In an interview conducted yesterday by Midas Letter Founder James West, Aphria Inc (TSE:APH) (OTCMKTS:APHQF) (FRA:10E) CEO Vic Neufeld cautioned investors of the challenging circumstances facing smaller licensed producers (LPs) in the coming months. Should Mr. Neufeld’s words prove correct, the trajectory of the industry will irrevocably shift—along with the opportunities presented to the victors.

The money comments appear in the back half of the interview, where Mr. Neufeld spells it out in black & white.

The Aphria front man first insinuates that cannabis supply deficits will become an issue, stemming from smaller licensed producers failure to deliver on promised crop outputs.

“There’s been a lot of press releases by many, many licensed producers about their abilities to grow; they’re funded, this is their plan, they’re building but now grow it… I can tell you that in January, in that window of time we will be there to really service the under-performance of whatever LPs have failed to live up to their commitments, province by province.”

This ramifications of Mr. Neufeld’s would-be prescient forecasting are twofold.

First, the potential supply glut some are predicting upon legalization will likely not materialize—at least not initially. Although there’s enough funded capacity to serve Canadian appetites and beyond, many smaller LPs will likely underperform due to technical setbacks, greenhouse downtime, and crop failures stemming from operational inexperience.

Vic Neufeld’s forecast is backed up by a newly-issued BMO Capital Markets research report, which opined: “We believe the majority of LPs, many of which are still developing their facilities or waiting for licenses, will not have the inventory or production capacity to meaningfully supply the initial recreational market.”

Quite simply, many new entrants underestimate how highly sophisticated cannabis cultivation process is. Climate control, irrigation, lighting and air filtration systems all much work lock-step with each other in order to produce sufficient yields. Certain cannabis strains are also notorious for requiring specific soil requirements. The chances of smaller LPs missing on many or all of these requirements is elevated at outset.

Secondly, Aphria may be positioned to scoop up additional market share where none previously existed. Should many small LPs fail to honor existing supply agreements, Aphria will have the capacity to fill that void by next spring. According to Vic Neufeld, Aphria should be “kicking out 20,000 kilos a month” by May 2019, or about half the projected total Canadian recreational demand in 2019, according to BMO.

The bottom line: whatever supply agreements Aphria has signed right now, the company is well-positioned to acquire additional market share as other LPs fail to deliver in 2019. This dynamic also extends to the international arena, granting Canadian LPs with hard-to-achieve GMP certified status a significant opportunity to boost international influence. Only a select few will reach this important threshold.

Price Compression Warning

If imminent supply challenges aren’t daunting enough for smaller LPs to consider, the coming price compression surely will be. Should this play out, it may trigger substantial consolidation within the industry, as margin constriction thins out the herd and forces shotgun marriages within the sector (or reorganization). According to Vic Neufeld:

“So June, July, August of 2019; it’s our belief that some, not all but some of these LPs and their aggressive sound bites on press releases, there will be some more capacity coming on board… The strong will survive but the weak will not. Between now and then, forced consolidation by way of just survival mode. The price compression will begin by about the fall of 2019 in our opinion.”

In other words, once a critical mass of growers ‘figure things out’ and execute harvests with greater precision, the market should flip to an oversupply condition sometime in late 2019. Once this happens, vendors will start asking for price concessions, driving down margins and profits for companies not growing in sufficient quantity.

The key cutoff number appears to be $1.00/gram all-in costs; any grower not able to meet that benchmark—unless it is niche organic or specialty grower—will unlikely thrive in an increasingly competitive landscape.

Vic Neufeld believes Aphria will get below $0.80 all-in cash costs per gram—much of that achieved through highly-automated production facilities which can slash unit labor costs by half. For the smaller LPs harvesting through traditional growing methods, that number may be impossible to obtain.

Again, the major LP’s will be a major benefactor in such a scenario. It means Aphria, Canopy Growth, Aurora and the other majors will likely be afforded the opportunity to pick up quality distressed assets at nickles on the dollar. It may force a consolidation wave at prices favorable to acquirer shareholders. It will also allow Big Cannabis to consolidate market share where smaller LPs drop off.

Ultimately, scale and cost are king in the cannabis sector. For smaller LPs not getting the memo, time is running out to establish scale or niches which insulate them from the harsh economic realities of industrial farming.