The Hydropothecary Corporation (Hydropothecary Stock Quote, Chart, News: TSXV:THCX) has announced a commercial agreement with the Société des alcools du Québec to supply an estimated 200,000 kg of cannabis over five years. The largest deal to date in the pot sector, the agreement warrants a rerating of THCX, says Robert Fagan, analyst with GMP Securities, who on Thursday reiterated his “Buy” recommendation with an increased target price of $8.50 for THCX.

The terms of the agreement will see Gatineau-based Hydropothecary Corporation supplying 20,000 kg of cannabis products in year one, 35,000 kg in year two and 45,000 kg in year three, with the volumes in the final two years to be decided upon at a later date.

The SAQ deal is a big step for THCX, says Sébastien St-Louis, co-founder and CEO of Hydropothecary. “Becoming the preferred supplier to the Quebec market out of the gate post legalization is a source of great pride and a vote of confidence in our ability to scale operations to meet our supply commitment,” St-Louis says in a press release. “This agreement marks an important step in the execution of our growth strategy, which is focused initially on the Quebec market by expanding our Gatineau facilities and hiring new employees, and then establishing our presence in other Canadian markets.”

Fagan says the deal gives a high degree of visibility to Hydropothecary in the run-up to recreational cannabis legalization.

“We view yesterday’s SAQ announcement quite positively as; 1) it equates to the company securing a ~10 per cent share of our Canadian recreational market size estimates for the first few years of legal sales, 2) it provides a strong endorsement of THCX’s ability to deliver high quality products at scale, and 3) it demonstrates solid execution by management against their strategic plan,” says the analyst in a research update to clients on Thursday.

“Management is targeting total costs to decrease to the ~$2.00/gram level over the longer term driven by scale benefits as volumes increase. Under the SAQ pricing, this could generate quite favourable economics for THCX with potential EBITDA of ~$2.00/gram, representing a margin of ~50 per cent.” he says. “While our forecasts incorporate higher total costs to remain conservative ($4.28/gram year one, $2.85/gram year two), in our view such potential profitability levels are impressive and ahead of our longer term expectations of 30 per cent margins.”

Fagan says the deal’s estimates of the rate of transfer from the black market, namely, 35 per cent in year one, 45 per cent in year two and 55 per cent in year three, are in line with his own forecasts for the Canadian rec market. At the same time, the analyst admits that those estimates are on the conservative side, meaning that there could be potential upside to THCX’s supply volumes to the SAQ.

The analyst believes that Hydropothecary’s shares are trading at a 45 per cent discount to its peers, and thus, that THCX represents “one of our best ideas in the cannabis sector.”

Fagan has raised his target price by $0.75 to $8.50, representing a potential return on investment of 111.4 per cent at the time of publication.