Alternative View: Cannabis Stocks Rally Not Assured Ahead of October Legalization

Image credit: Wendy McCormick

The rally in cannabis stocks over the past two-plus weeks has been a godsend to just about everyone. The sector is immersed in one of those rare periods where both novice retail, institution buy side and insiders are all making money concurrently. But can this most unsustainable situation last until legalization? Quite possibly, however I’d like to dispel one particular truism some retail investors are making in regards to individual buy-and-hold strategies heading into October 17th.

The truism I’m referring to is the amateur mindset of buying cannabis stocks at any price, under the assumption that the sector will keep levitating into d-day. With rampant FOMO seemingly entering the market at any price, the prevailing attitude among retail investors seems to be A) Big Alcohol will continue to drive the bid as they frantically attempt to partner-up with select Canadian LPs ASAP and/or B) It doesn’t matter what price you pay now, because the market will rally into legalization regardless (enabling investment”mistakes” to be offloaded). While both scenarios are plausible road maps for how things may play out, investors should be mindful that it’s simply one of several possible scenarios.

Just as likely, the market could be setting itself up for a bull trap event, where unbridled sector enthusiasm sucks retail money into a hyped-up abyss. Upon analyzing the market further, I can think of several credible reasons why this situation could unfold.

Cannabis Legalization Is Tiered

Instead of revenue and earning generation hitting the balance sheet like a freight train, October’s (Q4, Q1 2019) impact will be more subdued. The reason being, provinces like Ontario (most populous, by far), British Columbia (third most populous) and Alberta (fourth most populous) will not be instituting full-throttle retail sales right away. In the case of the latter, brick & mortar sales won’t be happening at all until April 1, 2019 at the earliest. In other words, well over half of Canada’s population will either have no physical retail access, or limited access, until well into 2019. As well, certain significant population centers have already chosen not allow cannabis retail outlets operate in their communities once the deadline has passed.

Of course, cannabis will be readily available online from government coffers for all who qualify. But will that be enough to persuade a significant portion of fence-sitters, first-timers and curiosity seekers to engage right away? Chances are, a significant portion of non-hardcore cannabis patrons may sit the first few months out, opting to speak with an agent and see the product in-person.

Online Government Sales May Not Be Seamless

In the provinces where government-run online sales will compete with retail—which is most of them—unforeseen challenges may arise. For example, Alberta will require a double identification check before product can be delivered to the consumer (once upon purchasing online, and again on delivery). This may raise a litany of issues pertaining to online privacy, ordering hassle, and inconvenience as younger adolescents and teenagers will not be eligible to receive packages.

Even assuming individual online networks are robust enough to handle the ensuing demand without issue, it remains to be seen how effortless the ordering process will be. If it becomes too inconvenient or cumbersome—always a possibility when identification requirements are thrown into the mix—Canadians may be slower to migrate to government sanctioned sales where retail outlets are unavailable.

The net result is that the anticipated pricing power of an expected legalization supply crunch may never materialize, and the revenue cycle could be elongated past original presumptions. Both scenarios would not be particularly supportive for cannabis stocks in the near term.

Transcendent Big Alcohol Partnership Not A Given

Stoked by mainstream financial media—including CNBC, which seems to be going all-in on cannabis stocks these days—the big expectation driving cannabis stocks is that Big Alcohol is imminently about to partner with a sector player. While that may indeed happen, the key question is what type of partnership may be forthcoming. Are we talking about a Canopy-Constellation scenario, where direct equity ownership drives an ongoing mutually beneficial value proposition for both companies. Or are we talking about a HEXO-Molson junior venture agreement, which is more of an arm’s length product development “partnership”.

To date, these are the two precedents the cannabis sector has to work with. But the further cannabis stocks drive higher on anticipation of what could-be, the more disappointment will ensue if scenario #2 comes to pass. As we witnessed with the gap-fill and market swoon following the HEXO-Molson deal, an upcoming JV or non-direct equity stake agreement will do little to buoy investor enthusiasm going forward.

In my opinion, timing could also play a factor over the next six weeks. While a deal could materialize anytime in 2018 or beyond, why wouldn’t Big Alcohol play the waiting game if they fail to procure a deal by early-October? At that point, they might as well wait to assess the anecdotes on how the recreational market is performing in Canada. What happens, to everyone’s surprise, if cannabis sales actually disappoint in the market’s opening weeks? That would be intel Big Alcohol or beverage conglomerates would want to account for before engaging in big debt or shareholder dilutive transactions.

Final Thoughts

The purpose of this article is not to throw a wet blanket on the party currently raging in the cannabis market. Nor is it a market call that the sector will buckle heading into legalization (I’m neutral right now). It’s to serve as a reality check that certain assumption investors (mainly retail) may hold might be completely off-base. Being the engaged qualitative analyst that I am, I’ve read hundreds of accounts over the past several days eluding to the assumption that cannabis stocks will only run into legalization. Equally troubling, I have yet to witness even one account that cannabis stocks may fall in the weeks ahead. Retail investors are definitely buying the kool aid, which is troubling because retail macro investment theses generally lack reliability.

Be that as it may, market sentiment rests with the bulls at the present time. Perhaps bubbly enthusiasm and willing sideline capital will continue to drive prices ever higher in the coming weeks—we certainly hope so. But investors should keep in mind that alternate possibilities do exist, and that getting married to positions under the assumption that bullish realities will play out could be a hazardous approach heading into October.

Original article: Alternative View: Cannabis Stocks Rally Not Assured Ahead of October Legalization

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