Post-legalization correction?

Investors have piled into cannabis companies over the past 12 months, driving up the value of cannabis indexes by more than 180%.1 With the Canadian government on the verge of legalizing adult-use cannabis and the market expected to open nationwide in October, a day of reckoning may be looming for many players. At that time, market forces (described in chapter 1 of this series) may drive a swift separation of the wheat from the chaff in an industry already undergoing rapid transformation.

It’s only by acting now to establish a seamless, efficient and agile operating model that companies will free up the cash and resources they need to stay ahead of rivals. In the months and years ahead, access to capital will become the enabler of innovation. The players who are flush with cash and have a clear strategic plan with the supporting business infrastructure to deliver will be able to take advantage of opportunities in a quickly consolidating marketplace. Otherwise, companies will likely be consolidated or enter bankruptcy.

Too much of a good thing?

Most licensed producers (LPs) have been pursuing aggressive expansion plans with the hope of securing a large share of the early market. Assuming all growth and expansion plans are executed on time and as advertised, by 2021 annual production capacity will reach between 2,000 and 3,000 tonnes. But according to our estimates, total Canadian demand for both recreational and medicinal cannabis will only reach between 900 and 1,200 tonnes a year. The effects of this oversupply could be further exacerbated by black market purchases, especially if the federal and provincial governments set taxes and minimum pricing levels too high or are too heavy-handed with regulations.

Many Canadian LPs are expanding into international markets to take advantage of the liberalization policies in South America, Europe and Australia. But the extent to which exports will support overcapacity in Canada remains unclear, particularly in the face of rising protectionism and a current preference for domestic production in overseas markets.

Green leadership

The industry’s rapid growth and regulatory complexity have left cannabis companies scrambling to implement sustainable business systems, develop adequate governance and reporting structures, and recruit experienced talent to a new and non-traditional sector. As we’ve seen in some of the recent headlines about non-compliance, some management teams don’t yet have the business acumen or experience to handle the large acquisitions occurring in the sector or the expertise to satisfy shifting compliance and accounting regulations. Getting access to the right talent will be key to success in the future.

Getting the data needed to move to the next level

It may take up to two years before investors gain the production and financial data they need to properly assess the market dynamics of this nascent industry and the subsequent company-level performance. However, this insight will bring greater pressure on LPs’ strategy, profitability and cash generation. Sound fundamentals will replace speculation as the key driver of valuations and access to capital. Early retail investors who sought quick gains may face disappointment, and their exit from the market will make it harder for LPs to raise capital.

At the same time, a more measurable industry will likely attract more sophisticated institutional investors who will begin to offer new forms of equity and debt but also impose greater scrutiny and performance standards on businesses.

With the rise in alternative debt products in the market, a concern for LPs will be preserving the collateral value of their business as the value of the ACMPR license decreases with more LPs receiving Health Canada certification. We see the potential for future insolvencies in the sector, caused by liquidity shortfalls driven by a lack of traditional bank financing and working capital constraints.

Sustainable business infrastructure

Cannabis companies need to be proactive to address challenges if they’re to emerge as winners from the coming industry shakeout. It’s essential to create strong foundations on which long-term success can be built.

A sustainable business platform that includes a management structure with appropriate supporting systems and personnel brings three key benefits:

  1. Less risk of falling afoul of regulators and compliance requirements
  2. Greater managerial and financial capacity to plan for where the company should be and how to get there
  3. Reduced risk of shareholder activism in the face of lagging capital markets performance

Operational restructuring

Already, some M&A deals in the sector appear to lack operating efficiencies and have instead created inflated cost bases. LPs should conduct comprehensive reviews of their selling, general and administrative expenses in order to remove duplicate and unnecessary activities and to optimize profitability. As part of this process, they could consider adopting centralized back-office services and using outsourced solutions.

As market requirements and insights into competitors’ capabilities become clearer, businesses may consider a strategic refocus that could include the disposal of non-core services as well as the acquisition of other assets that improve their cost bases and create value. To best take advantage of opportunities, businesses should:

  • Model the financial implications of various revenue and cost levers to determine the types of investment that will deliver optimum benefit
  • Identify target opportunities, either through distressed investing or growth by acquisition, that complement their business model and strategy
  • Seek advice to make sure transactions are executed and integrated effectively

Cash management

Available capital has been plentiful during the early days of the cannabis industry. But as discussed above, that will change as investors grow more discretionary. Companies should prepare for this new climate in several ways:

  • Invest in systems and personnel to provide accurate cash flow forecasting and business planning
  • Utilize working capital by looking beyond just payables to include receivables and inventory; this will free up cash and also help manage customer risk, payment flows and days of inventory—working capital is a cheap source of cash that helps a business stay competitive and invest in new technology
  • Access alternative sources of debt and capital at the best possible terms

Crisis management

Industry players are operating in a highly connected yet disparate market that’s saturated with competition. Pressure is only going to increase as investors and consumers become more discerning. To cope, business will want as much time as possible to deal with problems. This will require effective planning, systems and processes to identify and address issues early and with minimal disruption to the business.

Once problems are identified or happen, management should bring in situational expertise to help manage affairs and stakeholders quickly and effectively.

Looking ahead

During this period of consolidation, companies that develop a clear plan that is supported by a flexible operating model and the business infrastructure (financial, managerial and operational) and resources to deliver it, will be best positioned for opportunities. Without this planning, companies may face liquidity challenges that increase the risk of being consolidated at unfavourable value or eliminated altogether.

What’s next?

Canadian LPs have a unique opportunity to stake a leadership position in the emerging global cannabis market. In chapter 7 of our cannabis series, we look at some of the opportunities, and tax and regulatory risks, associated with international expansion.