Why Canadian Cannabis Stocks are On Sale

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Canadian cannabis producers took the stock market by storm in 2016 and 2017; however, they’re are off to a rough start in 2018 with the Canadian Cannabis LP Index down 12.7% year-to-date despite reaching all-time highs in early January. A longer-term view explains the decline as a correction of a very strong advance since mid-2016.

It’s worth noting the overall markets, not just in the cannabis sector, have returned to recent lows.

Canadian stocks, as measured by the S&P/TSX Composite Index, have declined 5.6% in 2018. Another technical issue is many investors want to sell shares to pay for taxes on gains in 2017.

Since its peak of 1438.87 on January 9th, the index, now at 877.46, has shrunk by 39%. Despite the correction, prices have still advanced 83% since late October.

There are now 29 publicly traded Canadian cannabis producers; the number continues to increase as private licensed producers (LPs) enter the market.

The top four companies, in terms of sales, include Aphria, Aurora Cannabis, Canopy Growth, and MedReleaf; all have declined in 2018.

Several factors have contributed to this recent decline. First, although legalization of recreational marijuana is expected in July, its implementation will likely require more time, extending through September. Second, and perhaps more concerning, legalization was thought to be a “done deal;” however, the decision will not be determined until June 7. Finally and, perhaps, most importantly, restrictive packaging guidelines from Health Canada are unfavorable to the industry since they make it more difficult for the LPs to compete with the black market supply.

The worst performer in 2018 among major LPs has been Aphria, plagued 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. Although Aphria’s stock surged in December when it announced a potential supply agreement with Shoppers Drug Mart, subsequently, four other LPs also announced similar deals. Aphria will report its FY18-Q3 in mid-April.

Industry experts feel the general sentiment has moved from overly bullish to either more neutral now, or, somewhat bearish.

Regarding the issue of oversupply, others predict there will be a shortage in the near term, similar to what we have seen in many American states when they first opt for legalization. Very few LPs have substantial inventory at this time with the exception of Canopy Growth and it’s likely much of the anticipated supply won’t be available immediately.

Historically, the publicly traded LPs have moved mainly in unison, but, one can expect to see substantial differentiation in the returns of these companies upon legalization of recreational use of marijuana. Just because a company has succeeded under the medical cannabis program does not assure its success in the new recreational use market in part because it has a very different distribution model varying from province to province. For these reasons, assessing execution risk and management capability should be a top priority for any interested investor.

Investors are advised to take a longer-term perspective when assessing valuation.

For starters, the LPs in Canada aren’t going to sell a mere commodity because, over time, their product offerings and branding will become more differentiated as regulation begins to permit vape pens, extracts, and edibles. Secondly, there are many international opportunities for these companies as marijuana use grows in acceptance. Finally, and, perhaps, most significantly, some of these companies will ultimately be able to pursue the creation of pharmaceutical products which will address and capture an even larger market than the the current one, including adult access and medical.

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