Three Cannabis Industry Market Scenarios in a Post Bill C-45 World

Benjamin A. Smith
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It’s official—the Cannabis Act (otherwise known as Bill C-45) passed with flying colors in the Senate this evening. With 56 yeahsayers against 30 detractors (1 abstention), cannabis will soon become legal to consume and possess in Canada. As the industry enters a new chapter, we look into three market scenarios as investor sentiment shifts from dreams & unicorns, to stark business realities.

But first, the big news of the night.

As reported everywhere, Bill C-45 passed in the upper house just after 9:00pm by a vote of 56-30 with one abstention. It now goes back to the House of Commons, where the Liberals will decide whether to approve, reject or modify the Senate’s amendments. Assuming that clears and Royal Assent is granted, the Health Ministry will require between two and three months to prepare before retail cannabis sales.

With this historic (if not anti-climactic) event behind us, the investing environment will likely shift in many unforeseen ways. Not so much in how it operates, rather, in the way the price action carries itself and ‘feels’ going forward. Below are three such scenarios we’re watching out for as the sector moves towards its middle innings.

Scenario #1 – Market Sentiment And “Feel” Will Shift Abruptly

The cannabis sector has experienced two distinct bubble tops in 2016 and 2018—but now it’s time to play catch-up. With cannabis valuations having run way ahead of themselves (rightfully so) in anticipation of the soaring and continuous revenue windfall which lie ahead, I believe a pause is coming in the next quarter or two. The uncertainty surrounding who fulfills their promises, execution risk (both provincial retail rollout and company specific), and actual sales/pricing power in Canada and abroad should keep frothiness levels down. The market hates uncertainty.

BMO Capital Markets apparently carries the same measured viewpoint. In the first cannabis analyst coverage ever issued by a “Big Six” Canadian bank, BMO slapped a $45 price target and “outperform” rating on Canopy Growth Corp. While the projection implied a ↑23.05% upside in Canopy Growth over the next 22-months, it was hardly the lofty upside many in the sector have come to expect. The same report pegged Aphria Inc. at a non-euphoric $17/share during the same time period.

While I believe BMO’s ultimate projections are too low, I anticipate Big Cannabis will begin trading more like consumer discretionary or drug manufacturer stocks going forward. The passage of Bill C-45 officially transitions the sector from the unicorn (a.k.a. what could-be stage) world to one where earnings and free cash flows models dominate. Combined with an increasingly and more a stabilizing institutional/indexing presence, volatility (alpha) should trend lower at the top of the sector.

Prices can still run, but the days of 8%± sector swings are coming to a close.

Scenario #2 – The Market Will Punish The Stragglers

With the countdown officially “on”, the focus now shifts from abstract or conceptual expectations to the stark reality that business continuity is at stake. Bill C-45 passage means LPs will need to soon start living off their income statement, and easy access to capital will become more challenging. Those who don’t or can’t execute their business model will find themselves at a major disadvantage—or worse—out of business.

Thus, we expect the market will punish LPs who can’t fulfill distribution agreements or lack the operating structure to deliver from seed to package. Aphria CEO Vic Neufeld predicted as much, warning an LP squeeze is coming as early as next summer (we agree). If the market gets wind some LP is struggling on some portion of the supply chain, the market reaction will be crushing.

Aphria Inc CEO Vic Neufeld Warns Licensed Producer Squeeze Is Coming

This will be both a boon and albatross for investors, depending on the quality of the issue. Strong mid-major LPs will likely be swept up for a premium in the coming consolidation wave, opting to cash out and avoid going head-to-head with the giant Tier-1’s. But many lower-quality LPs will get steamrolled by the big boys, unable to compete on cost or distribution. Big Cannabis will clamor like vultures circling a desert carcass for distressed LPs unable to survive the liquidity crunch a lack of free cash flow entails.

Now, more than ever, quality of the cannabis investment matters. If it doesn’t possess distinct niche qualities or compete on cost, branding power, or distribution prowess, you probably shouldn’t own it.

Scenario #3 – There Will Be No Protracted Sell-The-News Event

Unlike the period between April 2017 to July 2017—after the hype of Trudeau’s tabled Bill C-45 subsided—I don’t anticipate the same voracious sell-the-news decline this time. That was a different time in the growth cycle, where revenue sourcing was still abstract in nature.

At that point, the sector had much less visibility when it came to funded capacity, annual yields; legislative risk remained elevated. All of those issues are behind the market at this stage, and the clearing international legalization picture provides an ongoing headwind for those big enough to participate.

Today’s market is less muddied and more predictable.

Final Thoughts

For those permabears expecting the market to crater once legalization came to pass, it’s probably not going to happen. But neither is the extreme fronthiness which lead to two distinct bubble phases of the market in 2016 and 2018. The industry is morphing into a more mature period where revenue and profit generation catches up with expectations already built into the market. That’s both good and expected.

For the lower end of the cannabis spectrum, the moment of truth is coming. For everyone involved, it’s put up or shut up time.

Benjamin A. Smith

Benjamin A. Smith

Ben is a research analyst and capital markets professional with nearly 20 years of experience. His areas of expertise are broad-based, and include extensive knowledge of macro economics, stock/derivative trading, commodity complexes, cryptocurrencies and technical/quant analysis. He also maintains an particular affinity for U.S. politics and the macro-regulatory environment facing...
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bsmith@midasletter.com |

Midas Letter is provided as a source of information only, and is in no way to be construed as investment advice. James West, the author and publisher of the Midas Letter, is not authorized to provide investor advice, and provides this information only to readers who are interested in knowing what he is investing in and how he reaches such decisions.

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