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Beyond legalization: Eight questions for the cannabis industry

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Saturday, October 20, 2018 – Page B6

It's time for the haze to clear.

Recreational cannabis is now legal across Canada, and the industry must now prove its legitimacy to customers and investors.

Day 1 of legal weed was marked by smoky celebrations and blocks-long queues of people looking to be among the first to buy legal product in a variety of packaging.

The enthusiasm, however, revealed an industry still finding its feet and struggling to supply a market whose eventual size is difficult to predict. The limited number of retail locations in many provinces quickly ran out of stock as Weed Wednesday progressed, and provincial online sites struggled to keep up with demand as orders flooded in.

Still, long waits and some empty shelves looked to be mere hiccups in the first few days of legalization.

"It proved to the world - and it is the world stage, because there are a lot of eyeballs on it - that it's not Armageddon and society isn't going up in smoke, pardon the pun," said Sonny Mottahed, a cannabis investor and the chief executive of 51st Parallel Life Sciences, an Alberta-based company that has applied to be a licensed producer. "There's not going to be a bunch of walking zombies around."

Now, after years of promises in the lead-up to legal pot, growers and retailers have to show themselves to be reliable suppliers, capable of meeting financial projections to support their lofty stock prices. They must also lure increasing numbers of enthusiasts to the world of weed through clever branding and by convincing Canadians that pot can have a place in their social lives alongside, or instead of, alcohol. It won't be a quick process.

This week, shares in the industry - which had been on a roll since August - weakened as legalization approached and came into force, prompting investors to take stock of what pot companies have to deliver now and what their real prospects are.

"There's been a lot of hype in the sector, and there's been a lot of volatility in the market as well," said David Kideckel, health-care and life sciences analyst at AltaCorp Capital Inc. in Toronto. "We probably won't see meaningful results and data until the first quarter of [2019]. In the fourth quarter of 2018, all cannabis companies are going to get a pass. So we're going to start seeing the winners and losers in early 2019."

Then, and beyond, the industry has key questions to answer about such issues as supply and demand, meeting financial targets, accessing export markets and a host of others.

How will the black market respond? For many consumers, the decision to buy legal or illegal cannabis comes down to price. And long-time users are already grumbling about the price of legal pot, which will keep them looking for cheaper alternatives from dispensaries and black-market dealers.

Allen Doolan, a 60-year-old retired longshoreman who has consumed cannabis regularly since he was 16, said he was disappointed with the B.C. government's new cannabis website when it launched this week.

"I'm not paying $10 delivery and I'm not paying tax - they have all sorts of extra taxes that I'm not going to pay," Mr. Doolan said outside Vancouver's Farm dispensary in the city's Downtown Eastside, where he was hunting for his usual weekday deal on a favourite strain. "Most of my dispensaries are open, and I will continue to shop there until they make it more competitive. Right now, the government is not competitive."

Farm dispensary co-owner Neal Galbaransingh is in the process of obtaining a provincial licence, but entering the regulated sector means he will have to purchase products through the government's wholesale system at greater costs.

He said one of his most popular items are the $2 pre-rolled joints, especially among locals living on social assistance. The government website's cheapest pre-rolled joint is at least double that - plus a $10 shipping fee - with high-end variations costing as much as $16.

Across town at the BC Pain Society in the bohemian Commercial Drive neighbourhood, hundreds of customers a day are still purchasing dried cannabis from the dispensary's vending machines. The four-year-old shop sells grams for as little as $4, as well as packets of high-powered concentrates not offered by any licensed retailers.

Self-described "cannabis educator" Jonathan Hirsh, who runs an organization called the Education Station, said "the government has priced themselves out of competing with the black market.

"Unfortunately I don't think they can win against the black market unless they come down below $5 a gram maximum - $5 a gram will be the tipping point to kill the black market," he said in an interview in Toronto.

Regulators in Canada will have to entice black-market growers and operators to join the legal market, Mr. Hirsh said. "Until you bring the brain trust [of the illegal pot business], there's no chance - zero-per-cent chance - that we kill the black market."


Just how big is the market? The long waits and sellouts of some product in the first days of legalization suggest that demand is strong. The hiccups in satisfying demand will work themselves out in time, observers say, and prices should ultimately fall, just as they have in legal U.S. markets.

"I've seen this happen several times - a handful of stores open, and there's a lot of interest," said Adam Orens, a principal at Denver-based Marijuana Policy Group, a firm that has done extensive examinations of U.S. markets and recently completed a demand study for Health Canada.

"It takes time to roll out, just like in every other jurisdiction where it's been done, and I'm sure Canada will settle in to a system that will work."

