The summer is no stranger to market weakness in the cannabis sector, the team at Eight Capital writes in a new report published Thursday, but the sector could show “significant outperformance over the remainder of the year.”
“Between the catalysts ahead in the Canadian market and the potential deregulation in the United States,” the analysts write, “the cannabis trade is not over.”
Below, Cannabis Professional summarizes the most significant potential catalysts that Eight Capital argues could serve as “possible trigger events for a re-rate of the sector” in its 27-page report as well as the investment dealer’s top cannabis stock picks.
Product differentiation as supply equilibrium is reached in 2020
Legal cannabis production will finally be at a level high enough to satisfy demand by the middle of next year, the report predicts. While that would normally bring big margin pressure for LPs, the authors note the situation will be “more nuanced given the introduction of derivative products [such as edibles, beverages and vape products starting in late 2019] which have the ability to command a higher price per unit."
Pricing issues aside, the report notes equilibrium will spawn a migration in the consumer decision-making process, “from one that is based predominantly on potency and price” to one “including, but not limited to: potency, terpene profile, strain, form factor, package size and brand.”
“LPs will have to significantly differentiate their products while staying ahead of the curve on consumer trends and preferences in order to consistently fill sales channels and drive demand for products at the retail level,” the report says. “Otherwise, they risk facing significant sales returns or see their products heavily discounted as retailers look to turn over their slow moving SKUs.”
[That means, for example, partnerships like the one between PAX Vaporizers and four major Canadian LPs announced in June - or Tantalus Labs CEO Dan Sutton’s more recent promise to use “100% single origin cannabis inputs” to deliver an “elite” vape experience - will become increasingly important.]
Gross profit is “the first line of defence against falling prices,” the report says, expecting only a “handful” of Canadian LPs to achieve profitability in 2020, with those focused on building global scale “likely to remain in a loss position”, including Canopy Growth, Tilray and Cronos Group, the report says.
“Given the market has taken a sharp turn toward valuing profits over market share, we will be watching closely to see if LPs start to message a change in strategy to facilitate an accelerated pathway to profitability,” the authors write.
Strategic investments from Fortune 500s still on the table
“While much of the fervour over strategic investments in the cannabis space has subsided, the cannabis industry in 2019 has seen continued penetration by Fortune 500 entities after a number of landmark deals in 2018,” the report says, specifically citing British tobacco giant Imperial Brands’ $123-million investment in Auxly Cannabis Group and convenience-store chain Alimentation Couche-Tard ‘s investment in Fire & Flower as recent examples.
“We continue to believe that additional strategic deals will occur as time goes on,” the report says, adding buyers will focus more on “companies with a distinct pathway toward profitability.”
Edmonton-based Aurora Cannabis and Organigram of New Brunswick are both good examples of LPs “that have not yet signed deals, but make likely candidates,” the report says, adding both Nanaimo-based Tilray and Hexo of Quebec “have made it known publicly that they are actively seeking to sign additional strategic deals.”
More stores to drive more sales
“We continue to believe that industry growth remains closely linked to expanding bricks-and-mortar infrastructure nationwide,” the analysts write.
The report estimates just 384 active retail locations selling recreational cannabis across the country, comparing that figure to 660 LCBO locations in Ontario alone and over 2,200 private liquor retailers. “
The Canadian market clearly has a long way to go before it reaches a saturation point,” the report says, noting provinces with “higher instances of bricks-and-mortar show that sales per capita outperformed their peers by 2.6x in the month of June.”
Two recent transactions - Couche-Tard’s investment in Edmonton-based Fire & Flower and Tilray buying Calgary-based FOUR20 - “validate the importance of retail as part of the cannabis value chain.”
Further deregulation in the United States
Legislative efforts in Washington, D.C. remain “key to de-risking the business environment in the U.S. and unlocking outsized value,” the report says.
High-profile bills such as the Strengthening the Tenth Amendment Through Entrusting States (STATES) Act “have gained bipartisan support and stands a legitimate chance of being passed, according to several politicians...However, we believe that Bills that deal with periphery issues outside of de-scheduling/legalization have a better chance of passing in the near-term, as they deal with topics that are less sensitive than full legalization.” such as the Secure and Fair Enforcement (SAFE) Banking Act.
The SAFE Act would allow cannabis businesses complying with state laws to access federally chartered banking services and would also allow major credit card providers such as Visa and Mastercard to process cannabis-related transactions from legal jurisdictions.
Eight Capital details the current status of 12 different pieces of pending U.S. federal legislation that could each serve as an investment catalyst for the cannabis industry.
CBD as a natural health product in Canada
Health Canada has held consultations on the idea of allowing cannabis-based natural health products, which the report argues “could unlock significant value.”
Passage of the U.S. Farm Bill in 2018 led to “an explosion in the CBD market,” the report says, “with major retailers such as CVS, Rite-Aid and Kroger starting to carry CBD-infused SKUs.”
In Canada, however, “CBD continues to be governed under the Cannabis Act, meaning that products containing CBD, whether it is sourced from cannabis or hemp, must be processed, marketed and sold in the same limited manner as those containing THC.”
Canadian hemp growers and food makers have been lobbying the federal government to reclassify CBD as a natural health product, but thus far little progress has been achieved.
Authorization of cannabis extract-based products in late 2019 “will open up the form factors for CBD infused products to include edibles, topicals and vapes” the report says, “however, the distribution of these products will remain limited to existing channels.”
Health Canada’s consultations, meanwhile, have not been specifically about reclassifying CBD as an ingredient that could potentially be included in natural health products (NHPs) such as Vitamin B or Echinacea. The agency has drawn criticism for instead proposing to create a new regulatory category for so-called Cannabis Health Products (CHPs), which industry advocates argue would be much more restrictive than NHPs.
The U.S. market for CBD-infused products, according to a recent Brightfield Group projection, will nearly quintuple from US$5-billion in expected 2019 sales to US$23-billion by 2023.
Jameson Berkow