War of the buds

The majority of the United States is in a funny position when it comes to the legal status of cannabis — depending on where you’re sitting as you read this, it’s most likely that you can’t legally buy the plant, but you can invest in companies that sell it. Michigan recently became the 10th state in the US to have legalized recreational cannabis. And Canada went federally legal in late 2018.

The investment community building up around cannabis isn’t quite as big as the recreational scene, but you can still find your kicks if you know where to look.

Most of the big investment banks still won’t touch the market. The gap left by the absence of traditional analysts has allowed a handful of independent desk jockeys to make a name for themselves. My favorite of these is a Reddit community called the Cannalysts.

The Cannalysts tend to focus on publicly traded firms. At the moment it’s possible to keep a fairly solid grip on the entire picture for public cannabis stocks, because there aren’t that many. Most of the US-based exchanges have declined to list cannabis companies so the industry has routed its public offerings through a handful of small Canadian exchanges, where recreational cannabis is enjoys full legal status at the national level.

That said, it’s pretty easy to find a brokerage that lists these shares:

$APH (Aphria)

$ACB (Aurora)

$CRON (Cronos)

$TLRY (Tilray)

$WEED (Canopy)

$CURA (Curaleaf)

$MMEN (MedMen)

$GTII (Green Thumb Industries)

$ACRG (Acerage)

$IAN (iAnthus)

$CWEB (Charlotte’s Web)

Once you start looking at the numbers you’ll notice that most of the companies on this list have a pretty large P/E ratios (meaning, the amount of revenue that they’re currently earning is worth less than what they’re trading for, which suggests a market where investors expect to see growth ahead).

So if your basic cannabis thesis is, gee, I bet this industry will grow as more government bodies agree to legalize it — just realize that these P/E numbers suggest that market is ahead of you on this assumption. The expectation of rapid growth is “priced in.”

The guessing game of which company will grow the fastest is what sends a lot of cannabis investors into the black art of stock picking. If you have a good grasp on the fundamentals of the market and the financials of the operators, you’ll probably have a better chance at trying to pick a winner.

This is where following analyst communities like the Cannalysts can be a big help in getting started. These folks love to break down balance sheets and skeptically pore over company statements, just like their counterparts in traditional markets. They have a strong preference for GAAP accounting standards (vs IFRS), are critical of certain inventory reporting practices, and tend to think deeply about the realities of the supply chain.

That said, I’ve noticed one area where they, and by extension, a lot the cannabis investment community, has shown a bias that could use some correcting for: they’re too Canadian.

I don’t mean, like, culturally. (Yes, they’re funny and weirdly polite, for a bunch of finance guys.) I mean that because the Canadian market has made a buffet of fundamental financial data for them to feed on, they’ve over-focused on the role that the Canadian markets have to play in the year ahead.

Let’s compare the addressable markets in the US and Canada. Recreational cannabis has been legalized nationwide in Canada, compared to only 10 states in the US.

But if you compare the combined populations of these 10 states you’ll see that the US is already a much bigger market:

Canadian population: 37 million

Combined population of recreational markets in the US: 80 million

My point isn’t just that US companies have a larger addressable market — it’s that the hurdles that US companies are facing are more applicable to the industry at large.

When we discuss cannabis “supply chain challenges,” we’re usually discussing impositions made upon them by their highly constrained regulatory environments. Because Canada has legalized recreational at the federal level, they’ve created a smoother path to going public than we have in the states — and the financial data available to analysts is weighted by this fact.

So what mistakes could be made by focusing too much on the Canadian market? I want to share the largest one that I can see from here.

Canada has only legalized “flower,” that is, the green buds sold in baggies that are most familiar to anyone who dabbled in the black market before this whole regulatory party got started. The amount of manufacturing process layered on top of the flower market is comparatively light. You pretty much go from cultivation -> trim -> testing -> packaging -> retail. (Actually, add several more testing steps along the way. The labs are a key part of the supply chain at this point.)

And because cultivation initially seems like the most highly constrained link in this chain, it was natural to assume that most of the first wave of value would be generated by cultivators. If you look at the business models of the big 5 Canadian stocks, you’ll see exactly that. A lot of discussion of acreages and yield. You’ll also notice an emphasis on “verticalization” in the form of a single company managing cultivation and retail operations.

Unlike Canada, most markets in the states have already permitted the sale of other product formats, such as vape pens and edibles. And if you examine the sales of these categories you’ll notice something very important to the future of the industry. Manufactured product formats such as vape pens and gummy bears eventually outsell bags of flower. Hard core stoners may always prefer green buds, but the rest of them consumer market tends to favor things that don’t require them to pack a bowl.

So in the US, you see a line of business thriving here that hasn’t yet had a chance to register in Canadian markets: horizontally integrated manufacturers. These companies don’t own acreage, don’t cultivate, and don’t hold retail licenses. Instead, they develop deep supply chain connections with cultivators and retailers, and focus on the core of their business: productization, and crucially, brand building.

Ask yourself, which aspects of the cannabis supply chain will be least vulnerable to commoditization? It’s not cultivation — in the state of Oregon, wholesalers were briefly selling trimmed bud for not much more than $60 / pound. A pound! So long as the government is responsible for licensing cultivators, the material cost of cannabis will always be wholly designed by regulators. And because they make money selling licenses, I will argue that the margins of large scale cultivators will always be under assault and will eventually commoditize, leaving only a small network of low volume artisanal producers who are able to defend their margins.

The same reasoning applies to retail operators. Unless retail franchises are able to build brands that allow them to preserve a margin, they’ll end up being run with lower profits than 7–11 stores (thanks to aggressive tax overheads).

Think about it, would you pay more for the recreational cannabis brand that you’re after just because of the sign hung over the door? If consumer packaged goods companies thrive in the cannabis industry, they’ll eat at the retailers’ margins directly.

Which leaves us with the horizontally aligned manufacturers. First off, I like the relative simplicity of their business model. In hindsight I think the rush to build large, vertically integrated firms will be seen as a major strategic blunder. Operating in highly regulated spaces is fundamentally hard, but layering on multiple levels of regulatory complexity into one firm seems to exacerbate rather than reduce risk. I predict that we’ll see a lot of them suffer tremendous scaling pains.

But if you’ve outsourced compliance risk and volatile material costs to your vendors, you’re more likely to stay focused on the task of building an enterprise that’s able to scale up when it’s ready. And you’ve also bought yourself a window of time necessary to pull off the hardest, yet most essential move: building a brand.

If the markets gravitate towards consumer brand preference in product formats such as vape pens and edibles, I’d say that the near future of cannabis looks a whole lot different than the ones currently trading on Canadian exchanges.

Here’s your link of the week (from 2016, but whatever, it’s good):

The Invisible Helping Hand — How a network of food banks learned to feed more people by embracing the free market.