Here, we will try and contextualize the biggest dislocating factors
for the
Canadian market over the next six months, when we predict the information on which companies have missed their targets will start to become clear in their earnings reports. You can only use the IFRS biological asset trick so long before it becomes clear that you are wildly missing your projections. April 1st, 2019 could be looked at as "Confession Day", as companies start to hint that Q1 isn't living up to they hype or margins are suffering or something of a negative nature is occurring. Don't let the joke be on you next April Fool's Day. There is very little chance we predict everything perfectly but we tried to complie a reasonable list of what we are watching and why:
1. Where are the Dispensaries?
As we hinted at above, dispensaries are not going to magically appear with stocked shelves on October 17th. Due to rules around how transactions are processed, lines are sure to be long and there will be no lack of breathless coverage of the long lines at dispensaries. Retail investors will then get freaked out that they are missing the biggest opportunity since Dutch tulips and will buy any stock they can find. Expect the big Canadian equities to have some wild swings. The reality is that dispensaries are in a state of flux and most Canadians will have to travel pretty far to move from medical online sales to an in-face dispensary experience. It's obvious that with rules changing, local provincial law and municipality planning and zoning, opening dispensaries is not a 10-day process; it’s a multi-month adventure. Which leads to the next friction point.
2. Rules, Rules, Changing Rules
Changing rules, shifting requirements, and the ordinarily slow governmental responses to course correcting when rules make no sense are going to make it very difficult for smaller operators to react and compete with hugely capitalized entities who will throw huge gobs of money at every problem relating to governmental oversight or compliance. Look for those smaller companies to hit a wall five to seven months from now as the effect of big money “solutions” weighs on companies who cannot spend a tremendous amount to solve issues. California has seen the same thing as small companies have lagged in spending on compliance, licensing maintenance, and operational tools that can actually save them time, money and reduce risk because they don’t have time or money to explore these tools. We also think that Canadian regulators are likely to be far less forgiving with rule-breaking as scrutiny in Canada will be intense due to the enormous attention on the first G-7 country to legalize.
3. Canadians Know Diddly About Dispensaries
How many legally operating companies have ever operated a dispensary in Canada? Zero. How many have shipped products to a dispensary? Zero. How many have sold in any way other than to medical patients online? Zero. That is scary. Whether it’s shipping product to a retail location, or training staff at a dispensary they may own themselves, no company in Canada has a clue about the small friction points that come with operating a dispensary or selling through a dispensary. While operating phenomenal online sites, no Canadian grower has ever had to interact face-to-face with their consumers or compete for attention at a dispensary shelf. Patients who are on a current provider's website self-select where they get their medicine and are pretty easy consumers. Dispensary shoppers, particularly newer cannabis users, will take a long time browsing labels and looking for products they like. That means longer initial transactions, longer lines and the potential for operators to wildly miss their numbers in Q4 as the dynamic at the counter unfolds.
Imagine for a second that each dispensary consumer takes just two minutes longer for their transactions over the first two months. That could be the difference between seeing 1,000 consumers or 800. With an average spend around $100, that’s $20,000 in lost sales a day. In a place like Toronto which has large population concentration but will only have a few open retail locations on 10/17, 10 dispensaries missing $20K in sales is $200K per day or $6MM for the first 30 days. Nota Bene to those who have never been in a legal U.S. dispensary (b/c Canada has never had them); transactions often are very slow due to the required scanning of product and the fact that pre-packaged product must be retrieved from an inventory room. That takes time.
If you are behind a newer user asking a thousand questions, like one of Merida’s partners did at Lightshade in Colorado, it could feel like an eternity. We won't make a point of it, but it drove some of our more experienced partners a bit cray cray to listen to the hundred questions. Multiply this effect across a large base and the numbers could be significantly lighter until the dispensary business normalizes. If that takes 90 days, Q1 projections for Canada are going to miss by a mile and it won’t be because of a shortage.
4. Uncertainty in Dispensary Coverage=Delays in Ordering
As dispensaries grapple with regulations and the short time horizons to opening, they have to carefully consider whether they are even allowed to pre-order product under their certification license. It's not clear that every province has uniformity on this point and therefore dispensaries, along with the challenge of managing their local real estate, local licensing and provincial licensing must deal with federal code. That almost certainly means that the better prepared dispensary licensees can order a better supply of product and less prepared licensees will limp into the market with smaller supply of lesser products.
5. The Black Market Knows Dispensaries…Well
If you are searching for products on 10/17 and want to make sure you can access a plethora, the only sure bet you have is the black market dispensaries that have been functioning for a long, long time. Vancouver, Toronto and Quebec have dozens of dispensaries that are unlicensed and while there are strong economic disincentives at play, we don’t see these operators abandoning their clients at a time when they have a massive advantage over the legal market. The verbiage from authorities has been quite authoritative on this front but it's hard to imagine a scenario where there is adequate manpower to totally shut down dispensaries. In addition, these operators know much more about dispensary operations, having developed that muscle memory in the pre-10/17 world and would be well positioned to fill any gaps in product over the short term. That will definitely put a huge dent in projections of grandeur that originally came out about Canadian legal sales, especially if black market growers flood the market with cheap product like what occurred in California in late 2017.
