Welcome to The Best of Cannabis series where we discuss some of the most important trends and topics that every cannabis investor must know.
Since we made our 5 predictions for the cannabis industry in January 2018, things have changed a lot and we thought it would be helpful to review the predictions we made for 2018 and present our outlook for 2019.
Review Our 2018 Predictions
We made the following five predictions back in January 2018 and here are how they compared to what actually happened in 2018:
- Actual demand might differ from current expectations. (Reality: it's hard to assess the market demand as the severe supply shortages across Canada have made it all but impossible to gauge true market size)
- Marijuana production will become commoditized. (Reality: we did not quite get there yet in 2018 but we are seeing a trend among the cannabis producers to move in this direction. Greenhouse operators such as Village Farms (VFF) are starting to emerge as the low-cost specialized cultivator. On the other hand, more and more cannabis firms have decided to outsource their production and focus on branding and other areas such as Cronos (CRON) and Emblem (OTCQX:EMMBF).
- Smaller players lacking scale will likely fail. (Reality: the small/mid-caps have significantly underperformed the large caps and we reiterate our preference for more established players in the post-legalization world.)
- Branding and quality will be the key differentiating factor. (Reality: We are already seeing companies focusing on creating a unified brand in the U.S. where vertical integration is allowed. Acreage (OTC:ACRZF), Curaleaf (COTCPK:URLF), MedMen (OTCQB:MMNFF), Green Thumb (OTCQX:GTBIF), and iAnthus (OTCQX:ITHUF) are all working on creating a single brand for their portfolio companies in various states.)
- Supply agreements and profitability will take over licensed capacity as the most important valuation metrics. (Reality: No one is talking about capacities anymore. In fact, any capacity expansion announcements are being frowned upon as it becomes obvious that the Canadian market will be oversupplied by 2019/2020. Supply agreements determine which companies have access to 99% of the markets in Canada.)
Our 2019 Prediction
Below we will present our top 3 predictions for the coming year and discuss our reasoning. We believe 2019 is going to be another exciting year for the nascent cannabis industry and catalysts remain abundant.
1. Canada Will Become Oversupplied
Based on our long-time predictions that the Canadian cannabis sector will face significant oversupplies by 2019 and 2020. We have analyzed the popular industry estimates and concluded that the expected supply will outgrow the demand by a wide margin once Licensed Producers ("LP") complete their constructions. We have seen many newcomers into the market with ambitious plans to convert existing greenhouses and build brand new dedicated growing facilities. It is not that expensive to convert or build a cannabis facility, and the unlimited licenses issued by Health Canada will result in a situation where cannabis prices will fall dramatically once the supplies currently under construction enter the market. We expect this to happen towards the 2H of 2019 and 2020. Many U.S. states have experienced a similar dramatic fall in cannabis prices after legalization and we should expect the same to happen in Canada. See the chart below for what happened to pot prices in Oregon, Washington, and Colorado after legalization.
(Source: Oregon Office of Economic Analysis)
As Canadian LPs complete their capacity buildouts, which we estimate to be at least 2.5 million kg per year, there is a very high likelihood that the Canadian marker will become severely oversupplied. Most of the current research puts Canada's recreational demand between 0.5 to 1.0 million kg per year. Additionally, our supply estimate only included the announced capacities from the top 20 LPs, which means that a large chunk of the capacity is not accounted for and are being built by smaller producers across the country. Health Canada has issued 168 licenses at the time of this writing so it is plausible to imagine a much more robust supply picture.
2. U.S. Will Likely Outperform Canada
We think the U.S. cannabis market will outperform the Canadian peers in the coming year mainly due to the different regulations and business environment in the two countries. The U.S. companies enjoy the ability to operate vertically integrated operations that provided strong margin retention compared to Canadian retailers that have to procure from the government-run wholesalers. The regulations in Canada also include significant restrictions on cannabis retailers (37 per entity in Alberta, 8 in British Columbia, and 15% cap in Ontario) and Ontario had essentially banned licensed producers from operating retail stores in the province directly. The provincial governments in Canada will procure cannabis from LPs and will then act as the wholesaler for retailers after charging a layer of margins in addition to federal and provincial excise taxes. We also think the U.S. has a much more robust growth outlook as more and more states are moving towards legalization. During the latter part of 2018, three additional states legalized cannabis (Michigan, Missouri, and Utah) and the U.S. also legalized hemp cultivation federally, paving the way for CBD to be utilized in many product forms. Many states are also expanding their existing medical cannabis programs and companies are still in the early days of penetrating those states that have just legalized cannabis in recent years.
Overall, we just think the U.S. market has a much better growth outlook compared to the Canadian market and we tend to believe that the U.S. cannabis stocks as a group will deliver far superior returns and relative outperformance compared to the Canadian peers.
3. Divergent Performances Among Stocks
In 2018 we have seen the cannabis stocks moving in tandem which is very similar to the market in 2017. However, we believe 2019 will be the year when cannabis stocks start to show divergent performances. The reason the cannabis stocks largely moved together in 2018 was that the Canadian market remains undeveloped and companies are only starting to report earnings from the post-legalization period now. Now that Canadian companies have reported their 2018 Q4 results, investors would be able to assess valuation and performances on a more informed basis.
Overall, we think the early results were disappointing as supply shortages continue to hamper sales and profitability for Canadian companies in the near-term. Companies like Canopy (CGC), Aurora (ACB), Aphria (APHA), HEXO (HEXO), and OrganiGram (OTCGB:OGRMF) all reported strong sales from the recreational market. However, other firms such as CannTrust (CTST), Cronos (CRON), and Tilray (TLRY) have shown disappointing progress from legalization as sales came in way below expectations last quarter.
In 2019, the Canadian firms will start reporting full quarters with legalized sales and there will no more excuses for anyone. Investors will start assessing the pot stocks using conventional valuation metrics such as EBITDA and earnings and multiples will return to normal ranges, most likely around where retail and liquor stocks are trading now. Companies that have weak fundamentals will be punished mercilessly and we would not be surprised to see a few bankruptcies or delistings. As Warren Buffet once said:
You only find out who is swimming naked when the tide goes out
On the U.S. side, we are expecting to see continuous new listings as private operators attempt to raise capital in Canada. The fragmented nature of the U.S. market created a large number of multistate operators that are expanding aggressively in states where cannabis is legal. M&A will become a key theme for companies looking to dominate the industry as players look to combine for scale and efficiencies. Cresco Labs (OTCQX:CRLBF) just acquired Origin House (OTCXQ:ORHOF) in a no-premium deal which showed that companies are willing to accept such offers in order to survive and thrive in the long-term.
For most investors, 2018 was a dramatic year to be remembered. The cannabis sector went through two full cycles of boom and bust and investors were left with a bad taste in their mouth after the year ended with a prolonged selloff that sent most pot stocks into negative territory for the year. We remain confident that 2019 will turn out to be another great year for the industry as a whole as the Canadian market stabilizes post-legalization and the U.S. continues to push ahead towards full legalization on the federal level.
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.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.