The Times They Are a-Changin' in Canadian Cannabis.

Frederico Gomes 

“If your time to you / Is worth savin’ / Then you better start swimmin’ / Or you’ll sink like a stone / For the times they are a-changin’.”

In 2022, Canadian cannabis stocks danced to the same tune; prices continued to go down and to the right while the sector remained overly competitive (and unprofitable) with too many companies fighting for a market not big enough for all of them. But times are changing—macro conditions deteriorated, balance sheets are stretched, and capital is scarce. As the waters around them grow, many companies will be drenched to the bone; some will swim. We believe 2023 will be the year when fundamentals (i.e. earnings, and foremost cash flows) will start to matter in Canadian cannabis.

The Change:
Canadian cannabis has been built more on hope than fundamentals, as investors projected high growth and capital was inexpensive with rates at record lows. Now, growth expectations have become more reasonable and capital has become expensive; the capital allocation distortions of the past have begun to correct. With the 2022 valuation drawdown, we believe the sector is more reasonably priced vis-à-vis fundamentals, and stock-specific multiples have room for expansion (or contraction) based on operational performance. In 2023, we expect that the ability to generate earnings and FCF will drive stock returns and determine which companies will be around for the industry’s next stage.

Two Predictions For 2023:
(1) Market share will concentrate. In 2022, consolidation and bankruptcies continued to happen. In 2023, we think these trends will accelerate; fragmentation already shows signs that it has peaked. We see room for at least two M&A transactions among the top 10 LPs; we do not view appetite (or rationale) for M&A between major retailers, but we expect continued roll-up of mom-and-pops. (2) Margins (for survivors) will expand. Market share concentration, increased efficiency, and operating leverage support margin expansion. We see signs of easing retail competition in certain geographies, and flower prices bottoming. All combined, we expect share concentration and margin expansion to aid operational outperformers in generating FCF as early as H2/23e.

What Should Investors Do: 
Our “Four-step Guide To Find Value In Canadian Cannabis” offers a framework to identify opportunities in the industry (here). We believe retailers offer the most attractive hunting ground, as they trade at large discounts to our sector valuation. LPs are (on average) trading in line with our sector valuation; we believe investors should focus on operational outperformers with low liquidity risks and valuations below fair industry multiples. OGI and VFF are our top picks among LPs as they trade at attractive multiples and are well-positioned to accelerate market share gains in 2023. We think reaching sustainable positive earnings or FCF could attract institutional capital back into the space, serving as a catalyst for operational outperformers.