Mr. Orens saw no cause for alarm in this week's supply-demand imbalances and estimated it will take "a year, at least, for things to have some sort of settling point."

In Colorado, cannabis prices have declined by two-thirds over almost five years because consumers had easy access to the product and enjoyed competitive prices. Not all the components are in place here in Canada. On the day it legalized recreational use, Colorado already had a medical marijuana industry with physical retail stores, making consumer sales easier.

Still, though, many of Canada's major recreational suppliers started out as medicinal marijuana companies, allowing them to ramp up their operations and expertise well before day one - even if, in some provinces, they could only sell online.

The Marijuana Policy Group study, completed in August, estimates Canadians will settle in at 926 tonnes of "flower equivalent," which comprises edibles and oils as well as smokeable leaves. That's 271 tonnes higher than the mid-point of the range estimated by the Parliamentary Budget Officer. (The study requested by Health Canada does not include pricing forecasts.)

Canadians have "higher consumption profiles" than Mr. Orens first expected, and the question now is: "How long will it take for the footprint of the regulated market to absorb that?" In a first-day survey, analyst Martin Landry of GMP Securities found large average purchases - $80 to $90 per consumer, with Albertans topping $100. That, however, may have been a function of the first-day novelty.

"Customers were anxious to purchase cannabis given the significant media exposure and did not appear too price sensitive," he wrote in a note.

Still, for the longer term, "seeing cannabis shoppers wait in lines as opposed to take the traditional easy illegal supply route is refreshing and bodes well for the recreational market in Canada." DAVID MILSTEAD

How many new consumers will legalized pot attract? Cannabis growers and retailers are betting that legalization will expand the customer base and the industry's overall market.

The market, long dominated by black-market dispensaries and dealers, is poised to take off as older, more conservative consumers who were reluctant to break the law are expected to try cannabis, said Jennifer Lee, a partner at Deloitte who heads its cannabis practice. "Our research showed it will attract an entirely new consumer base."

Trevor Fencott, chief executive of cannabis retailer Fire & Flower, said its first five stores in Alberta and Saskatchewan enjoyed a good cross-section of customers on the first day - old and young people, professionals and whitecollar workers.

"We were quite surprised at the mix of people in line," Mr. Fencott said. "It is a very good representation of Canada. It's not any one particular segment."

Ken Wong, a marketing professor at Queen's University's Smith School of Business, said that as the consumer market expands and more products hit store shelves, customers will probably start to seek out more unusual strains of cannabis.

U.S. markets such as Colorado didn't necessarily see much growth in the number of people consuming cannabis over several years after it was legalized, partly because weed still has a stigma in the United states, which as a whole has not legalized the product, Ms. Lee said. In Canada, she expects the stigma to recede now.

"The stigma is still there [in the United States], whereas here in Canada the stigma is here but it's supported by the federal government," she said.

"Our research shows that is a big deal. Stigma is driving a lack of adoption or testing or trying the product."

The cannabis market in Canada is estimated to generate as much as $7.17-billion in sales next year - up to $4.34-billion of that from the legal recreational market and $1.04-billion from the illegal market, the Deloitte report says. Overall consumption through legal channels is expected to grow as much as 35 per cent, and cannabis spending is targeted to rise as much as 58 per cent, mainly because of higher prices for legal products.


What is the international opportunity? While much of the focus over the past few months has been on the lead-up to the creation of a legal recreational cannabis market at home, Canadian producers - and their investors - have been eyeing a much bigger prize: global expansion.

Canopy, Aurora, Aphria, Tilray Inc., Cronos, Hexo Corp. and CannTrust Holdings Inc. have all telegraphed plans for growth elsewhere, either by exporting product into foreign countries or by building facilities and teams in other places. Some of the popular regions so far are Australia, Germany and Latin America.

Countries on five continents have already legalized medical cannabis - and there are more on the way. Last month, Britain said it was reviewing how cannabis is scheduled for medical purposes.

Canada's early adoption of the use of medical marijuana and its legalization of recreational cannabis have provided Canadian companies with the expertise and war chests necessary to make a move into markets with larger populations and more potential customers who may be willing to pay higher prices.

"The world is opening up almost instantly, and Canada is the best example on the planet," said Bruce Linton, co-chief executive of Canopy on Wednesday, speaking to media and employees at Canopy's Smiths Falls, Ont., headquarters.

"The question is: Can we make the most of it? Can we get to every corner? We gotta move fast."

Going global is no easy task.

