As marijuana rules become clearer, risks remain

The rollout of provincial recreational marijuana frameworks has reduced some risks for investors, analysts say, but unknowns around distribution, supply and the impact of U.S. law on Canadian exchanges remain.

After a summer of premiers pushing back against the federal government’s plans to legalize recreational marijuana—and the July 1, 2018 timeline in particular—some investors have questioned whether the Liberals would deliver. Moves by the Ontario, New Brunswick and Alberta governments have led to “an overall de-risking” in the Canadian market, says Matt Bottomley, an analyst with Canaccord Genuity who covers several marijuana producers.

Those governments have ended the worry that legalization would either fail or occur much later, says Charles Taerk, chief executive of Faircourt Asset Management in Toronto. The firm advises the UIT Alternative Health Fund.

“When you know there’s actually going to be a recreational market, then there’s increased certainty of revenues and earnings and you can do your models rather than having a different discount rate,” Taerk says.

Read: Betting on a Canadian pot bonanza

In response, marijuana stock valuations have risen 25% to 30% in the weeks since the provincial governments began releasing their frameworks, Bottomley says.

The federal government also outlined taxation plans, including a $1 excise tax on sales below $10 and 10% on large purchases, with federal and provincial sales taxes on top of that.

But as provinces continue to develop their distribution plans in time for next summer, the industry still faces a number of unknowns. Those include the impact marketing and distribution rules will have on supply, the types of products that will be available and when, and how companies with U.S. operations will be treated on the TSX.

The largest province and first to act, Ontario, outlined a regime in September where a subsidiary of the Liquor Control Board of Ontario (LCBO) will manage the only retail outlets, with strict packaging rules. The plan is to have 40 stores open for July 1, 2018, 80 a year later, and 150 by 2020. Products will also be available for online purchase.

There are concerns there won’t be enough stores to satisfy the recreational market, which, “in terms of revenue, could rival certain alcohol sales within the LCBO,” Bottomley says. There are more than 800 LCBO outlets in Ontario.

Bruce Campbell, founder and portfolio manager at StoneCastle Investment Management in Kelowna, B.C., thinks Ontario will initially have a limited number of government-run stores in order to flush out the dispensaries that have popped up around the province.

“It will be pretty easy to figure out who the illegal dispensaries are come July 1 if you have 40 locations that you can buy from,” he says.

And once those have been shuttered, he thinks Ontario could see a second phase where private retailers are introduced. In the meantime, licensed producers (LPs) may have to rely on online distribution.

Read: Frothy or feisty: estimating cannabis values

Licensing limitations

Another move against the black market could also impact LP profits. Health Canada streamlined its licensing process for medical production in July, opening up the number of producers, which could affect prices by increasing supply. Canaccord Genuity analysts responded in the summer by lowering their price targets on Canadian marijuana stocks, citing “the prospect of intensifying competition.”

“I think the supply issue becomes much bigger than what people are expecting right now,” Campbell says.

Health Canada currently lists 67 licensed producers. That’s up from about 20 in early 2016, Campbell says, so LPs will have to be competitive on a cost-per-production basis in a more commoditized market.

The amount of money LPs have been able to raise with little effort is also a risk, he says. “How efficient are they at putting that capital to work? From an investor standpoint, that’s going to be something you have to be very cognizant about and watching these management teams.”

Taerk points to U.S. markets, where legal recreational marijuana had a head start. Companies there dealt with commoditization by introducing higher value-added products, such as oils and edibles.

“You’ve got to get your costs of growing down in order to have the same costs as everybody else, and then your differentiation is going to be what you do with your plant—whether you extract oil or mak[e] other derivative products,” he says.

Read: Why this advisor is bullish on next year’s pot framework

The federal government is still developing its framework for those products, which aren’t expected to hit the market for another year after legalization, or around July 1, 2019. But in the longer run, Bottomley says, it will be important to invest in companies producing these higher-margin products that are likely to be popular with recreational consumers.

Taerk says his fund is more focused on medical producers, since there are fewer unknowns around cost and distribution. Medical producers can focus on marketing to doctors and pharmacies without the uncertainty and restrictions of the recreational side.

“Margins are understood and you know what your goals are, and you know what your costs need to be to be profitable,” he says.

TMX, CSA have conflicting view of U.S. risks

Another risk was highlighted last week when TMX Group warned that companies with business activities that violate U.S. federal law on marijuana could face a delisting review at the TSX.

The firm said in its Oct. 16 release that U.S. federal law takes precedence over state laws. Though the Obama administration’s Cole Memorandum suggested the U.S. government wouldn’t intervene in states where marijuana is legal, the Trump administration may not take the same approach. Therefore, the group said issuers with marijuana-related activities were at risk of being prosecuted and having their assets seized.

On the same day, the Canadian Securities Administrators (CSA) issued a notice saying only that marijuana companies must tell investors about the risks when investing in the U.S.

The smaller Canadian Securities Exchange says it won’t review marijuana companies with U.S. links as long as they follow disclosure requirements and comply with appropriate state law.

Stocks took a hit following the TMX announcement, particularly Aphria, a high-profile Canadian company with U.S. operations that trades on the TSX.

“The TSX staff notice is extremely broad in its application, and it is difficult to determine what, if any, impact it could have on Aphria or its business at this time,” Vic Neufeld, chief executive at Aphria, said in a statement on Tuesday.

Taerk, whose UIT Alternative Health Fund includes Aphria, said U.S. companies aren’t a primary focus.

“With respect to those Canadians that have U.S. interests, we would maintain appropriate weightings in the fund and continue to monitor the situation,” he said in an email.