Investors betting on marijuana stocks got some disappointing news out of Canada last week. Statistics Canada reported that Canadian marijuana retail sales declined by 7% in February compared to January.
On the surface, that decline may seem troubling, but it’s not actually as bad as it seems. There is plenty of demand for Canadian marijuana. Unfortunately, there is not nearly enough supply to meet that demand. As a result, Canadian producers are in high demand, a dynamic that bodes well for marijuana stocks.
Consolidation Ahead
The drop in Canadian retail sales in February underscores just how critical the marijuana supply issue is. Typically, as demand for a particular product grows naturally, supply grows alongside demand and the market stays balanced. In the case of marijuana, demand has and will not grow at a steady, natural pace. Canadian demand was constrained up until last year by a federal ban on recreational marijuana use. Now that that ban has been lifted, there is a boom in demand. Suppliers can’t keep pace.
The situation in Canada is a potential preview of the problems the marijuana industry will face if marijuana is ultimately legalized in the U.S. as well. Marijuana producers are frantically trying to beef up their production, but they are facing an uphill battle. In addition to limited capacity, Canadian marijuana stocks have limited access to U.S. capital. Most banks are unwilling to deal with the headache of investing in companies running operations that are still technically illegal in the U.S. at a federal level.
In a nutshell, there are dozens of small-time Canadian and U.S. marijuana companies putting their pedals to the medal to ramp up production. Unfortunately, companies with limited resources can only grow so fast organically. As a result, there has been a flurry of marijuana buyouts and partnerships. That trend will likely continue in the coming years.
Given the current supply-constrained environment, the biggest buyers could end up dominating the market in the long-term. In addition, the biggest buyout targets could command a hefty premium given the limited supply.
Likely Buyer: Canopy Growth
Canopy Growth (NYSE: CGC) has already been aggressively adding to its capacity. In late April, Canopy announced a $3.4 billion conditional buyout of U.S. marijuana producer Acreage Holdings (OTCMKTS:ACRGF). The deal is contingent upon U.S. federal marijuana legalization. Bank of America analyst Christopher Carey says investors can expect plenty more buyout deals ahead for marijuana stocks like Canopy.
“We think Canopy showed that there are many options for Canadian marijuana companies to create value, and with Canada supply chain constraints likely to sustain near-term, we see potential that more deals are announced, potentially in the US, in the coming months,” Carey says.
Canopy has $3 billion in cash on hand but only had to commit $300 million up-front for Acreage given the conditional nature of the deal. Canopy has become the leader in Canadian production. It will likely be aggressive in establishing a similar position in the U.S. market. CGC stock investors can expect Canopy to pursue similarly structured deals with other U.S. producers. If Canopy is aggressive, it can have its pick of the top U.S. producers, leaving competitors to pick up the scraps once marijuana is legalized in the U.S.
Potential Seller: Hexo
In addition to the best potential marijuana buyer, Hexo (NYSE: HEXO) could be the best buyout target. With a market cap of under $1.7 billion, Hexo is certainly large enough to make a difference without being too big to digest. Carey says Hexo is relatively low-risk as far as Canadian marijuana stocks go. HEXO stock should benefit from its five-year contract as the official supplier of the province of Quebec. It is also expanding its own capacity with smaller deals, including the recent $260 million acquisition of Newstrike Brands.
There are two key reasons why Hexo stock stands out as the best potential buyout target. First, Carey says HEXO stock is a rare value among marijuana stocks.
“We think Hexo is the most attractively valued stock in our coverage group based on our valuation framework of EV/sales (near-term delivery) and DCF (long-term value creation),” Carey says.
Carey says Hexo trades at a discounted valuation to its larger-cap peers due to its limited capacity for global expansion. However, this limited global growth trajectory is the second reason HEXO stock makes a great buyout target. If Canopy, Aurora Cannabis (NYSE: ACB) or even a U.S. tobacco company like British American Tobacco (NYSE: BTI) decides to make a big splash with a deal, they have the global presence to get the most value out of Hexo’s limited operation.
Takeaway For Marijuana Stocks
The Canadian sales drop highlights just how much of a mess the marijuana market is in these days. Too many suppliers have too little capacity and limited ability to grow organically. As a result, a wave of consolidation among marijuana stocks is inevitable. The long-term winners of this consolidation will be potential buyers like CGC stock and potential sellers like HEXO stock.
As of this writing, Wayne Duggan did not hold a position in any of the aforementioned securities.
