Paradigm Capital: Here’s the hidden story in the recent Canopy Growth, Aurora Cannabis and Aphria earnings

Released this week, the third quarter results from Canopy Growth Corp (Canopy Growth Corp Stock Quote, Chart TSX:WEED) reveal it is the third multi-billion dollar Canadian LP to reflect sales into the adult-use market, says Paradigm Capital analyst Rahul Sarugaser.

This, the analyst says, is important to parse, because his thesis is that companies which target clinical uses will have a clear margin advantage of those he says are pursuing “adult use” cannabis, or products consumed for recreational purposes. The pharma buy-in, he says, is a gateway to a (US) two-trillion dollar global market.

With three large LPs now separating this data, the analyst says the evidence is becoming clearer.

“With an average COGS of $6.41/g*, contribution margins per gram for Canadian adult-use, Canadian medical, and international medical were $0.55/g, $3.36/g, and $6.87/g, driving contribution total margins of $4.6M, $5.5M, and $1.3M from each,” Sarugaser says. “In our review of the eight largest LPs’ Q3/18 earnings, we highlighted that medical oriented companies would drive better EBITDA margins over the short-term. This market dynamic, first seen in Aphria’s (APHA) results, then in Aurora’s (ACB) results, continues to be playing out: medical cannabis commands better economics from direct sales, resulting in medical driving higher margins than the economics of adult-use—effectively wholesale—cannabis.”

Sarugaser says early signs in the earnings from Canopy, Aurora Cannabis (Aurora Cannabis Stock Quote, Chart TSX:ACB) and Aphria (Aphria Stock Quote, Chart: APHA) point to the emergence of a trend he thinks will become more defined with time.

“While sales of adult-use cannabis are expected to outpace those of medical, we have not yet seen the economics play out in favour of the adult-use market,” he notes. “In WEED’s results, we see a clear contribution margin advantage of medical over adult-use cannabis. Furthermore, WEED continues to focus on IP development, and evidence based research to drive both its differentiated recreational products (e.g., beverages) and its clinically oriented drugs (e.g., phase 2b trial in insomnia). Therefore, this provides further evidence for our thesis that companies that pursue robust medical and clinical cannabis strategies will distinguish themselves not only in clinical applications of cannabis, but also in emerging adult-use cannabis markets.”

Sarugaser says while looking at the LPs through this lens it is important to define the cannabis nomenclature.

“Medical cannabis we describe as cannabis products produced and consumed for medical use. Canada’s medical cannabis system—the ACMPR—allows patients with a broad spectrum of conditions to access cannabis so long as a medical doctor signs off. While physician-provided guidance toward specific cannabis formats and doses are frequently vague or absent, quality control and consistency among these cannabis products remain highly valued,” the analyst says. “Clinical cannabis we describe as those cannabis derived or cannabinoid-containing products that are developed to address specific clinical indications. Clinical cannabis is evaluated for safety and efficacy using the same mechanism as Pharma: the randomized controlled clinical trial. Clinical cannabis products, therefore, are the most rigorously understood, most regulated, and most physician friendly cannabis products of all. These, we posit, represent the sustainable future of cannabis medicines.”