My firm regularly advises clients in the cannabis space, providing services ranging from regulatory advice to due diligence for hedge funds looking to invest in the sector. Over the last several weeks, given the recent spike in valuations of cannabis stocks, I have seen an influx in the number of cannabis related inquiries.
My response to the recent run-up has been relatively straightforward. Based on the financial statements of most marijuana companies, the fact that most are in a position of negative to low cash flow and the fact that many of these companies have not shown any profitability, the recent valuations are the result of speculation and irrational exuberance — investor enthusiasm, not supported by fundamentals, which has driven price levels to unsustainable levels. This argument is supported by data that demonstrates short-sellers are significantly increasing positions in marijuana companies which, as The Globe and Mail recently highlighted, is reminiscent of the 2014 run-up in U.S. cannabis stocks that began with a mania for cannabis related companies but quickly resulted in a steep downward trend on the bets.
Despite the current valuations and the fact that the recent run-up may face a reversal on selling pressure, several of the Canadian cannabis stocks may be solid long-term investments as the companies are substantial.
The issue at this early stage is trying to accurately value these organizations. To that end, clients have approached me to assist in dissecting estimates, reports, and forecasts provided by financial institutions in an attempt to come to fair valuation range of players in the cannabis space, which leads me to the topic of this article, marijuana pricing in the recreational marijuana market.
While studying analyst reports and pricing inputs, I noted that several analysts are employing market prices in recreational forecasts estimated using the current average prices in the medical marijuana space. In general, analyst price targets for marijuana stocks and industry wide valuation are based on average price per gram numbers in the $7.50 range.
In the Jaswal Institute’s view, these inputs are potentially flawed for two reasons. First, financial institutions are assuming pure market-based rates in a recreational market that are not impacted by regulatory price intervention similar to the alcohol industry. Second, assuming market-based rates, analyst estimates have not incorporated sharp price declines similar to those experienced in legal recreational cannabis markets in the U.S. subsequent to the systems coming online. Though these steep price declines surprised some investors in the U.S. space, the plummeting marijuana prices had been long predicted by experienced drug policy analysts. Accordingly, it is our view that current analyst reports in the industry are fundamentally flawed as they have failed to account for regulatory price intervention and price trends in the recreational market.
It is the Jaswal Institute’s view that both regulatory price intervention and price trends in the recreational market will be, among other factors, primarily shaped by cannabis pricing by organised crime groups. Consequently, to fully understand the potential economics, valuations and pricing in the recreational marijuana market, it is essential to understand cannabis pricing by organized crime groups as pricing must be competitive enough to dissuade consumers from an established and well entrenched black market.
As stated in a November 2016 report by the Office of the Parliamentary Budget Officer titled Legalized Cannabis: Fiscal Considerations, “when the average legal price is less than or equal to the average illicit price, almost all consumption (98 per cent) is projected to shift to the legal market…. However, as the legal price increases above that of the illicit price, the market share of legal cannabis progressively decreases.” If prices are too high, users will remain loyal to a deeply rooted black market that has been operating for decades.
As highlighted in a heavily-redacted Public Safety Canada document obtained through an access to information request, in 2014, Criminal Intelligence Service Canada reported that there were 665 organized crime groups operating in Canada, with approximately 85% involved in the $45 billion illicit drug markets. Canada’s economic history with respect to cigarette tax hikes, which shaped a flourishing illicit tobacco market, has shown that Canadians are willing to embrace a black market on price sensitivity. Conversely, if prices are too low, we can anticipate significant tax base and profitability impacts on governments and companies in the recreational cannabis space. To that end, organized crime pricing becomes an extremely important influencer with respect to the viability of marijuana companies in Canada as it shapes the pre-tax price of legal cannabis in a recreational market.
To assess the price of illicit marijuana, we reviewed the Office of the Parliamentary Budget Officer’s November 2016 report titled Legalized Cannabis: Fiscal Considerations, and Public Safety Canada’s September 2016 report titled Cannabis Performance Metrics for Policy Consideration. The Office of the Parliamentary Budget Officer arrived at a regionally-weighted average price of $8.32 per gram and a purchase-quantity-weighted average price of $9.36 per gram, using the average of the two weighting approaches to arrive at an $8.84 per gram figure for the overall average price of illicit cannabis in Canada in 2015-16. With respect to the legal market, the Office of the Parliamentary Budget Officer estimated that the minimum pre-tax price of legal cannabis per gram would be $6.67, with a midpoint estimate of $7.50 in 2018. By 2021, it estimated that the minimum pre-tax price of legal cannabis per gram would fall to $5.83, with a midpoint estimate of $6.67.
However, when examining the results of Boucher, Lawrence, and Maslov presented in Public Safety Canada’s report, though an older study, the average illicit price of cannabis is found to be $7.54 per gram, which corresponds with a pattern of substantial decline in marijuana prices in other Western countries. The lower figure presented by Public Safety Canada could imply pre-tax legal cannabis price numbers closer to the $5.00 per gram range in the legal recreational marijuana market to effectively seize market share from, and compete with, the black market. Even if we assume illicit pricing at the higher end of estimates, given the high profit margins of organized crime groups, we anticipate voluntary reduction in pricing by these crime groups to compete with the legal market and protect market share. As stated by Mostafa Askari, the assistant parliamentary budget officer, with respect to the illicit market, “…their profit margins are very high, so they have room to compete with the legal market....” If we begin to approach the lower bound of recreational estimates, the economic viability of cannabis companies is brought into question. As stated by Bruce Linton, CEO of Canopy Growth, in a recent news interview, Canopy tried pricing medical cannabis at $5.00 per gram, but found that though it was a great way to introduce and bring patients on, “it’s not a sustainable price at which you can run a business.”
When analysing the research and data presented above, there is an argument that current analyst valuation targets in the cannabis space are fundamentally flawed due to the assumed pricing of dried cannabis. Further, there is an argument that a recreational model, based on the existing medical model, which is assumed by most analysts in coming to their valuations, cannot succeed as a profitable enterprise. The conclusion is not that cannabis legalization will be a failed endeavour in terms of profitability, only that it must be formulated to adapt to factors such as organized crime pricing. By way of example, this could imply using dried cannabis as a loss leader to attract customers and stimulate sales in higher margin cannabis products such as oil-infused edibles, including chocolates, brownies, candies and soda, which would also create a larger tax base for governments. A key to this strategy however is that governments must allow these higher margin and value-added markets to develop via enacting regulations to allow companies to produce products currently offered on the black market. There are smarter licensed producers that have come to the realization that regulatory burdens and organized crime competition may inevitably price them out of the dried cannabis market and are thus preparing and lobbying for edibles regulation. It is not a secret that Canopy, which operates Tweed out of the iconic Hershey Chocolate factory in Smiths Falls, is looking to bring chocolate back to the factory through chocolate cannabis products and other edibles. In a previous article published by Lift we highlighted different ways that past, present, and future policy decisions influence and impact economic outcomes in the emerging cannabis marketplace. This article builds upon our previous analysis and highlights the need for governments and companies in the space to potentially shift strategies based on the existence of data that could suggest a flawed model.
- Johnny Jaswal
- Featured image via Wikipedia.
Johnny Jaswal, BEng, MBA, JD, is the Managing Director of the Jaswal Institute. The Jaswal Institute is a law firm that provides exceptional legal services, government relations services and a full range of related investment banking advisory services. If you require further information, please contact Johnny.