is a very common strain. (Customers don't purchase from Nine Point Growth Industries at all anymore.)
In Washington, cannabis is clearly labeled with pieces of information including the THC content, the CBD content, the strain, an indication of sativa/indica/hybrid, and the harvest date. Consumers choose cannabis based on these factors, along with price, rather than based on their preferred "brand" of cannabis.
I do not expect Canadian recreational cannabis to be different, at least when it comes to flower. The most important aspects of cannabis will be its freshness, its strain, whether it is sativa or indica, and its price.
Cigarettes and alcohol both have strong brands, such as Marlboro cigarettes (MO) or Budweiser beer (BUD). Those brands were built on years of advertising. However, Canada has strict advertising laws, which will significantly hurt (or outright destroy) the ability of cannabis companies to market their products. In my view, this will mean that consumers continue to purchase cannabis based on the characteristics of that cannabis, rather than being willing to pay a premium for a favorite brand.
Therefore, I expect cannabis flowers to be commodities. I would also note that, apart from reading Seeking Alpha articles, I've never heard of any of the cannabis brands that are said to be leading brands (e.g., Canopy Growth's "Tweed" brand).
Non-Flower Products May Not Be Commodities
While I expect flowers to be commodities, the same is not true for non-flower products.
Edibles will not be sold until July 2019, but will allow for much more creativity and unique product offerings. This will allow companies to build stronger brands in edibles than they can in flowers, in my view.
Edibles have much more unique characteristics than flower, including varying tastes, textures, and delivery mechanisms. Consumers will have a preference between a raspberry gummy and a minty breath spray, for example. Even among various raspberry gummies, taste and texture will lead consumers to having brand preferences and brand loyalty, just as consumers might be loyal to Budweiser (BUD) over other beers.
Further, edibles and other packaged goods may have more product packaging space for branding than flower. This is likely to cause those products to leave stronger impressions in consumers' minds. In my view, consumers are much more likely to choose an edible that they have tried and enjoyed before than they are to require that their cannabis flower be from a favorite grower.
Vape products will also allow for high levels of product differentiation. Vape products which take proprietary pods may be especially profitable and provide a valuable "moat" for those companies that develop them. This is akin to the Keurig K-Cup model.
For example, in Colorado, PAX offers the PAX Era liquid vaporizer. Notably, the vaporizer accepts only PAX Era pods, which means that consumers who have purchased the PAX Era will purchase PAX Era-specific pods in the future. This allows for a much wider moat than is available with cannabis flowers, where consumers will be ambivalent between different producers of the same strain of flower. Because of that, I expect that vaporizer makers (potentially including PAX) will be able to command a premium for their pods, relative to the prices charged for flowers or other extracts.
This will likely cause liquid vaporizers to be priced well below their actual cost. Roku (ROKU) sells its hardware for a loss (in operating margin terms) to grow its ecosystem. Razors and inkjet printers are also often sold for relatively low prices to charge higher prices for their consumables. I expect that liquid vaporizers will be sold the same way in Canada: Sell the vaporizer for as cheaply as possible to get consumers to use their product and come back to that product for refills.
Thus, I expect that cannabis flower, and direct extract products such as oil, will be sold as commodities. However, edibles and specialty products such as liquid vaporizer pods will not be as commoditized, and will allow for more product differentiation, brand recognition and loyalty, higher margins, and wider moats.
I expect the Canadian cannabis industry to command wholesale sales of perhaps ~ $5.3 billion/yr. The closest industry is perhaps the tobacco industry. Tobacco EBITDA margins are ~ 34%, which would lead to industry-wide EBITDA of ~ $1.8 billion/yr. Tobacco industry EV/EBITDA is ~ 15.
This would imply that the Canadian recreational cannabis industry might be worth ~ $27 billion CAD, in enterprise value. How does this compare to current valuations?
The top four holdings of the Horizon Marijuana Life Sciences Index ETF make up ~ 54% of its total holdings, as of January 5. These holdings are Aurora Cannabis (ACB.TO, OTCQX:ACBFF), Canopy Growth (WEED.TO, OTCPK:TWMJF), Aphria (APH.TO, OTCQB:APHQF), and MedReleaf (LEAF.TO, OTCPK:MEDFF). Their combined enterprise values are ~ $16.5 billion.
Extrapolating this data to see if the overall market is over- or under-valued is difficult. Many of the companies held by HMMJ are involved in both recreational cannabis and medical cannabis, which is a separate market apart from my ~ $27 billion estimate.
Further, it is difficult to guess how much of the cannabis market, especially flowers and extracts, will be centralized among the major players. Growing cannabis is not especially difficult (it is called "weed" for a reason), even for smaller companies. If consumers are not picky among flower and extract brands, barriers to entry may be low. The primary barriers will be seeking regulatory approval. This is certainly a barrier, but it is not a barrier that will stop all smaller companies from entering the market and from offering flower and extract products.
Thoughts On How To Invest
I expect that smaller companies can and will maintain a strong proportion of the market for flowers and extract for the foreseeable future. For larger cannabis producers to succeed, I see two possible paths.
First, larger producers fighting for share of the flower and extract businesses will need to compete aggressively on price. Investors should focus on which production capability and cost, since ultimately, I expect flowers and extract to be a commodity. I would also focus on producers' ability to jump through the required regulatory hurdles. The most valuable investments in flowers will be companies which are able to produce the most cannabis, in kg/yr, and who have the lowest enterprise value. I expect smaller growers to have a relatively large market share of the recreational cannabis market in flowers and extracts.
Second, larger cannabis companies should focus on areas in which they can build a moat. I expect that edibles and liquid vaporizers are two such areas. In both cases, customers are likely to have much stronger brand preferences and loyalty than they will in flowers and extracts. As an investor, I would look to see which companies are making strides in these areas specifically, as I expect these areas to have durably higher margins than flowers and extracts. The winners in these markets will be able to charge premium prices over the prices of flowers and extracts, and reward investors accordingly.
The safest investment in the industry is simply investing in the Horizon Marijuana Life Sciences Index ETF.
I am a bit skeptical of the current pricing on cannabis stocks, so don't currently plan to put money into the fund. I would encourage others to consider a slow investment into the fund - to dollar-cost average over a period of months - rather than investing all at once. This may offer some price protection should the hype around the industry die down a little, while still offering exposure to near-term potential gains.
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