Investors are delusional when it comes to Canadian marijuana companies - Macleans.ca
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Investors are delusional when it comes to Canadian marijuana companies

The model of state-run alcohol sales gives us an important clue as to why high-flying marijuana producers face tough times ahead


 

Marijuana plants grow in a climate controlled growing room at Tweed Inc., now Canopy Growth, in Smith Falls, Ontario in 2015. (James MacDonald/Bloomberg/Getty Images)

Allan Gregory is a professor of economics at Queen’s University.

As the July deadline for the provinces to legalize marijuana approaches, the stock prices of Canadian publicly-traded weed producers have been on a tear. On Monday alone shares in Canopy Growth Corp., soared nearly 20 per cent. The surge in market value comes as firms try to position themselves with sufficient product to meet anticipated demand. But as these companies, some valued in the billions of dollars despite generating no profits, continue to attract starry-eyed investors, it’s worth examining what kind of opportunities will exist for these firms when provinces regulate retail pot sales. It is not difficult to predict profit margins will fall under regulation and that current market cap valuations are predicated on unrealistic expectations.

While there are some variations across provinces in their distribution plans for legalized marijuana, the largest two provinces, Ontario and Quebec, intend to have provincial run outlets modelled on their government-controlled alcohol sales. Indeed, the alcohol model gives us an important clue as to how the industry is likely to shake out—and why marijuana producers face tough times ahead. Keep in mind that there will still be online purchases and the proportional divide between physical store and e-commerce is unclear. Ontario with only a planned 150 outlets might give us an early indication as to online traffic. But let us consider the possible ramifications from only the government outlets.

READ: How big is Canada’s marijuana market, really?

The Ontario Liquor Control Board (LCBO) and Société des alcools du Québec (SAQ) effectively have a monopoly on the sales of most alcohol products in their respective provinces (with the exception of beer and some wine). The LCBO is one of the world’s largest buyers and demands much from its suppliers in terms of large quantities and price discounts. Minor producers, even in Ontario, who are unable to meet the demands of the LCBO must sell their products elsewhere.

Giant provincial alcohol buyers with market power drive tough bargains in terms of price and quantity which dissipates suppliers’ profits. Of course, having a virtual monopoly on the retail side has meant that these pricing discounts are rarely passed onto its customers. I see the same tactics for recreational marijuana. There is the false belief that the licensed producers (LPs) of marijuana will get the same price from the provinces they have enjoyed in the retail-based medical market business.  However, aggressive bulk buying by large provincial authorities will whittle the producer price down markedly.

Provincial buyers are going to want to deal with licensed producers that can supply large amount of product at low prices. At present the average price of medical marijuana is roughly $10 per gram. Some publicly traded companies have boasted that their all-in costs are in the range of  70 cents to $1.75 per gram which translates into profit margins of more than 80 per cent. However, we can expect provincial agencies will severely cut into these margins. The Ontario wine industry provides us with some idea of profit margins that LPs might reasonably expect. In a recent study on Ontario Wine and Grape Industry (2015), for large scale operations the profit margins are just under 15 per cent and in fact many smaller vineyards were posting losses.

READ: Ottawa’s dangerous hustle to legalize weed

Meanwhile at implementation this will likely mean only the largest producers will be entering into contract with the provincial authorities. The notion of boutique suppliers of cannabis will have to wait, just like craft beer producers waited in alcohol sales. Establishing reliable supply lines will dominate initially any gourmet pot considerations.

Will provinces favour producers in their own backyards? Of course they will. Just as Ontario has favoured its own wine industry and shelves mostly their products for the domestic lines in their stores, so will it be true for provincial distributors. For instance, if you are a cannabis producer hoping to sell in Canada’s biggest markets, you will likely need a physical grow-op in Ontario or Quebec. This means regional producers will face additional barriers to growth. At present only the government of New Brunswick has announced a commitment to Organigram, a Moncton-based producer, to buy five million grams a year. The company, which has seen its shares soar 31 per cent in value so far this year, estimates that deal will translate into a retail value of $40 million to $60 million. (At present, Organigram’s market value stands at $630 million.) Other provinces will soon follow suit I believe and strike distribution arrangements for local provincial growers.

As in many stock market interactions, the industry tells a rosy story of growth and opportunity. But I would suggest a careful recall of the dot com bubble offers a somber warning. Canopy Growth Corp. is currently valued at just over $7.5 billion yet loses about 12 cents a share. At the same time, Canadian Tire Corp. has a valuation of $11.5 billion and earns $10 a share—and pays a dividend yield of 2.14 per cent.  What company offers a better long-term investment?

