Cannabis 2.0 will lead to meaningful revenue growth and improved profitability for many of Canada’s cannabis companies.

That’s the takeaway from a new report on the sector from AltaCorp Capital analyst David Kideckel, who says that the launch of cannabis derivatives such as edibles, drinks, vapes and topicals marks an inflection point in the development of the Canadian market.

In a research report to clients on Wednesday, Kideckel reviewed the impact that the derivatives market will have on the fortunes of six cannabis stocks in the company’s coverage universe.

We are now a week away from the legalization of cannabis-extract products on October 17, which comes a year after the legalization of smokable weed.

And while it will be another couple of months before Canadians will see derivatives products at their local retailer —license holders will be required to provide Health Canada with a 60-day notice of intent to sell new cannabis products — the impact on the industry as a whole will be significant, says Kideckel, who argues that cannabis companies will eventually see their profits rise.

“We observe the net average selling price for dried flower is on a declining trend, specifically for the recreational segment,” writes Kideckel.

“Dried flower will become a commodity over the long-term…”

“As we highlighted in our thematic review of Canadian, US, and International cannabis markets, dried flower will become a commodity over the long-term. In our view, LPs who focus on developing creative products and building brand loyalty will be able to protect their margins. However, there may be a temporary dip in margins, mainly due to the ramp-up costs associated with the preparation for new product launches,” he writes.

The analyst says that the cannabis market has been dragged down at least in part by concerns over vaping-related illnesses which have surfaced both in the US and in Canada. But Kideckel says that because the illnesses have, by the evidence presented so far, been linked to black market sources, the ultimate impact will likely be positive for cannabis companies and their share prices, as consumers will likely turn in greater numbers to legal and regulated sources for their product.

“We believe that the market is factoring an extreme scenario of a ban on vape related products, which in our view is unlikely. We believe that the temporary concern over the safe usage of vapes will not have a meaningful impact on the long-term growth outlook of cannabis derivative sales and that the overall sector will rerate gradually as many cannabis companies are set to experience a significant improvement in their profitability over the next few quarters,” Kideckel says.

Starting with Organigram Holdings (Organigram Holdings Stock Quote, Chart, News TSX:OGI), Kideckel says that derivatives should improve OGI’s growth and margin outlook, as they will form 16 percent of OGI’s sales in fiscal 2020 and 30 per cent in fiscal 2021 (year ending August). The analyst says that while gross margins may be under pressure over the near term due to cost ramp-up, revenue from the company’s derivatives segment will likely be margin accretive over the long-term.

“We believe that the market is factoring an extreme scenario of a ban on vape related products, which in our view is unlikely..”

“We continue to have a bullish outlook on OGI, which is one of the premier names in the Canadian cannabis sector. Our optimistic view is mainly driven by its robust profitability, strong balance sheet, focus on branding through innovations, strong management team, and good governance, as well as their forward-thinking investment in Hyasynth,” he writes.

Kideckel rates OGI an “Outperform” with a target of $13.15, representing a projected return of 66 per cent at the time of publication.

Next is extraction company Valens GroWorks (Valens GroWorks Stock Quote, Chart, News TSX:VGW), whose demonstrated leadership in its white label segment will be a boon during Cannabis 2.0. Kideckel expects Valens’ adjusted EBITDA to grow at an annualized rate of ~88 per cent (CAGR) over the 2019-2022 three-year period.

“We believe Valens’ long-term outlook will depend on the execution of its white label strategy. Our belief in Valens’ success is driven by the Company’s emphasis on building out a differentiated product offering and a unique IP portfolio, as well as the increasing focus on securing white label contracts. We observe that Valens is currently trading at an attractive valuation relative to its peers. We believe valuation multiples will expand gradually, driven by the Company’s improving visibility as it executes additional white label contracts,” writes Kideckel.

The analyst rates Valens as “Outperform” with a target of $8.15, representing a projected return of 129 per cent at the time of publication.

