There has been a lot of hype concerning what has been dubbed Cannabis 2.0 in Canada, as the country legalized a variety of derivatives that are expected to boost revenue and earnings of companies successfully navigating the new waters.
The first thing to keep in mind concerning Cannabis 2.0 is that even though it went into effect in Canada in October, a required 60-day notice sent to Health Canada announcing intent of companies to sell the derivatives means they won't be allowed to start selling until the last couple of weeks of December. That means there won't be a lot of impact or feedback on the potential of derivative products until the end of the first calendar quarter of 2020.
Another thing to take into account is with the legalization of recreational pot in Canada in 2018, it only included legal sales of sprays, oils, and dried flower. With the launching of Cannabis 2.0, it includes vapes, edibles (like chocolates, cookies and gummies), and infused beverages like juices and beer, among other product lines.
Over time, this should produce a significant increase in revenue and earnings because of wider margins associated with these products.
A key thing to consider here is that the introduction of legal recreational pot sales in Canada appealed to long-term cannabis users. With the advent of new consumption options, it should attract new users that weren't comfortable with the way illegal pot had been consumed, even though it has been legalized.
While it'll take time to prove my thesis, I think edibles will probably be the largest contributor to the improved performance of Canadian cannabis companies, including the big three being covered in this article.
In this article we'll look at the three largest cannabis producers in Canada, and what to expect from them in regard to the potential impact on their top and bottom lines.
Aurora Cannabis (ACB)
As with most cannabis companies, Aurora Cannabis has been under enormous pressure since early 2019; that's especially true of companies competing in Canada, because of the low number or retail outlets to sell their product out of. That's changing, but it'll take time for enough stores to open to make a big difference in the performance of Aurora.
Consequently, the company has halted construction on a couple of its facilities until there are enough stores opened that can meet demand. The overall issue hasn't been too much supply, but not enough places to sell legal pot out of.
For that reason, the black market continues to thrive in Canada, and will until legal outlets provide more competition.
As Aurora starts to sell its line of derivatives, and the number of stores grow, it'll have a strong impact on revenue and earnings.
Concerning production capacity, it can quickly finish off its facilities and ramp up capacity to over 700,000 kilograms annually. Based upon its existing assets, it could do more than that if demand justifies it.
I believe as demand grows for derivatives, the market will want reliable and consistent sources of supply in order to have predictable product available at the retail level. Aurora will be one of the leaders in that regard.
Canopy Growth (CGC)
Canopy Growth has the potential to reach production capacity of a little over 500,000 kilograms annually, and so is well positioned to capture meaningful market share of the Canadian cannabis derivative market.
A concern with Canopy remains its lack of a permanent CEO, which to me has resulted in a lack of focus, which has produced weak results. For example, it made a poor decision in relationship to what types of CBD oils to sell, which didn't perform near to expectations in the latest quarter.
The big mistake made by Canopy in the first couple of quarters after recreational pot legalization in Canada was that consumers preferred to go with softgels and oils. The thinking was because many medical cannabis users preferred those means of consumption, so would recreational users. The company was wrong. Product returns and huge discounts on recreational oils has resulted in hot of over C$40 million over the last couple of reporting periods.
Assuming Canopy can get its act together, it does have the production capacity base to take some market share in derivatives, but it has to make decisions based upon much more accurate research and data in order to improve its performance.
The idea of it having a lot of cash to back it up is getting old; after all, how much has it helped its performance so far? Being able to survive longer than many of its peers is much different than growing and taking market share on a sustainable basis.
Aphria, the third-largest Canadian cannabis company as measured by production capacity, will be able to, with the combination of Aphria One, Broken Coast, and Aphria Diamond, produce up to 255,000 kilograms of cannabis annually.
With that capacity, it could generate up to $700 million of sales in fiscal 2020.
With most of its performance coming from non-operational sources, the company has yet to prove it can be profitable from cannabis sales alone. For that reason, it's not as strong as has been suggested in the financial media, and needs to show stronger operational results in the quarters ahead.
Aphria does have a strong balance sheet of cash and cash equivalents of about $464.3 million, which will allow it to not only survive, but potentially thrive if it's able to build out a solid distribution network over the next year.
There is no doubt Aurora Cannabis, Canopy Growth and Aphria will be able to generate a significant amount of cannabis supply going forward. The major issues will include the pace of the roll out of license retail stores, how quickly market demand for derivatives will grow, and the amount of black market share these companies will win.
On the positive side, I see many smaller companies dropping by the wayside in 2020, bringing more opportunity for these big three Canadian producers to grab more market share.
Assuming the black market starts to shrink, that will remove a lot of lower-cost recreational pot from the market as well.
For these reasons, I see the big three Canadian producers turning things around in 2020. What investors should take into account is this isn't going to happen in the first quarter, it's going to take at least to the second calendar quarter before we get a clear look at what is and isn't working with derivatives.
We also have to see how accurately the marketing teams of these companies identify what consumers want. Canopy Growth has proven you can miss big in a segment of the market that was expected to do very well for the company.
Last, I believe retailers will increasingly look to suppliers that can consistently deliver quality product on time. Aphria, Canopy Growth and Aurora Cannabis shouldn't have problems achieving those results.
Cannabis 2.0 has the potential to be a real game changer for these three companies. If they deliver the goods, by the end of 2020 it should find them all reaching sustainable profitability for long into the future.