The budding industry will rapidly change. Only some will survive.

For years, registered patients in Canada have had legal access to medicinal cannabis, and if the federal government’s plan remains on track for this summer, Canada will become the first G-7 country to federally legalize adult-use cannabis.

The market now sits on the edge of a seismic shift that has already enticed investors to pour billions of dollars into cannabis companies and attracted adjacent industries, from tobacco to alcohol to pharma, into the fray. This early activity is only the harbinger of developments to come with the next two waves of adult-use legalization on the horizon: dried leaf and oils later in 2018 and an expanded product range in 2019.

To succeed in this rapidly evolving industry, companies will need to grasp the realities of the marketplace and quickly enact a focused, disciplined plan of attack.

Deal mania

More than 100 licensed producers (LPs) already populate Canada’s cannabis landscape with hundreds more awaiting government approval. Most LPs continue to function as startups despite being in operation for a few years. Notwithstanding a considerable lack of strategic focus within the sector, the LPs have been handsomely rewarded in capital markets.

Largest LPs market capitalizations over past 12 months

Sources: S&P CapIQ (As of May 14th Close)

Circling on the periphery, large corporations from adjacent industries are selectively putting stakes in the ground:

  • Constellation Brands Inc. purchased a 9.9 per cent stake in Canopy Growth Corp. for $245-million in November 2017.
  • In December 2017, Shoppers Drug Mart inked its first cannabis supply deal with the acquisitive grower Aphria Inc.
  • In February this year, U.S. tobacco company Alliance One International Inc. bought a majority stake in Goldleaf Pharm Inc. and Canada’s Island Garden Inc. for an undisclosed amount.
  • In March, Sandoz Canada announced an agreement with producer Tilray Inc. to develop and distribute non-combustible cannabis medical products, such as sprays and caplets for hospitals and pharmacies.

Regulatory rulebooks

The adult-use and medicinal segments of the market will operate separately with oversight from Health Canada. Federal government bodies will oversee commercial production and processing of adult-use cannabis while the provinces and territories will be responsible for providing oversight of distribution, wholesaling and retailing in the segment. Most provinces and territories have elected to set up exclusive distribution channels for adult-use cannabis through their liquor control boards. Meanwhile, Health Canada has announced new federal commercial licenses to replace the Access to Cannabis for Medical Purposes Regulations (ACMPR) with a new set of production, processing and sales licences that will allow greater flexibility for all types of cannabis companies.

The net result is that the provinces / territories have created a unique marketplace with its own regulatory requirements. At the same time, the new federal commercial licenses will likely devalue the core ACMPR license and allow for greater intermediation along the value chain.

Strategic moves

While governments develop the legal and governance frameworks for the cannabis sector, LPs have been pushing ahead with a variety of strategic initiatives.

Numerous LPs are positioning themselves for a role in the medical market, establishing supply agreements with pharmacies and product development arrangements with pharmaceuticals. This strategy also has LPs working with patients and physicians on education initiatives and with healthcare institutions and universities to fund research programs.

When the new cannabis marketplace opens, it’s anticipated consumers will encounter a supply shortage. Therefore, most LPs have moved to aggressively expand their production capacity to ensure they can meet their demand requirements – a move encouraged by investors. However, the shortfall is likely to last only 6-12 months, in part because Health Canada is quickly licensing a significant number of new producers.

The net result is that over the long term, cannabis supply will almost certainly exceed demand.

Initially, LPs are also going to be challenged on how to differentiate their products, as Health Canada currently restricts branding activities and is still hesitant to allow new product forms / formulations. The government is expected to legalize new product categories, including edibles and cosmetics, by 2019 or later. For now, most producers are aiming to stand out in a crowded marketplace by offering a variety of cannabis strains. Some of them are also trying to develop brands that register as “premium” lifestyle products. However, it will take time before the nascent industry develops the sophisticated branding and marketing techniques employed by other consumer packaged goods companies.

LPs are also pursuing supply agreements with provincial liquor boards. To succeed, these companies will need to have the right resources and tools in place to develop, submit and update the data these provincial bodies require.

Finally, the liberalization of medical cannabis laws in the United States and overseas may help producers avoid a potential market glut in Canada and pursue more attractive economic opportunities. As such, LPs are looking to export both products and expertise. The risk here is that too many Canadian LPs are trying to become global corporations before they have established sustainable domestic businesses, opening the door to complications down the road.

The future: seven drivers

The cannabis market will evolve quickly over the next few years, propelled by seven connected drivers of change.

