Highlights from Life Sciences.

Frederico Gomes, CFA

Cannabis retailers are struggling with competition as stores open across Canada. We believe consolidation will happen soon, and larger retailers will benefit. This report elaborates on (1) why and (2) when consolidation will happen, (3) what stocks should investors buy, and (4) risks to our thesis. Circumstances have changed since our last sector report, but our thesis remains that retailers are the most compelling investment opportunity in Canadian cannabis due to a combination of growth, valuation, and optionality.  

Poised To Consolidate
We believe fragmentation and store saturation will drive consolidation among retailers. There are thousands of retailers in Canada, and none has more than 5% market share. Moreover, store openings are causing saturation across provinces, leading to more competition, and lower margins and sales per store. This situation impacts smaller retailers the most due to their frail access to capital. Larger retailers have access to public markets or other capital sources, and some of them can leverage other business segments to maintain company-level profitability.

When? 
Given the pace of store openings and the store density in key provinces, we believe consolidation will occur over the next 12-18 months. Retailers will consolidate faster than LPs due to their different underlying economics. Retailers are asset-light and can rapidly open and close stores, whereas LPs rely on longer investment cycles with an expensive fixed asset base. Competition among stores is local, increasing the scale benefits of geographical diversification and how much pressure a large retailer can withstand in a specific market. In addition, retailers have no hard assets, and there are fewer publicly-listed retailers compared to LPs, limiting access to capital. 

What To Buy? 
Capital availability and diversification will determine which retailers will drive consolidation and expand their brick-and-mortar footprint—organically or through M&A. We believe HITI and FAF are well-positioned to gain market share and outpace the industry’s growth. We view their current valuation as offering a large margin of safety, with an opportunity to buy Canadian retail at a discount, and get other segments (US CBD and accessories, Hifyre) + US THC optionality for free. 

Regulatory Risk Is The One To Watch
Current regulations essay to level the playing field for smaller retailers by hindering the ability of larger ones to leverage scale. For example, in certain provinces there are store caps and no direct relationship between retailers and LPs (e.g. provincial wholesale distribution). We view regulations in place as a net negative for larger retailers, but we believe they have levers to pull to offset some of those impacts. Despite those challenges, our thesis is that fragmentation, store saturation, and capital asymmetry will inevitably lead to consolidation.

Frederico Gomes, CFA 437.778.5172