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Investors are delusional when it comes to Canadian marijuana companies

  1. Allen – you sound like my former investment guru’s. Well over a year ago when this was starting I wanted to invest $30K across the board with the big four at the time. I was basically called an idiot (similar to your article). I put the money in a self directed plan and invested. That $30K is now well over $100K as I watched it go up and down, selling when it is high, buying more shares when it was low. You know. The basics. That may not seem like a lot of money to you, but making >$70K in one year is very very good to me. I have been able to get my original investment back and now playing with house money!!!
    The problem with people like you is that you are kind of over educated. You probably don’t go home and light up so you don’t understand the demand. I have been to Washington State many many times over the past year. There is a shop on almost every corner and the stores are busy all day, all night. They have three staff in most stores serving people and you usually have to wait to talk to someone (its not like a liquor store where you grab from the shelf). It is so convenient and civilized, but the main thing, BUSY. There WILL be turmoil with these stocks especially when it starts because it WILL be like WA and CO whereas there will be panic, issues with distribution, supply problems etc. All I know is both those States reporting record sales year after year. I think comparing this market to a box store which Amazon can wipe out at an instant is not a good comparison. Although, keep writing nonsense like this and sit back on the fence throwing stones. The stock going down helps because it will go back up, especially year one and year two of distribution.

  2. You could have made the same comparison with Canadian Tire and any other very presently successful company when it was in its infancy. You’re also not taking into account the international opportunities Canopy Growth and a few others are involved in. Marijuana stocks are obviously risky especially in conventional investing rationale but the potential is there and it’s not delusional.

  3. Your article is not consistent with your credentials. You are comparing a long-established company in a long-established industry with a very low anticipated growth rate (this is why they must pay dividends to attract investors) to new businesses with strong balance sheets that are projected to have very substantial growth rates. You are placing weight only on the current P/E ratio with no attention to the forward P/E. These businesses haven’t even fully rolled out their income streams because the stuff is still illegal in Canada. Investors know profits have been low thus far. That’s not their focus.

    The is not a bubble like the dot coms at this stage. Not even close. These are real businesses with real funding and tangible assets with excellent management expected to make real money. If Aphria sold 1237 kg and earned $.05 / share based on today’s announcement, what will the earnings per share be when they are selling 120000 kg of product per year? Margins are anticipated to diminish but costs based on economies of scale will improve. This math is not terribly difficult. Also, they haven’t even announced how they will deploy at least $100 million.

    Readers who rely on your article to educate themselves should also be taught that growth companies often grow into their valuations and this is why valuations will continue to climb. The music will stop for growth companies eventually, that will happen when further growth is not anticipated. That is not where we are today.

    Your article discusses medical marijuana. That business has barely begun. Presently, in Ontario, in order to access the product, one needs to have a license and go through a cumbersome process to get the drug. Is it unreasonable to anticipate that in short order, marijuana-based drugs will be developed in pill or some other form that will be available on a prescription basis in pharmacies across Canada and perhaps the world?

    In terms of recreational marijuana, if you were around at the time of prohibition you would have likely advised people to stay away from runaway alcohol company valuations too. People who see things you don’t aren’t necessarily delusional.

  4. Very little research went into this article:
    – no mention of vast global potential (and current business in Germany, Netherlands..)
    – no mention of the head start Canadian producers have enjoyed
    – comparing two companies (Canopy founded in 2014 vs Canadian Tire founded in 1922) at two different points in their existence

    Please do better research.

  5. Hey Allan, some of your facts are wrong. There is not a single company valued at over $1B without profits like you said. Any LP valued at over $1B or “Billions” as you say has had strong history of medical revenue and profits.

    You have some decent points like how the LCBO will have a strong bargaining power. Which is why companies that have adopted the B2B model without B2C costs like Supreme (FIRE) with massive grow space (342,000 ft) will be in prime contention to supply Ontario.

    All in all your article is ok (meh really), but your fraudulent sensationalism about they being worth billions with no profit in unfounded. I mean everyone has an opinion, but is it informed?

  6. ……”profit margins of more than 80 per cent”….. If that is indeed true, Trudeau’s fabricated excuse for legalizing marijuana (to protect our children and get rid of organized crime involved in this business) will never be addressed. Rather that $10/gram+tax, it would have to sell at $2/gram to take the fun out of it. So, as they are heading, this will just be another failed initiative.

