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Canadian Cannabis: Thinking Strategically

|About: FSD Pharma Inc. (FSDDF)
Summary

Meeting the real Cannabis market.

Keeping cash ready to take opportunities.

Loading up for edibles.

As companies come up to the October 17, 2018 starting gate for recreational cannabis in Canada they are having to choose actual business strategies to meet the actual market for marijuana. Thinking about those strategies and the relative positions of the various publicly traded companies will likely make a huge difference in investors returns in the marijuana sector.

Will a company be a pure grower or will it seek to enter the manufacturing and distribution businesses? Retail? Each company has to work out its own strategy.

Some of the big names in the business Canopy, (WEED) or Aurora (OTC:ACB) are looking to be fully integrated producers, manufacturers, distributors and even retailers on a national and international scale. Others like CannTrust (NASDAQ:TRST) are primarily focussed on growing leaving manufacturing and retailing to others. With the very high valuations of these companies, investors seem to be betting that the current strategy is going to work in the new market.

New entrants like FSD Pharma (C.HUGE) (OTCPK:FSDDF) have strategic options because they are not facing significant sunk costs. While they have to get up and running from a standing start, they will be able to run in the right direction from the beginning.

The likely winners of the coming pot battle are going to be the firms which can sustain losses in at least four consecutive quarters, can do excellent market segmentation, are well connected for distribution and can start-up with minimal sunk costs utilizing economies of scale, and, frankly, other people’s money. Earlier we looked at market segmentation in some detail; here are some of the other factors.

Meeting the Grey Market

Firms need to be able to fund facilities to meet future market segments for concentrates and edibles, as well as straight production. Critically, the US experience suggests that up to 50% of the overall market may be in edibles. In Canada, there is no regulatory framework for these products. There is, however, a huge grey market sector. As soon as that framework is created, whoever can immediately produce on a mass scale will have the opportunity to push the grey market producers - even the big ones - out. There is a caveat - the largest grey market producers are already producing on such scales. Many are run by people who do not have criminal records and are gearing up to go legal as soon as possible. According to one source, there are indoor factory farms in parts of BC that produce pot, process it for distribution into flower, concentrate, edible and tincture forms, and distribute it, all in house. These operators have no reason to go public, they’ll get their licenses and continue to produce - they have no need for the capital that going public offers.

Public firms that have any hope of competing need to be able to compete with these guys as well as the other, non-grey market, licencees. That means investing in factory-sized facilities and doing intensive research and preparation for further market segmentation. It means being able to compete with guys who skirt the regulations in ways that public companies can’t until the regulations include all market segments.

Part of competing may be offering to buy some of these grey market operators’ expertise and, in some cases, figuring out ways to buy their operations. Where purchase is not available, companies must be prepared to invest capital into research - market segment research as well as actual product research. Making high-quality concentrates and edibles isn’t rocket science, but it requires a degree of knowledge and a large laboratory to succeed on a large, pharmaceutical-grade scale. Investing the required capital prior to the regulatory framework being in place is a significant risk but it will be essential to capturing those markets. The firms that come out on top will be the ones who could afford the losses this initial leg-up will bring - R&D into products you can’t yet sell is always risky. In short, successful competitors will keep their treasuries full while making strategic, competitive, investments.

Building Distribution

The other major factor in terms of firms that will succeed and ones that will fail is the ability to distribute their product effectively. As we write, the various provinces are creating and modifying their distribution regulations. Some, like British Columbia, are already entering into supplier agreements with licenced producers and, interestingly, with outfits which have not yet been licenced. In each province, companies will have to meet the provincial requirements in order to distribute. In some cases and markets, this may mean developing connections with existing dispensaries.

However, distribution itself is not actually selling product. It is simply being allowed to sell product. The real marketing effort occurs at street retail level. For example, in the Vancouver market, the city already has a bylaw framework and vast numbers of grey-market dispensaries will become retail pot shops as soon as they can. In these cases, having a competitive product and legal distribution are first steps: the ability to develop relationships with the already existing dispensaries and pot shops will be key.

However, some companies may decide to bypass existing retail channels and develop retail distribution in-house. That means choosing locations for retail outlets that reflect specific target market segments. It also means, in the provinces where it is legal, preparing for the eventual “order your weed online” recreational retail opportunity. If your production firm is also your distribution firm, you need to have the ability to diversify products and branding. Just selling your own brands in your own stores is not likely to work. Why? Because most consumers will want to go to retailer and see a variety of products, not just one brand. That means selling competitors’ products, albeit while pointing out why it is better in your branding. Developing brand loyalty will be key.

Strategic Options

At the very root of the emerging competitive marketplace for recreational marijuana in Canada is a critical business decision: what is the focus of the company’s business strategy? For some of the larger public companies, the “seed to sale” model of vertical integration seems to be the ticket. However, other companies such as FSD Pharma (C.HUGE), perhaps because they do not have large amounts of money already invested in production, can view the process as more segmented. HUGE is taking streaming funding from Auxly – a marijuana streaming fund with huge production facility construction experience – to finance its actual production of marijuana. This leaves HUGE free to spend the $53 million dollars it has raised in public equity, on higher value activities like edibles. And where better to manufacture edibles than in a former Kraft food plant (NASDAQ:KHC) which HUGE owns. Branding, marketing, distribution, retail outreach, brokerage, product development: these are all value adds to cannabis production.

Being able to tailor your operations to your market, having aggressive sales teams going dispensary to dispensary, making retail agreements on the Prairies, having really good bureaucrat types negotiating with the Government of Ontario, are all, potentially, as important as growing pot. Being able to afford retail space, sales teams, marketing teams, research and development, new product testing and a host of other value-add activities may be a better use of capital.

Growing marijuana itself is going to be a matter of scale, efficiency, cost management and, ultimately, recognizing that cannabis will fairly quickly become a commodity. Being exclusively a cannabis producer is going to mean settling into a highly competitive, low margin, marketplace. More agile companies, while they will certainly grow low cost, high quality, cannabis, will be looking for value-added opportunities further away from the grow show.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.