It’s still an emerging market but signs are pointing to a slowdown in Canadian cannabis, according to ATB Capital Markets analyst Frederico Gomes who published an industry report on Thursday, saying growth in cannabis retail sales is decelerating. As a result, Gomes says investors need to be even more careful when wading into the space.
Canadian cannabis retail sales are expected to hit $4.5 billion in 2022 and that’s up from $3.8 billion in 2021 for a projected year-over-year increase of 16.6 per cent. But the figure represents a trend in cannabis where sales growth is slowing and at a faster rate than expected.
Gomes pointed to September 2022 sales which increased a mere 7.7 per cent over the same period a year earlier, the first time ever since legalization that year-over-year growth fell into the single digits. Gomes said growth rates have declined every quarter for the past two years, with price and volume compression playing a role.
“This growth slowdown is more pronounced than we had originally anticipated. We believe this trend cannot be attributed only to temporary deflationary pricing pressures but rather to a maturing market that is growing volumes slower,” Gomes wrote in his report.
The result is a recalibration of how big the pot market will eventually become, with Gomes now moving his previous target of $11.2 billion in sales for the year 2030 to $10.1 billion, causing his estimated CAGR for the 2021-2030 period to fall from 12.6 per cent to 11.3 per cent.
Gomes said the legit cannabis market will continue to take market share away from the illicit trade, although he expects the black market will end up at about four per cent (previously two per cent) of market sales penetration by 2030. Population-wise, Gomes said a mature market will see 28 per cent of eligible Canadians buying legal pot by 2030 (previously 30 per cent), driven by increased acceptance, the aging of younger generations and new product introductions.
What the updated forecast means is less wiggle room for error among Canadian cannabis companies, with Gomes advising investors to stick with names that are heading toward profitability and have some cash on their balance sheets to prevail through the currently challenging macroeconomic conditions.
“We believe investors in the space should be defensive and assign a premium to strong balance sheets (cash on hand, little to no debt) and low or narrowing cash burns (indicated by adj. EBITDA profitability). Companies positioned to act as consolidators (with moderate to no dilution) should be preferred,” he said.
Overall, Gomes favours the retail players in the cannabis space over the LPs, saying consolidation is likely to occur at a faster rate in retail and that there’s more visibility into growth and profitability drivers and even into who the likely winners will be.
“Given this improved visibility, we believe the valuation of retailers looks particularly attractive, as they trade at an average FY2023e EV/Sales multiple of 0.3x, a ~80 per cent discount to LPs. While this valuation gap can be partly explained by the different business models (retailers generally trade at lower sales multiples), we believe the magnitude of the discount is unwarranted because, over the short to medium term, the economics of large retailers are better, there is lower liquidity risk, and there is more certainty about their key growth drivers (new store openings, consolidation of mom-and-pops),” Gomes said.
With that backdrop in mind, Gomes reevaluated the cannabis names under ATB’s coverage, as follows.
Stock: Aurora Cannabis (Aurora Cannabis Stock Quote, Charts, News, Analysts, Financials TSX:ACB)
Rating: Sector Perform (unchanged)
Target Price: $1.80 (previously $2.00)
Projected 12-month return: 7 per cent
Gomes said Aurora is one of the leaders in the medical cannabis industry with over 20 per cent market share in Canada and material sales from international markets. He said he likes the downsizing the company has been performing of late as well as its focus on high-margin segments. At the same time, limited visibility on the value, timing and achievability of medical cannabis sales growth is a reason for caution with the stock.
“We believe the market is adequately pricing in ACB’s growth outlook, supporting our Sector Perform rating,” Gomes wrote.
Stock: Fire & Flower (Fire & Flower Stock Quote, Charts, News, Analysts, Financials TSX:FAF)
Rating: Sector Perform (unchanged)
Target Price: $2.80
Projected 12-month return: 57 per cent
Gomes said Fire & Flower is going through a transitional period, and he is expecting growth to re-ignite for the retailer in coming quarters.
“In our view, FAF’s partnership with Alimentation Couche-Tard and its digital capabilities position the Company well for future growth. However, we believe the market is adequately pricing in FAF’s growth outlook in Canada (we do not factor a potential expansion into the US in our base case scenario), thus supporting our Sector Perform rating,” Gomes wrote.
Stock: HEXO Corp (HEXO Stock Quote, Charts, News, Analysts, Financials TSX:HEXO)
Rating: Underperform (unchanged)
Target Price: $0.10 (previously $0.15)
Projected 12-month return: -60 per cent
The challenging outlook persists for HEXO, according to Gomes, who noted that the company has continued to lose market share even as it stands as one of the top three LPs in Canada.
“While management is taking actions to turn operations around, and though the balance sheet has significantly improved, the deteriorating macro environment and competition in Canada weigh on HEXO’s future, supporting our Underperform rating,” he wrote.
Stock: Khiron Life Sciences (Khiron Life Sciences Stock Quote, Charts, News, Analysts, Financials TSX:KHRN)
Rating: Speculative Buy (unchanged)
Target Price: $0.30 (previously $0.45)
Projected 12-month return: 200 per cent
Internationally-focused Khiron is developing an effective strategy in the medical cannabis space and is seeing improved margins and new clinic openings in places like Brazil and Colombia, but Gomes said expansion won’t come without its challenges.
“We remain wary of the balance sheet; we believe KHRN may need to cut more costs (which could impair growth) and pursue additional sources of financing over the near term (adding liquidity risk to the investment). A material potential upside balanced with the significant risks inherent to nascent international cannabis markets supports our Speculative Buy rating,” Gomes said.
Stock: Nova Cannabis (Nova Cannabis Stock Quote, Charts, News, Analysts, Financials TSX:NOVC)
Rating: Speculative Buy (unchanged)
Target Price: $1.60 (previously $2.00)
Projected 12-month return: 105 per cent
One of ATB Capital’s top picks in the retail space, Nova Cannabis has positive momentum and the highest annual sales per store of any publicly-traded peer, Gomes noted.
“NOVC is poised to benefit from operating leverage as its revenue base scales and management keeps costs in check (SG&A as a percentage of sales dropped to 14.5 per cent in Q2/22 from 18.5 per cent in Q1/22). We believe accelerated consolidation in retail, positive regulatory developments, and margin expansion could serve as catalysts for the stock,” he wrote.
Stock: Organigram (Organigram Stock Quote, Charts, News, Analysts, Financials TSX:OGI)
Rating: Outperform (unchanged)
Target Price: $2.70 (previously $3.50)
Projected 12-month return: 111 per cent
The second-largest LP in the Canadian rec pot market, Organigram stayed as one of ATB’s top picks among LPs based on its proven ability to defend market share and its status as one of the few LPs to report positive adjusted EBITDA. OGI has a solid capital position, as well, Gomes remarked.
“OGI has one of the strongest balance sheets in the industry. OGI ended Q3/FY22 with over $120 million in cash and virtually no debt. We estimate FCF (cash from ops. minus capex) was negative $23.6 million, of which $17.1 million was capex (mostly related to facility expansion),” Gomes said.
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