Differing regulatory regimes from region to region are a major hurdle. Take the United States, for example: Thanks to restrictions imposed by the stock markets where they are listed, Canada's largest growers are locked out of generating revenue today in the United States, which prohibits cannabis at the federal level even as many states have eased restrictions on the drug within their own borders. Several big players, such as Canopy, Aurora, Aphria and CannTrust, have already struck deals that give them the right to buy certain U.S. assets if cannabis is legalized at the federal level.

Part of U.S.-based Constellation Brands' $5-billion bet on Canopy is a desire to see the Canadian producer spend on the United States and international opportunities when it is federally legal to do so, with Canopy saying it doesn't need any more cultivation assets in Canada.


What will the next wave of M&A look like? The cannabis industry has been rife with mergers and acquisitions this year, racking up about $13-billion worth of deals to date.

Activity is expected to heat up in the coming months.

The industry's biggest transaction took place in August, when Constellation injected $5-billion into Canopy. For its money, Constellation, which sells Corona beer and Robert Mondavi wines, gets a 38-per-cent stake in Canopy and an untested hedge against future declines in alcohol sales.

The deal was welcomed by the industry and its investors as a massive boost to legitimacy, and it fuelled speculation of lookalike arrangements.

Other consumer products giants - from Molson Coors Canada to Coca-Cola to Marlboro maker Altria Group Inc. - have either made investments in Canadian cannabis companies or have been reported to be talking about them.

Meantime, domestic producers have been on shopping sprees, largely to secure more capacity as legalization approached. The first days of retail weed shortages showed how important secure supplies are.

Aurora has spent freely, buying medical pot producer Cannimed for $1.1-billion in January and MedReleaf for $3.2-billion in May.

Aphria agreed to acquire Nuuvera Inc. for $826-million in early 2018.

The deal flow is expected to intensify once the industry has a few quarters of financial results on which to draw. Until now, many publicly traded companies have been priced in the market based purely on the prospects for growth-based expectations of broad industry trends.

That will change when investors and competitors can analyze records of sales, margins, earnings and other disclosures and as the market applies multiples to those.

"When you have some level of metrics that are going to drive the valuations of these companies, there's going to be more and more separation of the good and the bad and the ugly," said Mr. Mottahed of 51st Parallel Life Sciences, who spent much of his precannabis career as a deal adviser in the energy sector.

As with all other industries, investors will push underperformers to seek buyers. In addition, management teams must show that they are extracting value from previous acquisitions.

"The question is what are you going to do with these assets and how are you going to deliver?

And that doesn't change whether you're a cannabis company, an oil and gas company or a tech business," Mr. Mottahed said. "At some point in time you have to be accountable to your shareholders."


Will retailers cash in? It's early days for the retailing of cannabis, but the industry has big plans.

Long lines and limited supply in the first few days of legalized marijuana underscore the small footprint of stores currently serving the market. Canada only has 100 or so legal stores for recreational marijuana, and many are clustered in a few small provinces.

But industry experts say that will change as big retailers and ambitious smaller players quickly build new stores.

"You're going to see a proliferation of private retail," Ms. Lee predicted.

The retail landscape will eventually shift from scattered and underserved to widespread and hotly competitive. "I don't think a lot of retailers are going to be able to survive," Ms. Lee said.

Retailer National Access Cannabis has teamed up with Second Cup Ltd. to run the coffee chain's standalone weed shops and plans to operate its own stores under the Meta banner.

National Access expects profit margins of 30 per cent to 40 per cent from selling marijuana but is avoiding Newfoundland and Labrador because the province's regulator controls both wholesale and retail prices. At just 8 per cent, "the gross margin is too low - you can't sustain a retail operation on an 8-per-cent margin," National Access CEO Mark Goliger said.

As the country's retail market gets more crowded, margins are expected to be squeezed over the next year or more while more supplies become available, Prof. Wong said. At that point, retailers will need to differentiate their offerings with cannabis-infused edibles and higher-margin private labels and accessories, he said. Ottawa has said it plans to approve edibles within a year.

One firm betting on higher-margin accessories and eventually edibles is Green Acre Capital, which this week said it will invest $10-million in retailer Friendly Stranger to help it expand its accessories store to an Ontario - and eventually nationwide - chain as it seeks licences to sell marijuana.

Brian Sterling, president of SCS Consulting, which advises companies on their cannabis strategies, said large retailers such as Loblaw Cos. Ltd. will probably use cannabis products to draw more shoppers into their stores to buy other, higher-margin items.

Mr. Sterling said Loblaw, known for its President's Choice private-label products, could eventually create another of its own brands for a line of cannabis products.

Still, Loblaw spokeswoman Catherine Thomas said that while the grocer enjoyed strong consumer demand at its first 10 cannabis stores in Newfoundland, it has no other plans for recreational cannabis operations "at this time."

