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Pot stocks should rebound in 2020: Stifel GMP

Many licenced producers have not released their full suite of new products to retailers. (GETTY)

Clouds hanging over Canada’s cannabis industry could begin to part in 2020 as pricier products and more stores in sparsely-served Ontario translate to stronger quarterly results, according to analysts at Stifel GMP Research. The optimistic take on the legal pot sector departs from the prevailing gloom after a rash of stumbles in 2019. 

Only a handful of companies managed to report a profit last year as illegal dealers proved a tough opponent armed with much cheaper prices. The unlicenced pot scandal at CannTrust (TRST.TO)(CTST) cast widespread suspicion over the industry. Ontario, Canada’s largest province by population, ended the year with just 24 retail stores to serve more than 14 million residents. Meanwhile, legal producers grew enough cannabis to satisfy 81 per cent of total weed demand in Canada when their sales amounted to just 14 per cent of the market, according to one analysis.

The Horizons Marijuana Life Sciences ETF (HMMJ.TO) ended 2019 more than 37 per cent lower than it started the year. Steve Hawkins, president and CEO of Horizons ETFs, said it’s a “survival of the fittest” world for cannabis in a year-end release announcing the removal of seven companies from the HMMJ portfolio. 

Mackie Research analyst Greg McLeish said in a recent report that of the 52 publicly-traded cannabis companies the firm tracks, 13 of them have less than six months of cash left on their balance sheets.

For Stifel GMP analyst Justin Keywood, the cannabis reckoning of 2019 was largely the result of transitory factors within the nascent industry. 

“We believe licenced producers’ quarterly results should improve in 2020 (likely H1), which should bolster investor sentiment,” he wrote in a note to clients on Tuesday. 

The new wave of edible, vape, topical and beverage products beginning to trickle into the market underpin his optimism. So-called cannabis 2.0 items officially began to hit the market in mid-December, but the actual rollout has proven slow.

Many licenced producers have not released their full suite of new products to retailers. Canopy Growth (WEED.TO)(CGC), for example, is staggering deliveries to provincial wholesalers, beginning with chocolate and vapes in January followed by its distilled cannabis beverages in February. 

Retail cannabis sales increased at a pace of about 10 per cent month-over-month, according to data up to September. Keywood expects that momentum to continue. He also anticipates cannabis companies will see four to six months of accelerating sales to provincial wholesalers as retailers stock their shelves with new products that sell for significantly more than dried flower, and appeal to a broader range of consumers.

“Cannabis 2.0 effectively opens access to 50 per cent of consumer demand, potentially doubling the addressable market,” he wrote. 

“We estimate that vapes could be priced about 3.5 times higher than dry flower... while edibles could be even more attractive with about nine times higher average pricing than 1.0 products.”

Keywood believes the gross margin boost from edibles and vapes will be about 10 and 25 per cent, respectively.

ONTARIO RETAIL SLOWLY CATCHING UP

Frustration over Ontario’s lack of physical stores compared to other provinces has been a common refrain on quarterly earnings calls as executives attempt to explain weaker-than-expected results. 

“At the risk of oversimplifying, the inability of the Ontario government to license retail stores right off the bat has resulted in half of the expected market in Canada simply not existing,” Mark Zekulin, then-CEO of Canopy Growth, told analysts in November. 

Ontario’s approach to cannabis has suffered major growing pains. The province changed course from plans for a fully-government operated system to a public-private hybrid model. It initially capped the number of stores at 25 due to supply concerns, before abandoning its cap and lottery-based licence system in December.

That’s resulted in 24 stores open today, compared to roughly 300 in Alberta, a province with about one-third the population. The new open allocation system is expected to see 20 new stores opening per month beginning in April. 

“We see the changes as late but necessary to take share from the illegal market,” Keywood wrote. 

Fitting with the optimistic view on retail, Stifel GMP chose Fire & Flower Holdings (FAF.TO) as its top Canadian cannabis pick for 2020. 

The retail-focused company operates a network of about 30 cannabis stores, mainly clustered in Alberta and Saskatchewan, and plans to grow to 135 locations in 2021. 

Last July, convenience store giant Alimentation Couche-Tard (ATD-B.TO) announced plans to invest nearly $26 million for a 9.9 per cent ownership stake in the pot retailer, with the option of purchasing 50.1 per cent. 

Fire & Flower CEO Trevor Fencott said the relationship will help fuel the company’s “aggressive growth.” Keywood sees the company as an emerging player in Ontario, where it currently operates two stores.

“We expected a move to a more privatized model in Ontario and see FAF as being a large beneficiary with already 13 strategic lease locations in high traffic areas (mainly in Toronto) ready to go,” he wrote. 

“Fire & Flower could supply both its own stores and potentially many other retailers, leading to a very strategic position. We see the Ontario government favouring FAF for this functionality over other companies that do not have a similar operating history.”

Jeff Lagerquist is a senior reporter at Yahoo Finance Canada. Follow him on Twitter @jefflagerquist.

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