  1. The new licensing regime proposed by Health Canada and the provinces will remove the need for ACMPR licences and allow greater flexibility in the business models of cannabis companies.
  2. Expanding government regulations around cannabis product forms / formulations will enable companies to create a wider variety of products and develop distinguished offerings.
  3. The market’s growing sophistication will see profit margins move downstream, away from growers to value-add operations that include the extractors, who blend products to consistent specifications, and the processors, who use the cannabis buds and oils to create foods, drinks, creams and other innovative products.
  4. As the market becomes more established, institutional investors will step in and expectations will change. Companies will find themselves under greater pressure to deliver profits. Those that prove unable to adapt to this new reality could find themselves pushed towards mergers or acquisitions.
  5. The arrival of well-financed participants from adjacent industries will not only boost competition in the marketplace but also raise the standard of products and services. At the same time, with so many emerging players in the field, LPs will be forced to move away from a vertically integrated business model.
  6. The gradual internationalization of both the medicinal and adult-use cannabis segments will offer successful Canadian LPs lucrative expansion opportunities. However, the export market will also bring new challenges and companies will find partnerships and/or joint ventures essential for success.
  7. In the medicinal market segment, there will be an increase in research and development to understand the effects of cannabinoids, which will lead to greater physician awareness and support to recommend cannabis as a therapy. As a result, insurance companies will begin to offer improved medicinal cannabis coverage and businesses will design new cannabis formulations that target specific therapeutic areas and conditions.

On the horizon

Over supply of raw cannabis and increasing competition

Canada’s cannabis market is going to find itself transformed before it is even fully developed. An oversupply of raw cannabis, together with the arrival of well-established businesses from neighbouring industries, will force the sector to accelerate its consolidation. Before the starting gun has even fired, the deal-making has begun. In mid-May, two of the country’s largest LPs confirmed they are merging as part of a $3.2-billion stock deal1. Aurora Cannabis Inc.’s deal with MedReleaf Corp. comes just days after Aurora closed its $1.1-billion cash and stock acquisition of CanniMed Therapeutics Inc.

More stringent investor expectations

As cannabis players look to separate themselves from the pack via acquisitions to expand capabilities and enhance their brand, investors have been largely supportive of the perceived “winners” and provided the requisite equity to negotiate high-priced deals. The bigger challenge will be meeting investor expectations and delivering on deal value. Integrating the people, processes and technology acquired could prove a bigger hurdle than completing the deal itself.  Few, if any, of today’s cannabis companies will have the necessary skills in-house to manage such a process. Investors will hold leadership teams accountable to ensure that the integration is completed quickly and  ultimately accretive to the company.

Emergence of new players

Health Canada’s proposed licensing regime will allow for variations on the current LP business model. Companies will now be able to focus on the discrete areas of the value chain where they wish to compete and ultimately win. This focus will drive these players’ allocation of resources towards creating a compelling competitive advantage against the current LPs.

Vertically integrated LPs must assess and make critical strategic choices on their own value proposition to sustain their current competitive advantage.

This process demands that businesses take the time to truly understand what sets them apart from competitors and how to best leverage that difference.  It may also result in redeploying capital to build or enhance capabilities and systems, as many of today’s companies lack the internal processes necessary to support sustainable growth.

Beyond the horizon

The market issues outlined above will, in our opinion, lead to the following outcomes:

  1. Industry consolidation – an increase in the amount of M&A transactions among industry players is highly likely, though not all will be successful.
  2. Business model redesign – some players will refocus their strategy and align their business model  accordingly.
  3. Capability and system enhancement – many companies will be required to build or to enhance their capabilities and systems to support their strategy.
  4. Bankruptcies and restructurings –  a number of players will be unable to build a position of relevance and will be required to divest or restructure their debt.

The net result is a drastically different market landscape than what we see today. We predict that the industry of tomorrow has fewer larger players but an abundance of niche companies offering specialized products and services.

Taking the right steps

There are several things businesses in the cannabis sector may wish to consider to respond to market forces and be prepared for the outcomes we’ve described. For example:

  • formalize a focused strategy
  • identify the requisite capabilities and systems to deliver on the strategic direction
  • understand the core value proposition and how to leverage it in the value chain of tomorrow
  • invest in deal integration for any acquisitions to capture all synergies and truly deliver on deal value
  • acknowledge the need for appropriate financial controls and have them in place to ensure compliance with all regulatory requirements
  • ensure the right tax and accounting structures are in place for all jurisdictions targeted in any international expansion strategy
  • if restructuring becomes the only solution, find the right partners to maximize shareholder value and put the company in a position to succeed

A window of opportunity

While Canada’s federal and provincial governments have been developing the framework for a nationwide adult-use cannabis market, businesses and investors have already built much of the contents. Once all the legal, regulatory and oversight elements are finalized and the doors are opened to adult-use consumers, the market will evolve quickly.

Today, it is imperative for cannabis companies to understand what is happening and where the challenges and opportunities lie. More importantly, players need to know how to adapt their businesses to thrive in a fast-changing sector.  

What’s needed for a winning strategy is covered in Chapter 2 of PwC’s Cannabis Series.