Why the Cannabis sector in Canada will Recover and Flourish.
It seems everywhere you look another analyst is pumping out an article predicting doom and gloom for the cannabis sector in Canada. Discussion groups are filled with the angry comments of shareholders who feel they’ve been “had” as they watch their investments disappear. No doubt this is a frightening time for many investors who put their faith in this new industry.
Like so many others I’m dismayed at the glowing red numbers I see on my computer screen every time I check my portfolio. But it’s past the point of no return now and all I can do is stick with my original plan to stay long and wait for the cannabis sector in Canada to turn around.
The doomsday prophets can say what they like. I try not to pay too much attention to them. I find most of the articles to be poorly researched and based on personal opinion. What I hope to accomplish in this article is to look at facts pertaining to the cannabis sector in Canada and provide a compelling argument as to why I believe it will turn around.
So Why the Slump?
Before I discuss why I think the sector will turn around, it’s important to understand why it is in a slump in the first place. There is no shortage of blame when it comes to the poor performance of share prices in this sector. Not enough licensed retail outlets, restrictions on packaging, share dilution, short sellers manipulating share prices, lack of profit, excessive interference from Health Canada are just some of the causes linked to the problem. While all of the reasons are certainly problems plaguing the sector and may impact share prices, I believe there is a much simpler explanation for the sector-wide drop in share prices.
Ask yourself what is the single most important variable affecting a stock’s price. It doesn’t matter what sector the stock is in, the answer is volume. There is a positive correlation between share price and volume.
The Canadian Cannabis Index, published by the Midas Letter clearly shows the relationship between volume and price. Beginning in August, 2018 anticipation and speculation caused a frenzy of buying until legalization in October, then presumably those who had gotten in early sold their shares or a large portion of them, making a nice profit for themselves. From October 17, 2018 until December 28, 2018 share prices fell to near pre-legalization lows. At this point investors begin to enter the market again and volume picks up until the end of March 2019, when they start exiting the sector again. At the end of May, volume drops off and share prices start their steady decline to where they are now.
Based on the many comments I read from investors in the various discussion groups I belong to, it seems this simple relationship between price and volume is ignored. People would rather blame the government, the short listers or price manipulation. In my opinion, it all comes down to the principal of supply and demand.
But as I originally stated, I believe the cannabis industry in Canada is not only going to recover, it is going to flourish and here is why I believe this is the case.
The Building of an Industry
The first thing we need to remember is that the cannabis industry in Canada only just turned 1 year old. There is no one-size-fits-all formula to determine when a business start-up should be profitable, 2 to 3 years is considered typical. So for a cannabis company to start turning a profit in its first year of operation is a bit of an anomaly and personally I find it surprising that many of these new companies lead by experienced business people predicted profits within their first year of operation.
This industry needs time to develop. In this world of instant gratification we need to step back and let business do its thing because there is rarely instant gratification when it comes to building a business or an industry. The cannabis sector in Canada went through a magical period where people made small fortunes, but that time is done. Now is the time of heavy lifting. Companies need to prove themselves and use the resources they have to start generating profit. I believe this industry is only just getting started and current share prices do not reflect the success of the first full year of legalization that has come and gone.
What Do the Numbers Tell Us?
From October 17, 2018 – December 31, 2018 Canadians spent $152.5 million on recreational cannabis, which means medical cannabis sales would have accounted for $1.45 billion assuming the reported $1.6 billion in total sales for 2018 is accurate.
As of August, 2019 recreational sales hit $651,593,000. The chart below shows how retail sales have increased month over month (with the exception of February). Using these numbers and assuming sales of medical cannabis stay the same as in 2018, total revenue for 2019 will exceed $2 billion!
Source – Statistics Canada
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Despite falling share prices at least two credible market research firms believe revenue will continue to increase. In a report filed earlier this year by Brightfield Group, the Cannabis industry in Canada is projected to hit $5 billion by 2021. In a separate report titled “The State of Legal Marijuana Markets”, published by Arcview Market Research and BDS Analytics, it is estimated the legal cannabis market in Canada will hit $7.8 billion by 2022.
The table below appeared in an article titled “4 Canadian Cannabis Stocks Making Big Market Share Moves”, published on the Smallcap Power website. If we look at market share in CY Q2 we can forecast what these revenue projections will mean to future revenue of the major players in the industry.
