By: Rob Wertheimer
Cannabis sales in Canada have been constrained by shortages, as the industry ramps up to meet a large and growing market. This year is probably the last time overall production shortages will be an issue, though, and that means we may see a transition from valuations based on production capacity into ones based on sales and brand building. There are three separate inefficiencies in current production, that when resolved, will lead to surplus instead of shortage.
The first is that capacity that was licensed back before the industry legalized, in mid 2018, still hasn’t fully come online, though there is a steady build. Marijuana Business daily reported in July of 2018 that Canada had approved 11 million licensed square feet. As of March 2019, nine months later, only 7.5 million square feet were under cultivation. Assuming companies all achieved targeted yields, that 7.5 million would be about enough to supply the annual market, and 11 million would be too much.
The second issue is that cultivated area isn’t producing at nearly the level it should be, leading to shortages and some concerns that producers have quality issues. Finished production (which is basically packaged and ready for sale product) is less than a third of the level expected given the cultivated area. Unfinished production is tracking fairly well with the area that is being cultivated. But unfinished cultivation has been slow to convert into saleable products. That may be a temporary growing pain issue, in which case product will come through and the shortage will be greatly lessened in short order. Or it may be a sign of poor production, and some producers will have failed crops or similar issues to report.
The third issue is that capacity announcements have continued. Area currently available for planting should suffice to fulfill all of Canada and the likely near-term market in Europe, while more continues to be announced and built. The slow start to production has encouraged ever more announced capacity, but as the system gets through its bottlenecks, some of these announcements will prove unnecessary. The more that actually get built, the lower pricing will go, until producers give up and facilities are shuttered.
So what does that mean for stocks? Leaders with scale can use market cap or cash to broaden out the business lines and spread tentacles into other markets, while waiting for them to legalize or develop. Larger cap companies should also be more prepared to weather production ramping problems; millions or tens of millions in lost crops are a bump for the largest companies, but could be a more serious issue for others in the industry.
We have an Overweight rating on Aurora shares, an Equal-weight on Canopy growth, with upside to our C$80 target, an Equal-weight on Cronos shares, and an Underweight rating on Tilray. Our industry view was lowered to Negative back at the beginning of May, on the upcoming flip from shortage to oversupply, and on risk of a slower sales ramp as distribution limits exacerbate that issue. Failed production may keep supply from going to excess in the near term, but that has its own set of issues.