Whoa! Canada.

Updated: Mar 13, 2019

The Real Cannabis Arm$ Race Has Now Begun

Today is an incredibly exciting day. Canadian operators, pioneers, vendors, service providers, lawyers and lobbyists: Be proud of what you have helped accomplish. You have taken a concept that has been applied in smaller laboratories and become the first country in the G-7 to go adult-use legal.

If anyone predicted this five years ago, people would have fitted that person for a straitjacket. Truly unbelievable. And what is more interesting is the pressure that this will put on the U.S. to do something; and we think people are underestimating how fast the U.S. could de-schedule due to our bold northern neighbors. Even the muted response of the U.S. reminding people to not come to the border loaded for a frat party is interesting given some of the rhetorical bombast we have seen from the U.S customs officials over the past few months on cannabis, including our effervescent AG, Jeff "Deputy Sleepy Dog" Sessionzzz.

We can leave for another day and commentary how we see the Canadian legalization creating a distinct path for the U.S. to deschedule, particularly since the U.S. has a much stronger state by state framework in place whereas the Canadian provincial code needed to be built post Canadian legalization.

Now back to the real story of today-the reality is that it would be shocking if there are any products left on shelves for at least a few weeks. As Canadians purchase legally whatever they can both online and from licensed dispensaries, it's good to come right out and reveal the premise of what our research shows us relating to the Canadian market and the value of LPs.

It’s about to get real north of the border.

And by real, we mean normal. Not cannabis normal but business normal.

For many companies, this will be a great thing. Smart, well-run companies are about to take off and leave their weaker competition behind. But for those companies who have acquired huge valuations just by simply being licensed, or with great PR and aggressive stock promotion, or being associated with cannabis, it's quite likely their best days are behind them. Our goal is to give context so that you can avoid being a bag-holder in Canada, or the U.S.

There will be a period of euphoria that that will be hard to ignore. The long lines on 10/17, the empty shelves, the stoned people being interviewed on TV. It's going to be really fun (especially the “Gorillas in the Mist” documentary-style coverage of new cannabis consumers from mainstream outlets). I saw one this morning and it's always funny to have the media treat normal people doing normal things as if they are Diane Fosse observing the eating habits of silverback Gorillas from afar.

Stocks will probably be even more volatile than usual (hard to imagine but try) as people try to react to every bit of data and predict the winners and losers right out of the gate. Every product on every shelf will be sold as people clamor for “legal” products in these first months. Stories will come out about the insatiable demand and constrained supply and how growers can’t keep up with demand. But sometime after the initial sugar rush of legalization wears off, the challenges will rise to the foreground.

Many issues will be driven by government action, which will be slow to fix problems that are created by the transition to adult-use or the unintended consequences of certain rules. Others will be caused simply because of the huge transition to an in-person consumer experience or the new online experience. Good companies are about to get better, and bad companies will be exposed by the challenges of this new paradigm.

Recently, Vic Neufeld of Aphria said the following:

“All our products have been allocated between medical and provincial ‘rec’, but even there, we will not be able to supply in the next three months, everything that they want.”

In the Financial Post article, Neufeld goes on to say, “One of the issues standing in the way of the company shipping its finished product to the provinces on time is the delay in getting government-issued excise stamps delivered to Aphria’s facilities. Under the Cannabis Act, all packaged cannabis products are required to have excise stamps with specific colours, indicating the province or territory in which the product will be sold.”

When a sophisticated, highly professional company like Aphria starts sending out warning signals before the program even starts, well, that right there is a reason to dig in and gain a deeper understanding of what challenges Canadian recreational legalization presents so that we can highlight, review and synthesize the friction points of the coming post-Canadian legalization world. This allows us to better face the coming dislocation of the massive regulatory change, learn our lessons and identify the companies that will thrive. These lessons can then be carried forward to other global markets.