Market Share Leaders in Canada
For the purposes of the exercise, market share from CY Q2 will be used with the assumption remains unchanged.
|Company||Market Share||2021 = $5 billion||2022 = $7.8 billion|
Although the numbers in the table have little validity, because market share will ultimately shift as we can see with Canopy Growth and Organigram from Q1 to Q2 in 2019. The purpose in this case is not to make an accurate prediction about future revenues but to demonstrate what the future growth projections mean to the cannabis sector in Canada.
Commodity or Not Commodity?
One of the major arguments put forth by analysts to support their prediction that the cannabis sector will not recover is that cannabis is a commodity and it will ultimately drop in price making it impossible for producers to earn the kind of revenue necessary to recapture the interest of the investment community. It’s true, cannabis is a crop, but it isn’t the same as an apple. We eat apples because they taste good and are good for us. But the doomsday prophets are forgetting one fundamental truth about cannabis.
There is a reason we don’t pull up to our local alcohol station and pump a gallon of premium into a jug to take home with us. Alcohol has evolved over the millennium into its many forms. Those who enjoy drinking alcohol have their favorite kind and brand. But it never became a commodity because of the value added benefit we get when we consume it. We like the effects and for this reason I believe it becomes elevated beyond a simple commodity.
The same holds true for cannabis. It is consumed because of the value added effect it provides the user. It may suffer from lack of branding when it comes to packaging, but licensed producers are doing a good job of developing their brands through their websites and social media. Furthermore, if it is destined to be commoditized then why hasn’t it already happened in mature markets like Colorado and Washington? By looking at some of the more mature industries of our neighbours south-of-the-border I think we can get a sense of what cannabis in Canada might look like in 5 years.
Colorado is a great example of a thriving cannabis industry that has matured since it first made recreational cannabis available to the public on January 1, 2014. According to an article appearing in Westword titled “Colorado Cannabis Dispensary Counter: Growth From 2014 to 2018”, by the end of 2014 there were 460 dispensaries in operation, 313 were existing medical cannabis dispensaries that opted to offer both medical and recreational marijuana and 147 were newly licensed recreational dispensaries that could not offer medical marijuana due to government regulations. Revenue from cannabis sales was $683.5 million in 2014. By 2018 there were nearly 3,000 licensed dispensaries in operation and sales more than doubled to $1.55 billion. These are impressive numbers from a state with a population of just 5.69 million residents.
Washington is another state where the recreational use of cannabis has been legal since 2014. Retail sales of cannabis started in June 2014 and during its first year Washington recorded just $31 million in revenue. But like Colorado, sales have increased year over year and in 2018 Washington State posted combined medical and recreational sales of just over $1 billion. The majority of that sales volume went to recreational sales totaling $975 million. Washington has a population of 7.4 million residents.
California was the first state to legalize medical cannabis use, however, it is a relatively new entrant to the recreational cannabis market. The state legalized recreational use on January 1, 2018, just 9 ½ months before Canada. California most closely resembles Canada in terms of population. With 39.5 million residents, it is currently the largest legal recreational cannabis market in the world. Canada has 37.59 million residents. As of the latest count, California had just 873 licensed retail outlets. However, it recorded an impressive $2.5 billion in combined recreational and medical sales for 2018. Reports indicate that it is on track to hit $3.1 billion in 2019.
The most important lesson we can take from looking at the cannabis sectors in the US is that it takes time. Colorado did not open up 2,917 stores in its first year. Both Colorado and Washington have retail sales in excess of $1 billion but they didn’t start out at that volume. Canada is poised to become a global leader in cannabis, regardless of what some analysts might say. The reality is that profits are coming. Several producers have already recorded profits and it is my firm belief that 2020 will be the year many other producers will show profits.
Given the revenue projections we’ve seen for the cannabis sector in Canada, the investment community cannot ignore it for long. When we start seeing more positive earnings reports, the investment community will return. We will see volume increase and share prices will follow suit. If you are holding shares, hold on. If you are an investor looking for an entry point, don’t wait much longer.
I hope that this article will help to ease the stress that many investors in the cannabis sector are feeling. I’ve tried to present what I believe to be a valid argument to contradict the negative press that fills our news feeds. I stuck mainly to the cannabis sector in Canada when looking at the potential for growth. I didn’t even factor in the growth of CBD infused products or the enormous potential the global market brings to this industry. Many Canadian producers already have a presence in these new global markets opening up. To the doomsday prophets I can only say, this industry is far from dead, in fact I think it is only just getting started.
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Disclosure: I am long on Aurora Cannabis. I have no positions in any other stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Cannabis Investment Group). I have no business relationship with any company whose stock is mentioned in this article.
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