6. Variety is the Spice of Life
Cannabis consumers love product variety. They love trying a few different products every time they walk into a dispensary. Walk into any California or Colorado dispensary and the first thing you notice is the colorful and varied packaging. Whatever is available on the shelves day 1-90 in Canada will pale in comparison to the “pop-up” illegal dispensaries and online retailers from whom Canadians have been buying for quite some time. It also doesn’t seem like the RCMP is that interested in stopping it.
"The RCMP's Federal Policing program focuses its resources and activities against the most significant criminal threats and risks facing Canadians."
That sounds a lot like, "we aren’t going to do a thing unless forced to." Low priorities for clamping down on the black market in Canada would be another example of the government not caring if cannabis companies are profitable. And so it's fair to assume that consumers are going to find the products they want and if they cannot get it legally, then they may seek it illegally. Which will be exacerbated by the fact that...
7. Product Categories are Limited
It's unfortunate that many of the product categories other than vape cartridges are not currently allowed in Canada. Canadians are going to want to buy everything they have been hearing about, and everything they can get on the black market. Edibles and stronger forms of concentrate (shatter, resin, wax and dabs) will not be allowed on the first day of adult-use. This will slow the adoption of adult-use buyers as they chase their preferred form of banned products which will only be available from non-legal sources.
8. Privacy
Online ordering is far more private than going to dispensaries. That alone will deter some consumers from engaging in the adult-use market. While this may not seem like a large driver of behavior, there are numerous consumer studies that show that behavior can be driven by how consumers believe they will be perceived in their purchases. We know from behavior in stricter medical markets that many patients will avoid cannabis partly because they must go into a dispensary to acquire it. Mail order or home delivery solves that. With long lines at every dispensary, it's not clear how much attention will be devoted to delivery of adult-use products electronically at first.
9. Product Competition Will be Intense
Consumers will be standing in front of a wide variety of products for the first time. They will likely buy a variety of products in order to see what they like. Rest assured there will always be a significant amount of experimentation but in the early days, this will be the biggest consumer behavior driver, leading to a period of several months where lesser products will still sell as consumers begin to figure out what they want. Long term, it's very important that investors stay vigilant not to judge a company’s prospects (positive or negative) based on the first 30/60/90 days of sales.
10. Price Competition Will Be Intense
With product competition comes price competition. Add taxes into the mix and it's likely that profit margins for everything but the highest demand products will suffer significantly and disappoint projections. We can learn a lot from the U.S. medical markets on consumer elasticity when it comes to pricing. Medical markets have lagged when prices are too high which means the taxes charged and the mark-up from dispensaries are likely to dent demand for mediocre products, which will need to be priced aggressively to sell. This is a highly under-analyzed component of the new Canadian market that could have profound effects on the smaller companies, which will find it hard to compete on the broad, high-volume product categories and must find profitable categories in which to specialize.
11. Online to Dispensary Shift
There was a funny, ironic tweet a week ago about Amazon eventually opening “distribution centers” on the outskirts of towns where consumers can pick up their orders. Some people thought it was serious and said it existed already. Clearly it was a joke; of course it exists - it's called Walmart or Target. Importantly, what this highlighted is that people who order online behave a certain way and like the ease and convenience of not having to drive to a store. While there is no doubt that demand will pick up with the recreational market launch, it's unclear if that increased demand will more than make up for medical sales declining. It's unclear how this shift could effect sales, and whether Canadian rules are reasonably created to address this enormous change. Did we mention that uncertainty puts stress on smaller companies but typically helps better funded, more diverse organizations.?
12. The Changing Consumer Paradigm
Lastly, and most importantly, shifts in consumer behavior in this marketplace are going to test the flexibility of companies. Large, well-capitalized businesses should be able to adapt to the new consumer paradigm, whatever it might be. It's not clear that smaller Canadian companies are prepared for these changes. The Canadian medical market has necessitated that companies develop certain skills. When new skills, products, or methods must be invested in and these companies find capital markets more constrained, it could prove to be difficult for companies to thrive, further stressing their capital positions. Smaller companies that have been conservative in their spending and approach will find themselves succeeding and picking up market share as their peers struggle. The really large companies with huge war chests? They are going to go shopping and the companies that acquire smart pieces complementing their existing businesses will do incredibly well.
We aren’t the only ones to think this. An analyst report that came out this week from VIII Capital and said as much. We have also spoken privately to other Canadian-focused bankers who have expressed similar sentiment over the last 3 months.
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October 17th is indeed a historic day for Canada and the world. Canada has made it possible for other countries to envision a legal framework under which cannabis can be regulated. Research will accelerate, helping the medical vertical along. Non-violent “criminals” who have done nothing more than possess cannabis will see their records expunged. Freedom to choose will have won out over regressive beliefs about this amazing plant, many of which are 100% untrue.
It is hard to truly appreciate how important that is. The most important consideration for investors should be to focus on the changing landscape in Canada and what we can learn from this seminal event. Over the next 90 days, we will begin to see how companies perform, and that should be a good indicator of the winners there as well as how that could effect the U.S market going forward.
