Canadian cannabis producers, the darlings of the stock market in 2016 and 2017, are off to a rough start in 2018, with the Canadian Cannabis LP Index down 12.7% year-to-date despite a surge in early January to all-time highs. A longer-term view puts the decline into perspective as a correction of a very strong advance since mid-2016:
Since the peak of 1438.87 on January 9th, the index, now at 877.46, has contracted 39%. Despite the correction, prices have still advanced 83% since late October, when Constellation Brands announced its investment into Canopy Growth, sparking interest from investors across the sector who realized that this transaction had profound implications for the entire industry. Another cross-industry investment was announced in March, with U.S.-based tobacco company Alliance One International acquiring a 75% stake in Canadian LP Canada’s Island Garden as well as making additional investments.
There are now 29 publicly-traded Canadian cannabis producers, a number which continues to increase as private licensed producers (LPs) migrate to the public market, with more expected to join the group. The top 4 companies in terms of sales include Aphria, Aurora Cannabis, Canopy Growth and MedReleaf, and the performance among the group has differed greatly in 2018, though all have declined:
Why are the stocks falling?
In early February, when stocks in general were under intense pressure, I addressed a major challenge for the Canadian LPs, suggesting that the weakness in the stocks had been compounded by early-in-the-year ETF activity and, more significantly, a barrage of supply, as 14 LPs raised over C$1 billion. I have updated the table I shared, and, while this supply remains an overhang, there has been only one large deal subsequently, with Cronos Group raising C$100 million in March:
Several factors have contributed to the recent decline, most of which are specific to the sector. First, legalization had been expected to take place in July, but the implementation is likely to be closer to the beginning of September. Second, and perhaps more concerning, legalization, which was thought to be a “done deal”, came into question when the Canadian Senate considered the Second Reading in March. The deliberations were heated, but, in the end, C-45, the Cannabis Act, was moved to committee and will face a final vote on June 7th. Perhaps most importantly, preliminary packaging guidelines from Health Canada, released in March, were unfavorable to the industry. Aurora Chief Corporate Officer Cam Battley suggested to Bloomberg that “the federal government is risking a policy fail.” Restrictive packaging will make it more difficult for the LPs to compete with the black market.
Following the decline in prices, financial media has been very negative on the sector. Last week’s cover story from Barron’s discussed a pending supply glut and very high valuations. Several anonymous contributors at Seeking Alpha have shared very negative views on the largest companies in the sector as well.
The worst performer in 2018 among the large LPs has been Aphria, which has been impacted by concerns over its acquisition of Nuuvera, now known as Aphria International, with the stock down almost 46%. Market participants have struggled to understand the transaction thus far, and some have criticized the company for not disclosing prior investments made by officers and directors into Nuuvera. It’s also worth noting that Aphria’s stock was boosted in December when it announced a potential supply agreement with Shoppers Drug Mart that appeared to be somewhat exclusive. Subsequently, four other LPs also announced similar deals. Aphria will be reporting its FY18-Q3 in mid-April and hosting a conference call.
Outside of the cannabis-specific factors, it’s worth noting that the overall markets have returned to recent lows. Canadian stocks, as measured by the S&P/TSX Composite Index, have declined 5.6% thus far in 2018. Another technical issue is that many investors may be selling shares to pay for taxes on gains in 2017.
Is this an opportunity?
In my last article on the LP sector in early February, I discussed the trading opportunity following the price declines, suggesting “While I don’t believe the decline is necessarily over, I see this as a good opportunity to scale into the sector for longer-term investors and as a potential trading entry.” At this time, I remain concerned about the valuations, which are difficult to justify, but the timing has gotten somewhat better in my view, with lower prices and as we are moving closer to the June vote and the subsequent implementation across the provinces.
After having boosted my exposure in early February, I later reduced it in my model portfolios at 420 Investor following the bounce. After last week, when I used the sell-off on Wednesday to add exposure, I am somewhat long the sector relative. In Flying High, my swing-trading model portfolio, LPs currently represent 35% of the investments. My two longer-term focused model portfolios, 420 Opportunity and 420 Quality, both of which are measured against the Global Cannabis Stock Index, have similar or greater exposure to the index, which has about 27% of its weight in LPs, with 420 Opportunity at 27.6% and 420 Quality at 30.9%.
I believe that sentiment has moved from overly bullish to at least more neutral now if not somewhat bearish. My own view on the argument of oversupply is that there will be a shortage in the near-term, similar to what we have seen in many of the markets in the U.S. when states first go legal. Very few LPs have substantial inventory at this time (Canopy Growth is the big exception), and it’s likely that much of the supply that is expected to be available initially won’t be available on day 1. With that said, it’s important to understand that Canada is primarily a dried flower market, with its extracts extremely limited and edibles themselves not part of the legal offering initially. So, the true market demand won’t be available initially to the LPs, somewhat mitigating the supply shortage.
Longer-term, it is likely that the market will be oversupplied, though less so than many forecast. At this time, investors and analysts appear to take guidance from companies at face value without discounting the very likely outcome that many of these projects won’t scale as anticipated.
Historically, the publicly-traded LPs have moved mainly in unison. As the Canadian market moves into this new stage, I expect to see substantial differentiation in the returns of these companies. Assessing execution risk and management capability should be at the top of any investor’s due diligence list. Further, just because a company has succeeded under the medical program, ACMPR, is no assurance that it will be able to do so in the new legal market, which has a very different distribution model that varies from province to province.
Finally, I continue to suggest that investors take a longer-term perspective when assessing valuation. First, the LPs in Canada aren’t going to be selling just a commodity. Over time, the products will become more differentiated as rules permit vape pens, extracts and edibles. Second, there are many international opportunities for these companies. Finally, and perhaps most importantly, some of these companies will be able to pursue the creation of pharmaceutical products, addressing an even larger market than the the current market, including adult access and medical.
Bottom-line: Canadian LPs have been hammered but still sport high valuations. The decline in prices affords investors and traders an opportunity to buy, but it will become increasingly important to pick specific companies rather than the broad sector, which now includes 29 different public companies, with several more on the way.