Analysis | Marijuana

The pot frenzy

With the legalization of marijuana fast approaching, are companies and investors overestimating the expected ‘jackpot’?

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Pot has been making headlines in Canada since the government announced it would legalize recreational marijuana this summer. Shares of producers, among others, were the “flavour of the month” with investors, which sent a number of stocks soaring to excessive highs. Sure sounds like some people are dreaming in Technicolor!

In January, Canopy Growth, just one of several Canadian cannabis producers, had a higher market cap than Air Canada and almost reached that of Canadian Tire, even though it earned a fraction of these companies’ annual revenue in 2017. Then in January and February, Canopy Growth lost almost 40 per cent of its worth.

The optimism surrounding cannabis is such that backroom games are also well under way. In February, the Montreal daily Le Journal de Montréal reported that a number of former senior federal officials and high-ranking law enforcement officers were working for companies in the marijuana industry. For example, some former Health Canada officials, who helped draft the rules on legalizing cannabis at the very institution responsible for granting production permits, are now acting as consultants for marijuana producers. Ditto for the Royal Canadian Mounted Police. In addition, major investors in pot-related businesses include several former Liberal ministers or advisors.

A risky bet

But aren’t all of these companies and investors overestimating the expected “jackpot”? After all, the size of the Canadian market and the quantity of weed needed to meet the demand are unknown and open to debate. Do you really think that all current consumers—or even a significant number of them—will want to buy marijuana bearing the government’s seal? Or that people will suddenly start smoking pot in droves because it’ll now be legal?

It’s true that in Colorado, where marijuana was legalized in 2006, some made out like bandits. But several analysts point out the limitations of making comparisons. Colorado is surrounded by states that have not legalized marijuana—a situation that helped kick-start pot tourism, made up of consumers and resellers who purchase cannabis in Colorado to resell it illegally in neighbouring states, thereby fudging the numbers.

Others also seem to underestimate our government’s appetite. The two largest provinces, Ontario and Quebec, plan to have provincial points-of-sale modeled after their government-run alcohol retailers. However, when it comes to product quantities and selling prices, the LCBO and the SAQ are known to bargain hard with their partners and cut into their profits. Small suppliers who cannot meet the demands of the two liquor boards have to sell their products elsewhere.

In a Maclean's article published in January, economics professor Allan Gregory wrote, “At present the average price of medical marijuana is roughly $10 per gram. Some publicly traded companies have boasted that their all-in costs are in the range of 70 cents to $1.75 per gram which translates into profit margins of more than 80 per cent. However, we can expect provincial agencies will severely cut into these margins.” He adds that in the Ontario wine industry, for example, profit margins for large-scale operations are just under 15 per cent, and many smaller vineyards posted losses, primarily because of concessions they have to make to the Crown corporations. Even if it’s difficult to draw a clear comparison between wine and marijuana, Gregory shows there is a price to pay for selling to government-run liquor boards. What will the situation be like for cannabis producers?

Legalization is fast approaching. We’ll soon see who’s been smoking the good stuff.