Buy retail stocks over Canadian cannabis producers, ATB says

The industry is still finding its feet, now three years into legalized cannabis in Canada, and while licensed producers in the space remain challenged, investors should be looking at retail stocks. That’s the opinion of ATB Capital Markets, who on Tuesday published a research report arguing that valuations in the retail pot sector are looking attractive.

Prompted by the just-announced move by cannabis heavyweight Canopy Growth to sell off its retail assets, ATB analysts Frederico Gomes and Kenric S. Tyghe reported on the Canadian retail cannabis space, saying the pace of consolidation has been accelerating, as smaller shop owners are under pressure to exit the industry. That leaves more room for the bigger names whose capital positions are stronger and more able weather the strains of early industry development and regulatory ups and downs.

“In our view, retail consolidation … could serve as a catalyst for specific names in the sector (that is, those that have scale, access to capital, and can operate efficiently),” Gomes and Tyghe wrote.

Beleaguered industry bellwether Canopy Growth announced on Tuesday agreements to divest its retail business across Canada, which includes stores under the Tweed and Tokyo Smoke names. The move was in aid of righting the ship and reaching profitability as a cannabis brand and CPG business.

“We are taking the next critical step in advancing Canopy as a leading premium brand-focused CPG cannabis company while furthering the Company’s strategy of investing in product innovation and distribution to drive revenue growth in the Canadian recreational market,’’ said David Klein, CEO of Canopy Growth, in a press release.

Private retailer OEG Retail Cannabis, a licensee partner with Canopy that operates Tokyo Smoke store in Ontario, has agreed to acquire all of Canopy’s 23 stores save for those in Alberta. The announcement also said a master license agreement between Canopy and corner store giant Alimentation Couche-Tard related to the use of the Tweed brand in Ontario stores would be terminated. Canopy said it’s selling five of its Alberta retail locations to private company 420 Investments.

Looking at the announcement, Gomes and Tyghe said it likely leaves Tokyo Smoke with 66 stores in Ontario, the largest grouping in the province, with other banners Sessions, True North and ShinyBud following with 47, 43 and 38 stores, respectively.

Altogether, though, Ontario has issued a huge 1,616 cannabis retail licenses, and with the province having set a maximum store count of 75 per brand, that leaves a ton of room for consolidation, according to Gomes and Tyghe, whose coverage in the retail pot space includes High Tide (High Tide Stock Quote, Charts, News, Analysts, Financials TSXV:HITI), Nova Cannabis (Nova Cannabis Stock Quote, Charts, News, Analysts, Financials TSX:NOVC) and Fire & Flower (Fire & Flower Stock Quote, Charts, News, Analysts, Financials TSX:FAF).

“While the market remains competitive, retailers in our coverage have plenty of runway to expand in [Ontario] until they reach the 75-store cap; we estimate HITI has 34 licenses in Ontario, NOVC has 27, and FAF has 37,” the analysts said.

Turning to Alberta, Gomes and Tyghe called it the most mature market in Canada, estimating that High Tide has the largest store count at 72 locations, followed by Nova at 58 stores, Spiritleaf at 49 stores, Plantlife at 38 stores and Fire & Flower with 35.

The analysts pegged retail sales in Ontario at an annual run-rate sales of $1.9 billion, while Alberta was estimated at $0.8 billion.

Stocks across the cannabis space have been in retreat for the past year and a half, but Gomes and Tyghe said multiple contraction has been less severe for Canadian retailers over licensed producers. Moreover, the analysts said a multiple rebound in the retail space could happen more quickly. 

They said for multiples to expand from their current levels, there likely needs to be more visibility into how the market structure will evolve over the near and longer term. Gomes and Tyghe pointed to two potential catalysts for that movement: further consolidation in the retail space and regulatory changes that would give companies greater negotiation and pricing power (by easing market restrictions, for example, or privatization of provincial distribution) or access to other markets (through legalization in the United States, for example).

“Given present macro and industry headwinds, multiples may stay suppressed in the near term; however, longer-term industry dynamics support higher valuations for specific companies better positioned to win,” Gomes and Tyghe wrote.

The analysts said investors are getting a more compelling risk-reward tradeoff with retail over licensed producers in Canadian cannabis.

“Consolidation is already occurring [in retail] as smaller retailers exit the industry and M&A accelerates; as such, there is more visibility into the winners in the space,” they said. “Retailers trade at an ~80 per cent discount to large-cap LPs on FY2022e EV/Sales multiples; we believe this discount is unwarranted, as retailers offer a more compelling risk-reward due to the better visibility into their growth and profitability outlook.”

ATB Capital has an “Outperform” rating on High Tide and $10.00 target price, which at the time of publication represented a projected one-year return of 421 per cent. ATB has a “Speculative Buy” rating on Nova Cannabis and $2.00 target, which represented a one-year projected return of 138 per cent. And ATB has an “Outperform” rating on Fire & Flower, with a 12-month target of $4.50, representing at press time a projected return of 187 per cent.