    • It’s not true. Nor are Allan’s claims about the companies worth billions not having profits. This is liable

  7. Allen – I know you are very fancy economist, fancy degrees and all and so intelligent but sadly you are misinformed. Firstly, Aurora Cannabis and Canopy etc. arent looking to dominate just the Canadian market, they are looking to dominate the world market as the theory goes … once Canada legalizes, the rest of the western world will follow and the Canadian Cannabis industry will get a head start. I know its very tough for us Canadians to think big but please think big. Secondly, investments need to make sense to retail investors. Its very simple: an industry that was not publicly permitted to be part of the private industry is now coming into fruition – seems like a once in a lifetime opportunity to many naive people like myself. Thirdly, folks who invest have many strategies. Some like to ride the hype and momentum of popular sectors while others hold forever hoping to cash in 3 years from now. How can you tell what every weed investors strategy is? Most of the dot.com had the foresight to pull out their profits at the right time, who is to say weed investors will not? Fourthly, I dont mind your critique (criticism is healthy) but can you understand why us naive investors are skeptical when you say bubble? We have heard the dot.com bubble talk for months and even years now in relation to Canadian weed stocks, bitcoins/cryptocurrencies, vancouver/toronto real estate, all the while laughing all the way to the bank? Understand this: when i hear headlines like yours that allude to “bubbles”, my rule is to always buy. I love smart guys with glasses and degrees but unfortunately, they tend to play the stock market terribly. Look as naive as an investor that I am (the naive talk has been going on for about year and half now), my portfolio is up over 500% with these naive weed stocks along with plenty of my friends, colleagues, lots of naive idiot investors-whatever-you-call-them etc. I have also rolled off profits and bought 3 condos in Toronto (another bubbly investment). Its hard to argue with success, thats why you can expect to get alot of flack for this argument. I suggest you put your money where your mouth is and short the Canadian weed stocks if you feel so strongly ….lets see where that gets you smarty pants.

  8. Very silly argument that fails to factor in at least six considerations that just a regular dumdum like me can easily identify.
    1. Value-added
    – the margins on extracts are truly spectacular
    – exponential added value in edibles, infusions
    2. Pharmaceuticals (epilepsy, MS, PTSD, glaucoma, etc.)
    3. Herbal Remedies (insomnia, anxiety, weight loss, chronic pain, etc.)
    4. Exports (Germany, Spain, Czech R, Italy, Poland, Australia, etc. falling like dominoes legalizing medical)
    5. Hot on the heels of the little mom and pop retail investors, the institutional investors come along and lock valuations
    6. Then Big Pharma and Big Tobacco come along on shopping sprees.
    Here is a time capsule. Today, January 11 2018, I can buy these Canadian companies from 40M to 7B:
    Canopy 7.3B
    Aphria 3.1B
    Cannabis Wheaton 540M
    Supreme 566M
    WeedMD 200M
    Golden Leaf Holdings 210M
    Quadron Cannatech 43M

    “Buy Canadian Tire” is excellent advice… for 1990. Thank you popsy, gotta go jump in my Time Machine.
    If Canadian Tire outperforms ANY of these in 2018, 19, 20, 21, I will eat my damn Ove’Glove.
    As Seen on TV.

  9. I agree with the majority of posters regarding the Canadian Tire comparison. Canadian Tire is a mature company with very little growth prospects that haven’t already been factored in its valuation. It’s apples and oranges. Canopy is it’s “teenage” years of growth and with the United States essentially being handicapped by their federal government, Canadian producers are poised to takeover internationally. Investment capital flowing into these companies provides opportunity for acquisition of any smaller international companies/competition moving forward as well. Canadian / BC marijuana has strong branding already and is internationally recognized for it’s quality.

    There are many concerns with the legalization model within Canada, but that market is tiny compared to the worlds medical marijuana market. As countries move from medical to recreational that market opens up dramatically for those who have a stake in it.

  10. Just stupid money, These big LP’s buying small already actively producing cannabis LP’s does not add any more(new) product to Canada’s Cannabis supply. At this point if these fat wallet Corporations are not growing out new Greenhouses and buying new Growers with more grow sites, the whole Government sanctioned Monopoly will fail. At Canada’s current legal LP product level, the Canadian Cannabis supply will last about 2 months of legalization, after that there won’t be any legal weed to be had, and since the whole Medical supply is relied upon to supply the 200,000 + patients in Canada’s medical cannabis system, patients will be without their Dr. prescribed cannabis, because these LP’s and their American investors have made deals to ship Cannabis out of the country, and will never be able to fulfill the Billion Gram Contracts that they have made. Legalization will be a new novelty for a few months but when product runs out and the variety is limited, Recreational users will go back to their tried and true friends and dealers, “Back to the Blackmarket !!!!

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