BMO Outlines The Limits Of Limited License Markets

A new report from BMO Capital Markets outlines the state of the Canadian and U.S. cannabis markets and specifically calls out the increasing competition for American companies. The report also suggests that the Canadian LPs (licensed producers) are likely to fall behind as they lack the profitability of the neighbors to the South. Even though Canada was the first to legalize adult-use sales, the country has instituted punishing regulations and taxes and has an unlimited license regime (i.e., the federal government can issue an unlimited number of production licenses) that has caused the number of dispensaries to soar in Alberta and Ontario. In addition to that, BMO noted that miscalculations around what cannabis consumers want, and overspending in the wrong areas by many companies, have led to sizable P&L losses and dismal stock performances among the LPs. Green Market Report had a chance to review the report and will specifically focus on the analyst’s outlook for the U.S. companies.

Limits In Limited Licenses

One of the things that MSOs (multi-state operators)  in the U.S. have desired is access to a limited license state. This creates an advantage for the first movers to those states. However, analyst Tamy Chen believes that the competition is increasing in these states. She wrote, ” In Pennsylvania, Cresco Labs (OTC: CRLBF) and Trulieve (OTC: TCNNF) are investing in more premium flower production and Green Thumb Industries is doubling its capacity (GTII does not disclose its facilities’ sq. ft. but the company is already a leading operator in the state, so a doubling of capacity would presumably be notable). There are also several operators acquiring retail stores at relatively premium prices to reach the 18-store cap in the state. In Florida, there has been some aggressive price discounting by multiple operators. MSOs such as Columbia Care, CL and GTII have publicly indicated plans to deploy more capex into FL. Massachusetts is another state where we are observing several MSOs invest more capital to increase capacity. ”

Chen notes that some of the pioneers or first-movers in these limited license states are now facing the next wave of settlers or second-movers. Several of the cannabis companies that have a presence in one to two states are now spending big money to expand into these limited license states. They argue that they will be more successful than the pioneers because they can buy strategically and get top locations, whereas the first-movers took whatever location they could get. Chen, though points out that many cities are beginning to let first-mover MSO’s change store locations and so that point may not hold water. The report also says that the second-movers claim their cultivation facilities are better, although that comparison is difficult to make as the pioneers are growing as fast as they can due to undersupply issues. In the medical-only states, this expansion has proven to be a little harder than the second movers thought. Patients seem to be more loyal than recreational consumers.

First – Buy A Store

The BMO report described the approach by the second movers for these expansions. First, the MSO typically buys a bunch of retail stores. Chen wrote, “In fast-growing limited license states, stores could be generating upward of $10-15 million in annual revenues (sometimes even more). There are several strategic reasons to acquiring retail stores first. On a relative basis, it requires less capital and is a shorter lead time to revenues than building a production facility. It should be accretive as the stores should already be profitable, providing the acquiring operator with some time to identify a backward integration opportunity without a drag on cash. In some states, particularly those with a lower store cap, many first-mover MSOs have already reached the cap. As a result, valuations for independent retailers are not as elevated as a state like PA which has an 18-store cap. And finally, by acquiring retail stores, the MSO is acquiring a guaranteed distribution channel for its future production capacity. Once the operator integrates backwards, it can reallocate some of its stores’ shelf space to its own brands.”

Chasing these situations is driving up the valuations of these stores to the consternation of investors. With several states poised to switch from medical-only to adult use, the race to get established in these states is heating up. Chen wrote that operators in the new states say they plan to ramp up production and open the most stores possible. The MSO’s that are left out claim that they are just being patient and waiting for the move to be cost-effective. They think prices are too high and the states will eventually begin issuing more licenses.

Flower Power

In these early days for limited license states, producers can hardly keep up with demand. BMO thinks that once these markets settle down and supply issues wane, the importance of premium flower will emerge. Chen wrote that price competition in maturing cannabis markets typically concentrates in the mass and value segments, which has been experienced in CA, OR and Canada. “Even though CA and OR have many acres of outdoor cannabis cultivation, we consistently hear from industry participants that cannabis consumers continue to pay a premium for high-quality indoor flower. The higher the THC potency, the greater the retail price that flower product can command.”

The report pointed out that most of the flower grown on the east coast is grown indoors, which is more expensive. Plus, as MSOs scale up, the quality of the flower is compromised due to automation techniques. Chen wrote, “We believe successful businesses will be one of the following: a low-cost producer with scale or a premium producer that sells less volumes but
generates higher gross margin. We believe the fundamental reason driving the underperformance of several large Canadian LPs is a mismatch between the capabilities of their production asset(s) and the pricing strategy they are pursuing. Right now, the MSO group as a whole is executing well in favorable limited license environments where demand still somewhat exceeds supply. When this imbalance eventually disappears, it would not surprise us to see some U.S. operators recalibrate their pricing strategies to better suit the capabilities of their production assets.” The BMO report suggests that once these “new” markets mature, the first movers will learn that any old flower may not be accepted by seasoned consumers. She thinks the first-movers will lose their advantage as the race to the bottom pricing takes hold.

In Closing

It was an exhaustive report and this article doesn’t cover every point. Still, BMO thinks that Canadian LP’s shouldn’t pursue MSO chasing. She thinks that by the time the LPs get their MSO deals consummated, they are unlikely to generate the types of returns the MSOs are enjoying now. Instead, Chen thinks the LPs should focus on a cost advantage, product innovation and/or option agreements with successful West Coast cannabis brands.

“Regarding the potential likelihood of success in the U.S., the “pecking order” of our coverage is Village Farms (VFF), Cronos Group (CRON), Tilray (TLRY), WEED, HEXO, OrganiGram (OGI), Aurora Cannabis (ACB), Sundial Growers (SNDL), and The Green Organic Dutchman (TGOD).”

Debra Borchardt

Debra Borchardt is the CEO, Co-Founder, and Editor-In-Chief of GMR. She has covered the cannabis industry for several years at Forbes, Seeking Alpha and TheStreet. Prior to becoming a financial journalist, Debra was a Vice President at Bear Stearns where she held a Series 7 and Registered Investment Advisor license. Debra has a Masters degree in Business Journalism from New York University.


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