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Andrew Willis

Saturday, February 03, 2018

When friends learn that Oliver Babin, a 21-year-old business student, calls the shots on an $8-million stock portfolio, they usually have one question for him.

"Everyone wants to know what I think of marijuana stocks," said the fourth-year University of New Brunswick student, who is part of a nine-person team that runs an investment fund as part of their studies. Like many investors, some of Mr. Babin's buddies are caught up in pot-stock fever. Several of them, including those who occasionally enjoy a toke or two, made their first forays into the equity market by jumping into stocks such as Emerald Health Therapeutics Inc. last November, when its shares traded around $1.50; just three months later, the B.C.-based bud producer hit $9.

At that price, Emerald Health had a stock market value of more than $1-billion; it was valued at $657-million on Friday after cannabis stocks sold off sharply this week. That is quite something for a business that brings in less money than a well-run convenience store. The company's financial statements for the first nine months of last year show a mere $658,000 in revenue and a $4.8-million loss. Of course, that's not terribly surprising in an industry that recently saw a hot takeover battle for a company, Newstrike Resources Ltd., that has yet to sell a single gram. At one point last month, Newstrike enjoyed a market capitalization of more than $1.1-billion (it's now $390-million).

It has all the hallmarks of a mania, a bubble that is perhaps in the middle of bursting after marijuana company shares melted down this week. That's why, even on a cannabis-friendly university campus, Mr. Babin and his colleagues at UNB are just saying no to marijuana stocks. The student-run fund has never owned any pot plays and has no plans to do so. Mr. Babin said "the price on these cannabis companies makes no sense. It's market trading on momentum, not value."

Fuelled by the prospect of federal legalization of recreational marijuana in July, Canadian cannabis stocks have had an extraordinary run. A sector that barely existed three years ago is now home to dozens of public companies with a combined market capitalization of almost $30-billion. Those numbers are partly a reflection of growing interest from individual investors and new exchangetraded funds that are pouring cash into cannabis, even as pension funds and many other institutional investors regard the sector as too speculative.

Small fortunes are being made. Investment bank Canaccord Genuity Group Inc., a major underwriter of marijuana stocks, runs an index of publicly traded cannabis producers. It was up 277 per cent in 2017 - versus a thin 6 per cent gain in the S&P/TSX benchmark.

And an industry is being created. Across Canada, abandoned factories and warehouses are being converted in grow-ops.

Greenhouses once filled with flowers or tomatoes are now pot plantations.

Celebrities are getting in on the action. Rapper Snoop Dogg endorses products from Canopy Growth Corp., the country's largest producer, while members of rock band the Tragically Hip have turned a $21-million paper profit on their stake in Newstrike after crafting a deal to develop brands named after their hit songs.

But the hype no longer matches reality. The simple principle of supply and demand is going to knock the stuffing out of cannabis stocks - a process that may have begun this week, with cannabis stocks down 17 per cent. Legalizing marijuana marks a cultural shift in Canada, but it's still a commodity that is subject to the laws of economics.

"None of these companies invented marijuana. Canada is just changing the supply chain for the industry," Mr. Babin said.

Demonstrating that he has paid attention in economics classes, the native of Rimouski, Que., said: "The cannabis market is in its early stages, with low barriers to entry and numerous competitors who haven't shown they have a sustainable competitive advantage."

While companies such as Canopy Growth have been public since 2014, the market has been hitting new highs since last fall. As recently as last November, a study by Echelon Wealth Partners Inc. revealed that Canada's publicly listed cannabis companies were trading at a multiple of approximately nine times their forecast 2019 earnings before interest, taxes, depreciation and amortization (EBITDA). Then, as marijuana stock prices soared, the sector began to trade at more than 22 times its forecast 2019 EBITDA. The recent selloff - part of a broader stock market downturn that saw companies perceived as higher-risk swoon - has brought that multiple down.

But only to 14 times.

Can the marijuana industry get large enough - and profitable enough - to justify that kind of valuation? Here's how the numbers shake out.

First, let's look at demand for cannabis: Statistics Canada published a study in January that estimated Canadians spent $5.7billion on marijuana in 2017, when the product was still illegal. The agency figured 4.7 million citizens smoked, vaped or baked hash brownies, consuming 773,000 kilograms of marijuana. Obviously, most of the supply came from black-market sources. Statscan pegs the average price at $7.43 a gram.

Once cannabis is legalized, a recent study by Deloitte says, an additional 17 per cent of adult Canadians will use marijuana.

When legalization kicks in this summer, Canadians will spend somewhere between $4.9-billion and $8.7-billion annually on cannabis, according to Deloitte.

At the lower end of the scale, that's the size of the market for vodka, rum and other spirits, while the high end is equal to what's spent on wine.

When Canadians can buy their cannabis in a store rather than from their neighbourhood dealer, a gram is initially expected to sell for $10, which includes taxes and a cut for retailers.

That's a premium to the blackmarket price, which has experts predicting the illegal market will not disappear overnight.

Deloitte says it will take at least 600,000 kilograms of marijuana annually to satisfy demand from medical and recreational users in the legal market; at the high end of estimates, annual demand could be 900,000 kilograms. Using public-company disclosures, one investor we spoke to calculates that it will take seven million square feet of production capacity to grow that much cannabis.

So how is the supply side of the equation shaping up? There are approximately 60 public and private cannabis producers in Canada. They all highlight how much cannabis they plan to grow and the facilities they are building. Public documents show these companies have existing or planned facilities that will produce approximately 1.8 million kilograms of marijuana annually by 2020 - two to three times the expected domestic demand.

There is already approximately 14 million square feet of production capacity up and running, with another 10 million expected to come online over the next two years - more than three times the capacity required.

