Welcome to The Best of Cannabis series where we discuss some of the most important trends and topics that every cannabis investor must know.
Canada legalized cannabis on October 17, 2018, in a historic moment for the global cannabis industry. Since then, there have been numerous reports describing the difficulties facing both the government and private sector that resulted in severe supply shortages. As most Canadian cannabis companies reported their earnings for 2018 Q4, which included partial sales from legalization, we would like to analyze who is winning and who is losing in the early days of the legalization. Importantly, we will discuss implications for investors and their investments in these companies for the rest of 2019.
Winners and Losers
To assess the winners and losers of the first quarter of legalization, which is the fourth quarter of 2018, we think it is best to look at sales reported by companies from the recreational market. In the chart below, we have ranked companies based on their current market cap, and the blue bars showed their normalized recreational sales, which exclude revenue from medical cannabis (normalized based on different fiscal period ends to reflect three full months of sales on a straight-line basis).
Winners: As we can see, the top recreational sellers during the first three months of legalization are Canopy (CGC), Aurora (ACB), OrganiGram (OTCQX:OGRMF), Aphria (APHA), and HEXO (HEXO). Notably, Canopy reported the largest revenue, which is almost four times the amount from the second place. When combined with market cap, it jumps out that OrganiGram and HEXO are able to punch above their weights and report substantially higher revenue than peers with much higher market values.
Losers: The biggest losers are clearly Cronos (CRON), Tilray (TLRY), and CannTrust (CTST). Of everyone, Cronos probably had the worst performance with an estimated $2.2 million of recreational sales despite sporting $8.6 billion in market cap. Tilray was also disappointing, which was somewhat expected, given its historically weak positioning in Canada, similar to Cronos. However, CannTrust was the biggest disappointment, and the stock plunged 20% when it reported 2018 Q4 results. It is hard to grasp how these companies did so poorly in the early days of the legalization as if they were unprepared at all. On the other hand, it provides an important reality check for investors as to who is really focusing and executing in the Canadian market versus those that are spending their time and money elsewhere.
In order to estimate the market share, it is important to first establish the total legal recreational market. We have a few data points:
- Aurora management estimated that their Q4 recreational sales of $22 million represent 20% of the Canadian market which implies an estimated market size of $110 million
- According to Statistics Canada (see chart below), the total recreational market during Q4 was $152 million, higher than Aurora's estimates
(Source: Statistics Canada)
If we use the $152 million as reported by Statistics Canada, we can get a sense of the market share each player has garnered in the first quarter of legalization in Canada. Canopy took almost half of the market, while Aurora came in second at 14%, lower than the 20% estimated by its management. Cronos only had 1% of the overall market despite having the third largest market cap in the industry, largely boosted by the US$1.8 billion Altria investment. We think it is also worth highlighting that these only represent shares of the newly legalized recreational market. Many of these players also have meaningful sales from medical cannabis which have seen stagnation or decline since legalization. The decline in medical sales is the result of LPs offering to shoulder the excise tax imposed by the federal government after legalization and potential cannibalization from recreational sales.
So, what do all these tell us? We think there are three important lessons for investors as they evaluate their Canadian cannabis investments:
- Valuations in the sector still do not trade on observable fundamentals, and traditional valuation methods have limited applications such as EV/Sales, EV/EBITDA or Price/Earnings.
- Cronos had the worst performance in the early days of legalization. The company had only 1% of the Canadian market, and its revenues are almost negligible when compared to its C$8.5 billion market value. Investors need to figure out whether Cronos has other growth areas that could support is valuation. In Canada, Cronos is most likely not going to be able to capture any meaningful market share in the foreseeable future.
- Canopy and Aurora are the two undisputed leaders in the domestic Canadian market. However, Canopy's strong revenue might temper in the coming quarters as its inventory was very low, indicating less volume available for sale in early 2019. We think next quarter (2019 Q1) would be more indicative of the true market positions after the market normalizes and LPs had a chance to sort out the initial logistical hiccups.
Overall, we think it is clear to us who are the winners and losers in the first three months of the legalization in Canada. Among the largest public companies based in Canada, some players are capturing large market shares already, while others have struggled to make any headway. We think Canopy and Aurora are the undisputed leaders in Canada, while others are sharing the rest of the pie.
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.