Another extraction company, MediPharm Labs (MediPharm Labs Stock Quote, Chart, News TSX:LABS), should also do well through increased demand for its services in the white label segment, says Kideckel, who contends that LABS’ sales will materially increase over the first half of 2020 and its gross margins will expand for the 2020 year. Kideckel forecasts that LABS will achieve an adjusted EBITDA margin of 24 per cent in 2019, gradually increasing to 44 per cent in 2024, with its adjusted EBITDA margin to stabilize in the 40-42 per cent range from then onwards.

“We believe (MediPharm) is poised to benefit from the gradual shift from dried flower to cannabis extract products…

“We believe the Company is poised to benefit from the gradual shift from dried flower to cannabis extract products. LABS focuses on private label and white label services, as well as the production of APIs. In our view, these are attractive high-margin and high-growth product segments that expose the Company to a wide range of products and clients. Further, we believe LABS’ focus on these segments will allow it to differentiate itself and leverage its capabilities underpinned by technology, expertise, and scale,” writes Kideckel.

The analyst rates LABS as “Outperform” with a one-year target of $7.50, implying a return of 90.4 per cent at the time of publication.

The diverse asset mix held by cannabis streaming and cultivation company Auxly Cannabis Group (Auxly Cannabis Group Stock Quote, Chart News TSX:XLY) will be helpful in Cannabis 2.0, says Kideckel. Moreover, the strategic investment by Imperial Brands, announced earlier this year, will give Auxly access to the former’s vaping technology and R&D capabilities for the potential commercialization of cannabis derivatives in the future.

“We expect Cannabis 2.0 to be a game-changer for Auxly as we believe the company will experience a significant ramp-up in sales,” writes Kideckel. “We expect revenue of $240 million for 2020, and $411.5 million in 2021. As the Company increases sales, we forecast an expansion in gross margins, from 43 per cent in Q1/20 to 49 per cent by Q4/20, trending towards 51 per cent in 2021. We also forecast that the Company will generate positive adjusted EBITDA. For 2020, we expect an adjusted EBITDA margin of 19.9 per cent, expanding to up to ~30 per cent through 2025.”

The analyst rates XLY a “Speculative Buy” with a one-year target of $1.50, representing a projected return of 63 per cent at the time of publication.

Gatineau, Quebec’s HEXO Corp (HEXO Corp Stock Quote, Chart, News TSX:HEXO) has so far had a track record of developing innovative products and collaborative endeavours with the likes of Molson Coors Canada, both of which will help it with the opening of the derivatives market, says Kideckel.

“Currently, HEXO is developing various product formats including soft gel capsules, vapes, topicals, edibles, and beverages in order to be well-positioned for when these product categories come online. HEXO’s current products have been well received, winning multiple Canadian Cannabis awards, including 2018 Cannabis Product of the Year and Innovation of the Year with its Elixer CBD peppermint sublingual spray,” Kideckel writes.

The analyst estimates that cannabis derivatives will form 24 per cent of HEXO’s total revenue in fiscal 2020 and 34 per cent in fiscal 2021. He holds an “Outperform” rating on the stock with a target of $10.40, representing a projected return of 33.2 per cent at the time of publication.

“We expect Cannabis 2.0 and the execution of FAF’s store expansion plan to increase FAF’s sales to $160 million in 2020, up from $58 million in 2019..”

Lastly, cannabis retailer Fire & Flower (Fire & Flower Stock Quote, Chart, News TSX:FAF) will see its sales grow with the emergence of derivatives, Kideckel says, while the current rules restricting the packaging, labeling, branding and promotion of cannabis products effectively presents an opportunity for retailers to build a brand that will connect with customers and drive in-store traffic. The analyst thinks that customers will recognize FAF’s premium retail brand through the quality of experience its stores provide.

“We expect Cannabis 2.0 and the execution of FAF’s store expansion plan to increase FAF’s sales to $160 million in 2020, up from $58 million in 2019, Accordingly, we expect the Company will expand gross margins from 36.5 per cent in 2019 to 40 per cent in 2020, as FAF benefits from economies of scale and operational leverage. In our view, sales per store will increase as Cannabis 2.0 introduces to consumers a more diverse suite of products with different price points,” he writes.

Kideckel rates Fire and Flower a “Speculative Buy” with a target of $3.30, representing a projected return of 184 per cent at the time of publication.