Supply and Demand under the Prospect of Legalization

Since the two articles of the Passover/Easter weekend: Barrons and our White Sheep article in Civilized, and followed by two well researched articles in New Cannabis Ventures, there has been much debate and forecasting regarding the potential for an over/under supply in Canada. The arguments put forward in the articles are similar and consistent: the actual capacity to sell adult-use cannabis in Canada is severely limited in the months leading to adult-use legalization.

The starting point with supply and demand analysis is that it is a two-sided coin. Most of the analysis so far largely ignores demand and has focused on supply. Let’s take a quick look at both.

Demand in Canada – Analysts: Deloitte, Canaccord, the RCMP and CAMH, all have slightly different numbers, but they estimate between $5 billion and $7 billion in licit and illicit consumer spending on cannabis. Under today’s ACMPR, approximately $300 million (@5%) of that is licit (and therefore, by definition, medical). So, we are talking about some $4.7-6.7 billion in illicit sales – 95% of the current consumer market. The demand quantification problem is that there is no research on what to expect from Canadian consumer behaviour: how many will “try-and-buy” legal cannabis in the first months? How many will wait for reviews? Will there be a sudden surge in users, who have not used in years, or ever, to give it a shot? How long will it take to alter behaviour – not necessarily the consuming behaviour – but just the purchase behaviour of those who represent the 95% illicit users?

Journalists and reporters seem to think there will be a gradual, prohibition-like move from illegal (uncertain source, potential legal issues, quality concerns) dope dealers, to the professional distribution of legitimate cannabis. But, we are not able to predict the response on Day 1 … or even Day 101. The proposed legalization of multiple forms of extracts and MIPs (marijuana infused products), in 2019 or later, will dramatically impact consumption and purchase behaviour. If the behaviour of US consumers is any indication, the transition to legitimate sources is not an overnight event, so we ought not expect the illicit channels to dry up overnight.

On the supply side, we have the “funded capacity” argument: There is so much capital in the bank accounts of cannabis producers that we will have too much cannabis. Stoic Advisory, a leading cannabis consultancy, reports a funded capacity of 1.4 million kgs. But, that is almost all deferred capacity as the money remains in the bank: Canopy sitting on $500 million+, TGOD sitting on $140 million +, MedReleaf, CannTrust, ABCann, Supreme, Cronos etc. … All the original (pre-2015) licensees are sitting on a great deal of accumulated cash. But this capital has not yet been fully invested in walls, lights and cameras, and more importantly, the capital and its resultant asset base has not been leveraged through the sale validation process.

Some professional and amateur analysts in Canada rely on this simple metric of funded capacity. And then they compare the published inventory levels and imagine the combined data tells them all they need to know. However, using inventory numbers is not remotely accurate. In our initial article published on the issues surrounding IFRS and inventory of biological assets, White Sheep’s Michael Miller and Steve Looi wrote about how IFRS requires recognition of the change of value in biological assets on the income statement, even before it is harvested (and trimmed, and dried and tested and released) – at predicted pricing levels. Our economists at White Sheep have examined the financial statements of the public companies and we can report that we believe there will be an impactful reconciliation for several companies when the released inventory is cleared out of the vaults in the months immediately following legalization.

Further, trying to compare the inventory levels from financial statements with those reported quarterly by Health Canada (“HC”) adds a whole different layer of unknowns, as articulated by Alan Brochstein. Health Canada’s inventory numbers are derived from the requirement to manage and control every gram of cannabis (as a controlled substance) in a facility. This includes: harvested but not dried, dried, tested and untested, and as critically, any trim that has been retained for extraction. This trim can be valuable as an input for extraction but would never be sold as dried cannabis. Proportionally, trim comprises a material quantity of any particular batch. With our experience running grow operations, White Sheep is able to roughly estimate what proportion of any batch or lot is trim. However, even with our experience, our estimates are inconclusive because we do not know which strain’s trim are retained, and which are disposed/destroyed[1]. Retain/destroy is a properly confidential business decision that impacts the real, sellable inventory on hand and is not disclosed in financial statements or HC reports.

The analysis becomes even more confusing on a provincial basis. As readers will be aware, each province manages its own distribution – through government stores, private stores or a hybrid of the two. We also see the provincial government channels managing their supply chain and establishing preferred suppliers.

What happens when there are no or few LPs with sales licenses in that province? Or only one? On our map of companies with sales licenses ( http://whitesheepcorp.com/sales-map /),

we can see that Nova Scotia and Newfoundland have no LPs that are able to sell. New Brunswick, PEI, Quebec and Manitoba have but one each, Alberta added two more (to make three) just on May 18, and Ontario and BC each have a dozen or more who are able to sell. How do provincial buying preferences play out? For instance, even though Canopy owns a building and property, in the absence of a cultivation license in New Brunswick, and despite the supply contract, will Canopy be permitted the same amount of shelf space as the province’s own Organigram? Will Aurora, with a supply contract but no facilities, be permitted to sell in parallel with Organigram? How will the suppliers manage their channels – will they abandon Saskatchewan in favour of margins and customers in Quebec?

One of the interesting marketing challenges to consider is how the licensees will handle the launch dates in each respective province. To be successful, the marketers at each company will need, just like Apple for its iPhone launches, to make sure there is adequate inventory in every single distribution outlet across the region on that province’s opening day. And like a restaurant buying their daily special: What quantity of cannabis, in what package sizes, should be put into each store at risk of shorting another store, or missing the mark on package size? That level of sophisticated demand analysis is far beyond the capabilities of almost every licensee. Which provinces in what package sizes will be shorted?

In conclusion, on the matter of supply shortage versus surplus, we have several time frames to consider: the first six months, the next 24 months, and after that. For the first six months after legalization, given the issues with compliance and receipt of sales licenses, we predict a shortage or deficit, that may end up being regional if provinces stick to their preferred local companies and disallow out-of-province big companies to step in. Within 24-36 months, we believe there will be a balancing of supply and demand, leading to a longer term oversupply and rationalization of large-scale versus craft producers. In the meantime, prices will likely drop to find the so-called “sweet-spot” where legal companies can make money, the illicit suppliers cannot balance risk against reduced margins, and the government is motivated to finally prosecute the illegal growers.

White Sheep believes that in the long term, there will be a Canadian production surplus, which surplus will be properly taken up by export markets in which Canadian companies lead: Australia, Africa, South America, the EU, and in which Canadian producers have a 24-month head start. Subsequently, there will be a commoditization of bud and extracts that will be segmented by quality (Bentley vs. Lada), and branded, end-user consumables that meet the needs of a diverse consumer market. I am fond of saying that there will be as many ways to consume cannabis as there are ways to consume dairy. Walk around your grocery store and take a look … that represents a lot of consumer choice and ways to consume cannabinoids. Over time, and with the new licensing opportunities for micro-grows, we are confident the early supply shortage will balance out within two-four years, but with a lot of public flaying of the governments, suppliers and big LPs in the meantime. Investors are to be mindful of the expected volatility, but recognize that in the long term, your target might be to invest in a company, not just a stock.