The company does, however, have approval to open some marijuana stores in Calgary, and its Shoppers Drug Mart unit is nearing approvals for the sale of medicinal marijuana.


Can producers create strong brands that command high prices and high profit margins? On the first day of legalization, more than 95 per cent of customers who bought cannabis at the newly opened legal retail outlets were not familiar with the brands they had just purchased, according to a research report from GMP Securities. Once legal cannabis is more established, will consumers be willing to pay premiums for their favourite high-end brands, as we see in the beer and wine sector? Or will cannabis be just an indistinguishable commodity, such as corn or sugar?

In the fledgling legal recreational market, cannabis brand strategist Rachel Colic says producers such as 7ACRES (a sub-brand of the Supreme Cannabis Company), Tantalus Labs and Broken Coast Cannabis (now owned by Aphria Inc.) are trying to establish premium brands.

"It remains to be seen whether or not those products will meet the requirements from a consumer standpoint," she said.

Cannabis "connoisseurs" say smell, flavour and a consistent experience are some factors that distinguish premium cannabis flower.

Jaclynn Pehota of Althing Consulting expects the price for premium flower to be between $10.50 and $12.50 a gram, almost double the standard price.

"Cannabis is going to become rapidly commodified, which means its cost is going to drop rapidly," Ms. Pehota said. "However, I think a connoisseurs' market is going to develop as well, and that's where Canada has the opportunity to shine."

Marketing restrictions will make it difficult for producers to distinguish themselves through advertising and packaging. Quality will be key, and Ms. Colic says growing highend cannabis takes more time and attention; a subset of consumers will be willing to pay more, but only the most efficient operators will have higher margins, given higher production costs.

When small-scale craft growers join the legal market - something expected to happen when Health Canada starts approving microcultivation licences - they are also expected to target the premium market.

People who have studied legal recreational markets in the United States say it is difficult for producers to stand out today in Canada, given the limited type of products allowed for sale.

Michael Elkin, director of strategic sales at consultancy Cannabis Compliance Inc., says it will be much easier to develop brand followings and high-end products when edibles, beverages and concentrates enter the legal market.

"That's when you're going see a big price flux," he said. "You'll see someone charging $60 to $65 for a vape pen and will still have the ability to buy dry flower for $5."


How long will investors wait for profits? So far, cannabis companies have been "story stocks" - and oh, what a story it is.

The grand idea that today's leading pot companies will be tomorrow's multibillion-dollar industry behemoths have driven their shares to astonishing heights, completely divorced from today's financial results.

The vast majority of cannabis companies whose shares trade publicly are unprofitable, making a conventional price-to-earnings ratio incalculable. The 62 companies that make up the Solactive North American Marijuana Index trade at an average of almost 84 times sales, according to S&P Global Market Intelligence. By contrast, the average company in the S&P/TSX Composite trades at a little less than three times sales.

At least 25 pot stocks from various industry indexes are up 50 per cent or more in just the past three months, according to S&P.

These remarkable valuations have made cannabis stocks popular targets of short-sellers, who profit when shares decline. At a minimum, many investors have stayed on the sidelines.

And they have missed a remarkable run in the shares in the two months leading up to legalization.

What next, though? Will the great pot boom turn into a big bust? Many of the sell-side analysts who cover the big players have been able to maintain "buy" recommendations on the shares even at current prices, but caution is creeping in as analysts suggested that not all cannabis stocks will rise in the kind of wave investors have benefited from in 2018.

In the days leading up to legalization, Veritas Investment Research analyst Stuart Rolfe initiated coverage on four cannabis stocks - Aphria, Aurora Cannabis Inc., Canopy Growth Corp.

and Cronos Group Inc. - with "sell" ratings. In the case of Canopy and Cronos, Veritas's estimates of the shares' worth are less than half current market prices.

Mr. Rolfe said investors shouldn't "expect the black market to stand still" and worried that the major players' planned capacity expansions risk overrunning demand. Even with robust sales and a high conversion from the black market, Veritas estimates the stocks are currently trading at high multiples of potential profits in the year 2020.

"The tail end of the cannabis rainbow may be approaching much faster than investors realize," he wrote. "Our analysis suggests that the market still lacks perspective when it comes to the size, shape and sustainability of Canada's proverbial pot of gold." DAVIDMILSTEAD

Associated Graphic

The inside of the government-run BC Cannabis Store in Kamloops, B.C, is seen on Oct. 17. Observers say the hiccups in satisfying demand will work themselves out.






Fred Jackson smokes marijuana in Vancouver on legalization day, Oct. 17. For many consumers, the decision to buy legal or illegal pot comes down to price.


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