Since Canada legalized recreational cannabis in October 2018, the world has been watching its progress. After a disappointing 2019, we think the Canadian market will remain challenged in 2020. More failures will likely be needed before the situation improves materially.

The “Top 10” Canadian LPs

While there have been more active cannabis companies in 2017 and 2018, many of them ceased to be relevant during 2019 leaving only 10 companies that are worth taking a look. Micro-cap companies with a market capitalization of less than $300 million are highly risky and not suitable for average investors. The Canadian cannabis market is smaller and could only support a handful of players in the long-run. Canada has a population of fewer than 40 million people and the demand for cannabis is estimated to be 600 tonnes annually, with the majority of them still via illegal supply channels. The domestic sector simply cannot support that many companies. That’s why we think the top 10 names are most likely the survivors in the long-run.

(Source: Public Information)

Large-Cap: Canopy (CGC), Aurora (ACB), Cronos (CRON), Tilray (TLRY), and Aphria (APHA) are what we believe to be the large-cap LPs in Canada. These five companies have access to the largest amount of capital and are building capacities that alone could supply the entire domestic market in Canada. Given the mainstream estimate of 600 tonnes for the domestic demand in Canada, Canopy alone could almost supply the entire country based on its estimated total designed capacity. However, what differentiates these companies from the rest is their global infrastructure and adjacent opportunities in beverage, pharma, and other applications of cannabis. It is also worth mentioning that all of these stocks are listed directly on a U.S. stock exchange.

Small-Cap: HEXO (HEXO), MediPharm (otcqx:MEDIF), OrganiGram (OGI), Village Farms (VFF), and Valens GroWorks (otcqb:VLNCF) are what we consider to be the small-cap names. These companies also have sizable production capacities and meaningful market share in their respective categories. However, they tend to be more regional-focused such as HEXO in Quebec and OrganiGram in the Maritimes. They also have access to adequate capital but these financings could be more expensive. Many of them don’t yet have direct U.S. listings and they tend to be viewed as more domestic-focused with less pronounced international expansion plans. However, extraction represents a unique and growing segment within the Canadian market.

Fallen Angels: CannTrust (CTST), Green Organic Dutchman (otcqx:TGODF), Emerald Health (otcqx:EMHTF) are some of the stocks that fell the most in 2019. As we analyzed in a recent weekly cannabis report, many Canadian companies were destroyed by corporate scandals and toxic financings.

Large-Cap Outlook

We believe Aphria and Canopy are the best large-cap stocks within the Canadian large-cap space, due to their balance sheet strength and large installed capacities. Meanwhile, we think Aurora Cannabis is the weakest player given its stretched balance sheet and large corporate overhead.

  • Canopy: Despite a disappointing 2019, we think Canopy will return to its focus on market share, cost control, and disciplined growth. The insertion of Constellation’s former CFO as the new CEO is a statement by the U.S. beverage giant. We think Canopy’s large cash balance, backing from Constellation, leading footprint in Canada, pending acquisition of Acreage (OTCQX:ACRGF), and international scale remain ahead of other peers. We think Canopy remains a viable option for investors to bet on the Canadian cannabis sector. To a certain degree, Canopy is also only one of the few available options to gain exposure to the global cannabis industry.
  • Aphria used to be one of the highly-regarded medical cannabis operators but its credibility took a beating after the Nuuvera and LATAM scandals. However, we think the new management team has done a good job of executing nicely while preserving balance sheet strength. Aphria has completed its Diamond facility which brought its total cultivation footprint to 2.4 million sq ft and 255,000 kg per year. After Aurora canceled its Sun and Nordic 2 facilities, Aphria has actually surpassed Aurora to become the second-largest producer by capacity only behind Canopy. We think Aphria will use its strong cash position and leading footprint to grab more market share in Canada and potentially make opportunistic acquisitions.
  • Aurora has emerged as one of the riskiest large-cap stocks due to its liquidity crisis. The Canadian market has entered oversupply in 2019 as we anticipated and Aurora was forced to cancel all expansion plans including three large-scale projects (Sun, Nordic 2, Exeter). However, the company already stretched its balance sheet to the maximum and it has racked up too much debt relative to its ability to afford. The company also incurred significant losses and negative operating cash flow and there is no clear path to profitability in the foreseeable future. We think Aurora could become the largest cannabis company to become distressed in 2020 and would steer clear of the stock assuming the status quo.

Small-Cap Stocks

As we have analyzed in “Guide To Small-Cap Cannabis Stocks In Canada“, we think the small-cap space is ripe for consolidation in 2020. We believe there will be only a small number of firms within the small-cap space that can survive in the long-run. MediPharm and Valens GroWorks are two names with the best growth outlook due to their focus on extraction which is a fast-growing segment within an otherwise challenging Canadian market. However, the rest of the group largely depends on the legal market which has seen numerous challenges since the initial legalization in October 2018. We also believe that the Canadian market could only support a handful of large-scale players on a sustainable basis which doesn’t bode well for the smaller LPs.

  • MediPharm is a stock we have covered since its beginning. We think the company will continue to benefit from a first-mover advantage in the extraction space. The opportunities lie in white-label and private-label and international expansion. MediPharm is also self-funding its operations with a strong EBITDA margin achieved to date. We also think the company has ample access to capital markets for additional financing to fund its expansion given its track record and profitability.
  • Valens GroWorks has emerged as another high-growth extraction play after it reported strong Q3 results. We think the stock is similar to MediPharm in terms of market focus but Valens is behind in terms of its white label business. It might be a good idea to spread your bets in the extraction space between the top 2 players.

Closing Remarks

The Canadian market remains an important part of the global cannabis opportunity set but we think 2020 will be another tough year for the sector. The legalization ran into numerous issues in 2019 and we are hopeful that 2020 will see some improvements with the launch of 2.0 products. However, the oversupply issue won’t be resolved overnight and the short-term pain is the only way to reach long-term equilibrium. We see more corporate failures, asset deals, and only a handful of players surviving in the long-term.

We remain of the view that large-caps represent better risk-reward at this point due to their staying power and competitive advantages. Generally, we don’t recommend large exposure to small-cap stocks given the challenging growth outlook in Canada and the tough financing market. However, extraction represents one segment of the small-cap space that is worth taking a look. We expect an upcoming shakeout period for the Canadian industry during which weak players will be either eliminated or combined with others. Especially the small/mid-cap space will see many companies struggle or even fail in the coming years and investors need to dig much deeper during due diligence to identify the most promising players. Overall, we think for average investors the U.S. cannabis sector holds much more potential for gains and the Canadian market is likely going to face persisting headwinds during this shakeout period.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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