Are Canadian cannabis stocks a good investment opportunity?

Canadian cannabis stocks are way down and have been on the retreat for the better part of a year. Does that make them a good buy at these levels or stocks to still stay away from? Part of the answer will depend on how the overall pot market plays out over the next number of years, and on that front, there’s still a lot of growth and expansion to come, says ATB Capital Markets analyst Frederico Gomes who released a market forecast on Tuesday, saying the Canadian cannabis industry is still a compelling investment story,

Gomes’ updated forecast includes the most recent sales data and ultimately shows little change from his report of six months prior. All told, Gomes projects recreational cannabis sales of $4.8 billion in 2022, $7.9 billion in 2025, and $12.2 billion in 2030, compared to the previous ATB estimates of $4.9 billion, $8 billion, and $12.3 billion, respectively.

Meanwhile, Gomes also forecasts the industry to experience a compound annual growth rate of approximately 13.4 per cent from 2021 to 2030, mostly driven by a higher percentage of cannabis prevalence in Canada to reach a total addressable consumer population of 10.1 million in 2030, up from 6.5 million in 2021.

Along the way, Gomes forecasts the average annual spending per person in the industry to increase from $1,170/person in 2021 to $1,371/person in 2030.

“Our thesis is that the Canadian cannabis market presents a compelling long-term growth opportunity for select LPs and retailers,” Gomes said. “While the industry continues to struggle due to fragmentation and price, operational efficiency can successfully navigate this environment.”

In assessing the market, Gomes points to three key drivers, including the average spend per person.

Gomes also considers addressable population growth, which Gomes calculated by multiplying Canada’s total population by the percentage of inhabitants over the legal age for cannabis consumption, as well as factoring in cannabis prevalence among legal age consumers.

Gomes forecasts Canada’s total population to grow to approximately 41.9 million by 2030 with 80 per cent of the population being over legal age, while prevalence is currently higher among younger cohorts at 36 per cent prevalence in the 18-24 age group.

“We assume that prevalence will gradually increase from 20 per cent in 2020 to 30 per cent in 2030e, driven by increased social acceptance, the aging of younger generations, and new product introduction (e.g., cannabinoid-based health & wellness products),” Gomes said.

The final consideration for Gomes in his analysis is the idea of the dwindling illicit market following the legalization of cannabis, which ATB estimated as accounting for 40 per cent of Canadian cannabis sales in 2021. That figure is down from the 50 per cent reported in 2020, with Gomes projecting that number to drop to five per cent by 2030.

“We believe that sales conversion from the illicit market will be driven by expanded legal market access through an improved retail infrastructure (e.g. new brick-and-mortar stores, e-commerce expansion), lower legal market pricing, and the launching of new cannabis-derived products unavailable to the illicit market,” Gomes said.

Recreational cannabis sales are projected to account for just over half the revenue mix for the Canadian cannabis market at $3.9 billion in 2021, but with more acceptance and the gradual eradication of the illicit market, Gomes forecasts recreational sales to account for 90.4 per cent by 2030. Meanwhile, medical cannabis sales remain constant throughout the decade at approximately $600 million per year.

Gomes pays particular attention to companies in referencing the significance of the market on licensed producers and retailers: Toronto-based independent retailer Fire and Flower (Fire and Flower Stock Quote, Chart, News TSX:FAF) and Calgary-based producer High Tide Inc. (High Tide Stock Quote, Charts, News, Analysts, Financials TSXV:HITI).

In his December 14 analysis coinciding with the company’s third quarter financial results being released, Gomes viewed Fire and Flower in a positive light with an “Outperform” rating, paired with a target price of $15/share and a projected one-year return of 158 per cent at the time of his latest update on the company (December 14).

At the time, Gomes pointed to the company’s success with its recent Hifyre acquisition, which carries a 100 per cent gross margin as a digital asset, along with its partnership with the Alimentation Couche-Tard chain of convenience stores as reasons for optimism around the company.

“We view FAF as one of the long-term winners in the Canadian retail space due to their partnership with Alimentation Couche-Tard, digital capabilities, and strong capital position,” Gomes said.

Meanwhile, in his October 20 analysis, Gomes noted that High Tide had pivoted its Canna Cabana stores to a discount club retail model, a move intended to allow High Tide to compete with other Canadian value brands.

At the time, Gomes noted that the company’s strategic shift may result in higher market share, customer loyalty, and brand equity to produce a wider competitive moat in cannabis retail, though Gomes also noted the potential for operational challenges and uncertainties. Gomes gave HITI an “Outperform” rating in his October 20 report and $13.25 target for a projected return at the time of 79 per cent.

“For LPs, our thesis is that the Canadian market offers a large upside to the valuations of mid- and small-caps that execute well,” Gomes said. “For retailers, despite a congested setting (store saturation + deep discount competition), our thesis is that larger chains, such as High Tide and Fire & Flower, will ultimately benefit as mom-and-pops exit the market due to their scarce access to capital.”