3 Canadian Cannabis Sector Scenarios Leading Up To Legalization

With Canadian cannabis recreational sales about to go live on October 17th, there’s increasing chatter among retail investors about how the market will react over the next 15 trading sessions. After all, the sector (HMMJ) is up around ↑71.62% since August 14th, and most everything—from the Tier-1’s to small caps that won’t be around in three years—have mostly rallied. I’ll expand on three possible market scenarios heading into mid-October, as Canada becomes the first G-20 nation to legalize recreational cannabis.

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The Bear Scenario: Canadian Cannabis Stocks Sell-Off Heading Into October 17th

Starting with the negative, I can foresee cannabis stocks selling off heading into legalization for a number of reasons.

The first has to do with federal legalization itself. Owing to the pace at which legalization was fomented, not all provinces will undertake retail cannabis sales on October 17th. In Canada’s most populous province of Ontario (around 13.6 million people), brick & mortar sales won’t be introduced until April 2019. In Canada’s 3rd most populous province of British Columbia (around 4.7 million people), only one retail cannabis outlet will be ready next month. Several significant municipalities won’t allow retail outlets at all. In reality, Canada will employ a tiered retail system—at least at the beginning—and this will definitely have a negative material impact on sales versus full-suite recreational sales envisioned a few months ago. Invariably, many will want to see the product, talk to a live expert, or not be compelled to upload ID onto a government database to procure their supply. Such factors will serve to delay the legal uptake cycle.

Looking beyond 1Q 2019, all this will be forgotten, as full revenue impacts will be realized. But short term, revenues won’t be hitting the sector full-tilt as previously envisioned.

We also question whether the hype machine can operate effectively without retail sales in both BC and Ontario. No long queues will spring up in Ottawa or Toronto or Vancouver to whip up investor sentiment. Perhaps population hubs like Montreal and Winnipeg can fill the void; but removing Ottawa (Canada’s legislation hub) and Toronto (Canada’s biggest population center) won’t be helpful in the optics department.

There’s also the possibility that online systems could operate sub-optimally due to consumer demand. There’s a looming Canada Post strike, which has been averted for now. But the postal union is obviously going to play hardball with cannabis legalization as its primary bargaining chip. Private sector distribution will not be able to substitute for Canada Post’s absence should they walk out.

Lastly, the sector’s post-Canopy/Constellation Brands deal helped push valuation thresholds quite high in many names. Although we realize the move is largely associated with anticipation for international distribution, the performance in many stocks operating domestically has also surged. Keep in mind, the Big Beverage partnering hype fomented by the media earlier this month appears to be a mirage—at least for now.

In short, we perceive risks in the viability of the rally based on the sector’s frothy run-up and domestic retail operating risks/optics. This applies most prominently to the junior and mid-major side of the market, which derive most of their revenues through domestic sales.

The Neutral Scenario: Canadian Cannabis Stocks Flatline Heading Into October 17th

This is the scenario we witnessed in the month prior to Bill C-45’s passage in June. While Canadian cannabis stocks experienced sporadic upside extension (i.e. June 6th – ↑5.35%), every rally was sold into, and the majority of sessions were contained within the upward-sloping channel. The net gain in HMMJ between May 22-June 19 (the day before Bill C-45’s passage) was ↑3.72%, which is just a garden variety daily move in the sector.

Furthermore, Tier-1 cannabis volumes are starting to trail off after a substantial increase in September. CannTrust Holdings Inc., Hexo Corp., Canopy Growth Corp., Aphria Inc. and more will all end the session with low or near-low volume totals for the month. Considering some of the risk factor mentioned above—especially in conjunction with a slow news cycle—it’s certainly not impossible for sector prices to remain range-bound cruising into legalization. It’s conceivable bulls and bears could play a game of chicken, each waiting for the other side to show their hand before exiting or buying en masse.

The Bull Scenario: Canadian Cannabis Stocks Make New Highs Heading Into October 17th

This is the scenario most cannabis investors are hoping for. It would involve additional upside extension of some of the major LPs heading into mid-October, as prices break free for the current consolidation. It would likely mean that Canopy Growth—still the undisputed sector heavyweight—begins printing $80’s and $90’s on the Canadian side, willing the sector along for the ride. Given the current strength of the company, this scenario is well within the realm of possibility.

Possible catalysts sparking an upside extension are numerous. The sector could attain that defining equity stake partnership many have been anticipating. There’s no shortage of beverage suitors looking to partner-up, as Board pressure mounts on company executives hesitant to make big moves in the sector.

The resolution of the Canada Post strike would remove a significant headwind threatening the critical rollout in the early days of legalization.

There’s the $5 billion dollar cash hoard Canopy Growth will attain at October’s end once the Constellation direct-equity investment closes. Few catalysts are better at raising sector animal spirits than merger & acquisition activity, and that’s the direction Canopy Growth is going. Although it’s unclear when & where Canopy will act—or even whether it will deploy money on North American assets—that won’t stop speculators for trying to corral the next Hiku Brands. It’s a speculative catalyst for sure, but one that could provide a background omnipresent effect.

There’s also the straight-forward possibility of a sector short squeeze, triggered by bear capitulation heading into legalization. As we’ve explained recently, short interest within the sector is building up in many issues, and there’s always the possibility bears could capitulate should the sector consolidation impulse break away from upwards resistance. Despite very aggressive and forward-looking valuations, there’s no assurance cannabis stocks won’t get more so as contrarian investors get squeezed in the vice.

Final Thoughts

I don’t usually write articles void of conclusions, but the truth is, I believe all three scenarios have merit. Had full brick & mortar legalization been introduced concurrently along with online sales, the bull scenario would have more assurance. But with blunted revenue impact vis-à-vis unrestricted recreational cannabis access, the short term revenue picture becomes a little murkier. This matters, because I expect the sector to be more earnings-driven once Canadian legalized markets have been established.

Another thing to note is that retail investors—almost unanimously—believe the sector will rally heading into legalization. Practically all retail investor road maps I’ve come across—from novice to the professional—seem to believe the market will crest on October 17th, then sell off thereafter. Naturally, individual retailers believe that they will be the ones painting the top of the market. If the collective retail mind is already convinced of this conclusion, you can be 100% assured it’s not going to happen that way.

Perhaps I’m wrong. Even the blind squirrel finds a nut one in awhile. But somehow, we think Canadian cannabis stocks will arrive at a surprise outcome almost no one sees coming.

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