Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Don't Write-Off The Smaller L.P.'S, They May Not Be As Vulnerable As People Think

|Includes: Aurora Cannabis Inc. (ACB), APHA, CBWTF, CGC, SNNVF
Summary

Investors may be placing too much value on capacity.

Too much weight is being given to the first supply contracts.

Massive greenhouses may not be as valuable as investors think.

Keep in mind that demand will greatly exceed supply for the first two years, giving craft grows the chance they need to compete.

In some investor's minds, the winners of the legal cannabis sector in Canada have already been decided. There seems to be a developing consensus that the largest producers with the biggest facilities and the first supply contracts will dominate the industry, while smaller producers will not survive. This may ultimately prove to be true, but it is far from decided. In fact, in order for the large L.P.'s to gain and maintain dominance over the industry, they will need to either partner with, or purchase outright, the craft cannabis growers. 

It's true that the Canadian domestic market is not large enough to support all of the production that will come from the massive greenhouses being built by the likes of Canopy(TWMJF), Aurora(ACBFF), and Aphria(APHQF), and Cannabis Wheaton(OTCQX:CBWTF), just to name a few, not to mention the litany of smaller L.P.'s. Once all market participants are producing at full capacity, only the strong will survive. I'm just not convinced that being among the largest or the first to get a supply contract will necessarily mean success or that being smaller and a bit later to the game will equal failure. As I noted in a previous piece I wrote, "The Right Way to View the Cannabis Sector", the trend among cannabis consumers is toward highest quality, not lowest cost. 

This is what made Aphria's purchase of Broken Coast such a great move. Aphria is known as a low-cost producer, but they are not known for exceptional quality. Broken Coast, on the other hand, is known for high-quality, small-batch "craft" cannabis. Aurora did something similar when they purchased a large stake(that they have the right to increase) in The Green Organic Dutchman, a high-quality organic producer. Cannabis Wheaton* has several partnerships with smaller, quality focused producers, like Lotus. And of course Canopy has it's craft grow platform where they distribute the products of smaller, high-quality growers. These moves are not only beneficial for the larger firms, they are absolutely necessary if they want to achieve dominance and justify their large market caps.

Having massive greenhouses that will produce 100's of thousands of kilograms per year sounds very impressive until you see the type of quality produced by large greenhouses. This is not to say that they aren't great assets, they are. However, highly commodified, lower-quality cannabis is better suited for making edibles and derivative products than it is for being the flower that consumers will purchase to smoke and vaporize or the flower that will produce the highest quality concentrates. And given that edibles aren't even expected to be legal in Canada for at least another year, or longer, those with the highest quality flower will have an excellent chance to compete with the giants.  

It is estimated that for the first two years, give or take, Canadian domestic demand will exceed supply. This means that virtually every gram grown will be able to be sold. This is why I'm not certain that being granted an initial supply contract is the life or death situation that many investors believe it to be. The smaller producers will likely get the chance for consumers to try their product, and if it is superior to that of the giants, they could become serious competitors. This initial two years will allow them to expand organically by building more facilities, or make them very attractive acquisition candidates for the larger L.P.'s. By the way, it can be cheaper and faster to retrofit an old factory(of which there are plenty in Canada) to be suitable for indoor cannabis growing than to build massive new greenhouse facilities from scratch. Plus, small-batch indoor cannabis is superior to greenhouse cannabis, in nearly every way. While it is true that these indoor craft grows have higher labor and power costs, they produce a product that commands a premium price, unlike the greenhouses.

This does not mean I'm against greenhouse growing. It is cheaper and significantly more environmentally-friendly than indoor growing. Furthermore, the newest greenhouses under construction are purpose-designed facilities for cannabis growing, and firms such as The Green Organic Dutchman(TGOD) and Sunniva(OTCQB:SNNVF) claim that they can produce ultra-premium cannabis in them. But, whether they can match the quality of small-batch indoor grows at such a large scale, remains to be seen. Investors may want to think about it like this, would you rather own a massive greenhouse that produces 100,000 kgs/yr, with an average selling price of $4/gram, and average cost of $1.25/gram, or, 5 smaller indoor facilities that each produce 15,000 kgs/yr, with an average selling price of $7/gram, and average cost of $2.75/gram? Obviously, this is just a hypothetical situation, and what will actually occur in regards to pricing and demand is far from certain. But, I can say with great confidence that craft cannabis will be in high demand and will fetch a significant premium over mass-produced generic cannabis.

Upon maturity, I believe the recreational cannabis sector will very closely resemble the alcohol markets. The more frugal regular consumers will probably be happy to purchase the cheaper product(Budweiser), while the connoisseurs will demand the highest quality(Bells), and be willing to pay for it. The occasional user's purchasing habits will likely fall all over the quality/price spectrum, but they may be less price sensitive because it's not a regular purchase, and end up opting for quality. What portion of the overall market will each of these segments be? Impossible to say for sure, at this point. However, make no mistake, the market for craft cannabis will be huge, and simply having a massive amount of mediocre product will not necessarily equal success. The trend in all things consumers ingest is toward higher quality, and cannabis is no different. Because of the continually evolving tastes and preferences of cannabis consumers, I believe it would be a mistake to write off the craft cannabis growers.  

In the end, I do believe that the larger firms that I mentioned have a significant advantage over the smaller firms, and will end up acquiring many of their smaller competitors that actually pose a threat to their profits. In fact, I'm betting on it. They have greater access to capital, greater brand recognition, and have a significant head start on developing distribution channels. But, in the mean time, smaller firms that are laser-focused on delivering premium quality cannabis and developing strong brands that consumers identify with, could still do very well. They have approximately a two year window to differentiate themselves and build a loyal customer base. After that, the Canadian market will likely face a serious supply glut, and then, things are going to get interesting.

I realize that there is quite a bit of generalization in this post. In the coming weeks I will be providing some deeper analysis into specific firms within the sector. Follow me for more coverage of the cannabis industry.

*Cannabis Wheaton differs quite a bit from the other L.P.'s that I mentioned. For an in-depth look at Cannabis Wheaton's business model, see my recent piece "Cannabis Wheaton: A Unique Opportunity In The Cannabis Sector"

Disclosure: I am/we are long ACBFF, TWMJF, APHQF, CBWTF.