The marijuana market

Who’d have thought, in around 1972 when some of your school acquaintances may have been getting busted, that in 2018 we’d be talking about the outlook for EBITDA among producers and sellers of legal marijuana.

Even those who later ventured into financial services and accounting probably didn’t think they’d see the day when they were analyzing pot stocks and projecting earnings before interest taxes, depreciation and amortization.

(Just the word amortization might have made them giggle.)

But here we are, decades later, with Canada’s Liberal government aiming for legalization this summer, with a strong outlook for a new marijuana industry.

Just consider the fact that a recent report from CIBC World Markets came under the subject of “consumer staples” as it studied everything from producers and retailers to prices and tax revenues.

And the conclusion, from CIBC analyst John Zamparo, is that Canada is looking at “a legitimate industry” ripe for the taking.

“We believe that, by 2020, the legal market for adult-use cannabis will approach $6.5-billion in retail sales,” Mr. Zamparo said.

“For context, this is greater than the amount of spirits sold in this country, and approaches wine in scale,” he added.

“We believe the provinces will be the greatest winners from legalization, but the shift from the black market will be a boon to private enterprise, as well. As part of the shadow economy becomes legitimate business, we estimate private firms will generate nearly $1-billion in EBITDA.”

Some of Mr. Zamparo’s findings:

THE BUZZ

Production should represent more than 85 per cent of that EBITDA by 2020, with the rest “coming from retailing — largely in western Canada.”

While provincial governments “may claim otherwise, they are the big winners of legalization, with income estimated at more than $3-billion either in profits or tax take.

Consistent with the development of other transformational industries in history, we believe that while many players currently exist, only a select few will become industry titans.”

THE DEMAND

Citing Statistics Canada data, CIBC noted that almost five million Canadians spent more than $5.5-billion on medical and non-medical marijuana last year.

Consumption is believed to have increased by 5 per cent a year since the early 1960s, eclipsing “population growth by nearly 400 basis points.”

The legal market will top 800,000 kg., worth $6.8-billion by 2020, 95 per cent of it for adult recreational use.

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THE PRICE

To start with, prices are now at their lowest since 1981, Mr. Zamparo said.

Expect the provinces to be “bold,” looking at a 55-per-cent markup, or a 35-per-cent margin, to what they pay to producers.

Some other math: Retailers could see gross margins of about 30 per cent at an average $8 a gram. Add in harmonized sales taxes, assumed at 13 per cent, and excise tax of $1, and you’re looking at slightly more than $10 a gram. (Talk about the man.)

THE MAN

“The provinces will hold all the cards when it comes to distribution,” Mr. Zamparo said.

“This ostensibly is to safeguard product quality and security, which are reasonable enough goals,” he added.

“But it also provides the benefit of ensuring a significant level of profits flow to the provinces. In fact, we estimate that provincial governments will capture a stunning 70 per cent of industry profits.”

Mr. Zamparo calculated that a legal pot market of about $6.5-billion a year would bring the federal government its maximum take of $100-million, with provincial governments grabbing “a stunning $700-million from excise taxes alone.”

Add in sales taxes, assumed at 13 per cent, and Ottawa is looking at $300-million more, and the provinces and at an additional $500-million.

THE GROWERS

Producers will break down along the lines of “haves” and “have-nots,” and “those with product ready to go, production capacity already built, and supply arrangements in hand can jump out to a sizable lead, in our opinion.”

Capacity among existing producers is now about 350,000 kg. a year, with the country’s six biggest companies controlling more than 90 per cent.

“This is more than enough to supply the current medical demand, but it’s also nowhere near enough to supply an adult-use market.”

But, when you look further out, we could be looking at more than 1 million kg., which is more than will be needed.

“In fact, even if the market share of illicit dealers goes to zero, the current plans in place will vastly exceed demand,” Mr. Zamparo said.

“This suggests two critical questions that investors must ask,” he added.

“First, when assessing [licenced producers’] plans, how quickly will current expansion arrangements be executed? And, second, will investors still fund future development proposals once sufficient capacity exists and distribution channels are already filled?”

It’s “reasonable” to assume licenced producers could see a 60-per-cent gross margin, or a product markup of 140 per cent.

THE SELLERS

Some retailers could choose to link up with producers — did anyone think back then they’d be discussing vertical integration — though that may be hampered by the regulatory regime.

“Retailers will have materially less profit available to them than in a vertically integrated world, as the provinces can essentially set a ceiling on the retailers’ EBITDA margins through the wholesale model in which cost-of-goods pricing is regulated,” Mr. Zamparo said.

“That said, stores are relatively inexpensive to build, licences are in limited supply, and manageable operating costs still make this an attractive business to be in, with potential after-tax returns on capital of 20 per cent.”

THE HIGHS AND LOWS

This bit’s from analysts Matt Bottomley and Neil Maruoka of Canaccord Genuity, which built its own index to track the fortunes of publicly listed companies:

Valuations among those companies “took a slight dip” in April, down 6.3 per cent after a so-so March. That brought the loss from an early January high to more than 28 per cent.

“During April, many licenced producers reported quarterly earnings (with varied results) and operational updates that highlighted continued penetration into Canada’s medical market and progression on what appears to be a growing number of expansion plans throughout the country,” Mr. Bottomley and Mr. Maruoka said.

“However, to kick off the month of May, speculation surrounding potential M&A activity and consolidation in advance of recreational legalization has resulted in upward momentum to industry valuations, particularly for licenced producers with moderate capacity and relatively cheaper valuations that could be considered attractive to larger cap producers.”

Indeed, added CIBC’s Mr. Zamparo, merger and acquisition activity “will likely continue at a frenetic pace, as producers flush with cash look to quickly increase capacity or to acquire medical expertise, distribution channels or international exposure.”

Mr. Bottomley and Mr. Maruoka believe that “sector multiple expansion” could pick up soon given expected developments, including legislative approval, and the potential for more consolidation.​