Here's one more set of numbers to put this industry into perspective. If, as expected, cannabis is sold for $10 a gram after legalization, the industry initially appears to offer attractive profit margins. Once governments and retailers take their cuts, however, producers can expect to get about $3.50 a gram. After other costs, it is estimated that a marijuana sector with, say, $5-billion in annual sales could reap a little more than $1-billion of pretax profit.

But will these margins last in an environment of too many greenhouses producing too much cannabis for too few consumers? In states such as Oregon and Colorado, which legalized cannabis several years ago, the price paid to producers is dropping steadily. Wholesale prices now range from US$2 to as little as 50 cents U.S. a gram, depending on quality.

Let's go back to school for a prediction on how this will all play out. At the University of British Columbia, Mitchell McCullough crunched numbers on cannabis stocks for the $9-million Portfolio Management Foundation fund run by third- and fourth-year students at the Sauder School of Business. Again, young people living in a pot-friendly culture opted to steer clear of cannabis stocks.

Mr. McCullough said his research revealed far too much uncertainty over how marijuana will be distributed, along with risks of a "supply shock as several large producers enter the market after legalization, driving prices down.

"Statistics Canada has been tracking marijuana prices for decades and, in eight of the past 11 years, prices have fallen," the UBC student said. He added that buying shares in a cannabis producer means owning one player in a complex and evolving chain of businesses. "My question is whether it will be the growers, the brands, the retailers or the consumers who have bargaining power in the industry."

It's not just business school students who question the soaring valuation of Canadian cannabis stocks. On Wednesday, hedge fund manager Anthony Bozza at Lakewood Capital Management LP wrote a letter to investors explaining that his $5-billion fund was short-selling Canopy Growth and Aurora Cannabis Inc., betting that the share prices of Canada's largest marijuana producers will fall.

The short seller's logic is that barriers to entry in the industry are low and new producers are sprouting up each day. Health Canada has handed 90 companies a licence to grow marijuana, and a report last week from Canaccord Genuity predicted the federal government will grant another 200 such designations "in the near term."

"Simply, we believe it is not a matter of if, but when these stock prices collapse ... otherwise we should all be moving to Canada and growing pot," wrote Mr. Bozza, who is based in New York.

Marijuana producers are all too aware that they need to do more than run grow-ops if they want to keep the stock market party going. Canaccord Genuity ran its second annual cannabis conference in Vancouver in late January, staging pitches from 28 companies - up from 11 the year before. More than 600 investors heard variations on the same theme: Companies planned to preserve or enhance their profit margins by moving into products such as cannabis oils and extracts, by establishing brands and by exporting to the U.S. and Europe. In a report, Canaccord Genuity analyst Neil Maruoka summed up the emphasis on adding value by writing: "This will be important as producers look to maintain or expand margins in the face of potential commoditization of cannabis."

Institutional investors are targeting companies that service the cannabis industry with proprietary technology as the best way to play the sector. Deloitte estimates this ancillary market will generate annual revenues of more than $4-billion. Steven Palmer, CEO of small cap fund manager AlphaNorth Asset Management, has met with executives from some 30 cannabisrelated companies. He ended up investing in a handful: One extracts oils, another makes marijuana beverages, and he has a stake in Evio Inc., which tests cannabis for pesticides.

"I have no investments in the growers. Every company has its spin, like proprietary strains or low-cost greenhouses. But funded capacity for the industry far exceeds demand," Mr. Palmer said. "I'm not convinced there will be an export market. I expect other countries are going to want to develop their own domestic industries."

The marijuana business is going through a cycle that's no different than what has played out in any emerging consumer product industry. Think of the history around cars or beer: There's a flood of startups when the sector gets rolling, then consolidation around a handful of the strongest players and a few small high-end brands.

At Brock University in St. Catharines, Ont., the student-run investment club is trying to pick one of those winning cannabis companies.

"We know the marijuana stocks are very speculative, but one of our members made a case for buying a well-run company that's likely to emerge as a market leader," said Ishan Patel, president of the Brock Finance and Investment Group and a fourth-year student at the Goodman School of Business. The club, which invests $20,000 of its own money and has 19 core members, held a vote Thursday on taking a stake in Aphria Inc., its first cannabis investment.

The student who pitched the Leamington, Ont.-based company highlighted the fact that Aphria is conservatively financed - it presells the marijuana it grows - and has a proven ability to acquire rivals.

As the students prepared to vote, Aphria's stock price dropped 14 per cent on news the company is selling its U.S. operations to comply with stillfuzzy regulations in that country. Late Thursday, the Brock group voted unanimously in favour of buying 10 Aphria shares at $16 each - they are still students, it's not a bet-thehouse investment. On Friday, Aphria dropped another 10 per cent, closing at $13.88. The students are prepared for a bumpy ride and set a $37 target price.

Mr. Patel said: "We believe there's enormous growth potential. But the sector is still hugely speculative. We know we have to be careful." High on supply When marijuana is fully legalized, annual demand will range from 600,000 to 900,000 kilograms, according to industry estimates. But Canada's producers have existing or planned facilities that will produce roughly 1.8 million kilograms of cannabis annually by 2020, suggesting a huge supply glut is in store.

Associated Graphic

PHOTO ILLUSTRATION BY CHRIS WHITE/THE GLOBE AND MAIL

Members of the Tragically Hip pose with marijuana plants at a Newstrike facility in Brantford, Ont. Band members have turned a $21-million paper profit on Newstrike.

DAVID BASTEDO

MedReleaf employees in special work suits trim cannabis plants on Friday in one of the company's facilities in Markham, Ont.

CHRISTOPHER KATSAROV/THE GLOBE AND MAIL

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