We remember living through early days of Connecticut’s first-of-its-kind limited license medical regulation in 2013-14. In those days, it was a free-for-all. Dispensaries who had spent a fraction of the capex were charging patients 100% markups because of the rules that Connecticut implemented gave them all of the pricing power. The four cultivators in Connecticut all struggled to spend money in a low-patient environment and had little choice but to absorb the asymmetry of cost/benefit that the rules had created. All four 4 seem to be thriving now but those lessons, and ones learned in other medical states like Minnesota, Illinois, Maryland, Pennsylvania and most recently, California, can help give context for how to view the next six months in Canada. The main difference is in Canada, there are space-age facilities built to supply every planet in the Solar System and valuations are in the 100s of million to billions-that there are some real high stakes.

California, in particular, has seen the biggest legalization in the U.S. go sideways as changing rules, black marketeers, and new requirements have severely constrained the business in California. Good companies seem to have adjusted but many companies that were run in haphazard ways are now either out of business or in some state of organizational decline as the higher regulatory requirements strangle their business.

Let’s again recognize that Canada is the first G-7 country to legalize adult-use, the first to have a true liquid capital market to fund opportunities, and in many ways, is an established leader in many things’ cannabis. Every single person who has dedicated themselves to moving the industry forward should be proud that they created an ecosystem that has brought relief to suffering patients, helped countless parents treat their children with non-toxic medicine and created thousands of jobs from whole cloth. That is simply remarkable and like my compatriots in the U.S. we are all fellow travelers on an incredible journey.

When we last wrote about Constellation, we spoke glowingly about Canopy’s bold leadership into the unknown and also looked at other emerging leaders like Aurora, Tilray, Aphria, CannTrust, The Green Organic Dutchman and many others. Canada now enters into a stage where it is hitting the furthest evolution of legality and when that occurs, you can no longer create new metrics to justify market cap; remember the days of funded capacity, price per gram or better yet, multiples on 2022 earnings. We can’t envision an environment where capital will be more available than it's been over the past two years and it's quite likely that opportunities for most Canadian companies to raise capital at current valuations will see a steep decline in interest as fact replaces supposition in valuing operators.

While Canada’s medical legalization was federally driven, that has led to some type of false security that adult-use will follow a trajectory similar to medical rollout. The coming reality, and this survey of what that looks like, isn’t necessarily a judgment on the quality of companies so much as it is about the dislocating effect of legalization in general because of a little-known fact:

The government does not care if these companies make money.

As noted in the article above, government-issued stamps are stopping the shipment of product. We aren’t surprised in the least.

Health Canada cares that people get their medicine, but profit margins? I don’t remember anyone in government saying Tilray should charge more or rules should make production more profitable. Point me to the speeches by Justin Trudeau where he says legalized adult-use will be wonderful for creating profit. Jobs? Sure. Legal certainty? Yes. But profits? Didn’t catch that one.

Ask a Californian how centralized regulation of adult-use has been thus far for profits and you are going to get the stink-eye like you let one loose in an elevator with only two people. And that law was passed in November 2016 and implemented in January 2018.

In the short run, all of the momentum Canada has created in its capital markets might actually significantly hurt market values over the next six months because it is going to be a grind. The numbers will eventually reflect that. By the end of Q1 2019, producers will start to understand just how profound the dislocating effect will be and will start to discreetly push some of that information out there. Kudos to Vic from Aphria for seeing it and discussing it now. Investors and companies have looked to 10/17 as a panacea to drive market caps to a new, higher plateau but smart folks have been quietly discussing the fact that almost no retail is open in many places, that medical sales are dropping in anticipation of coming adult-use and the frustration of companies that just want to know exactly what the rules will be so they can plan and execute.

It's one thing if companies were trading at modest EBITDA multiples and could simply shrug off the dislocation as growing pains. For the past 15 months, liquid capital markets and federal medical legalization have given Canadian companies a margin of error as deep as the Marianas Trench and as wide as the Beaufort Sea. Companies have raised ungodly sums on the fantasy of earnings "just around the corner" when federal recreational laws go into effect. Add in expensive international investments that could take several years to come close to justifying the multiples put on them and you have a dangerous cocktail of forward-looking projections and exuberance.

That all ends on October 17th.

With dozens of companies trading at valuations of more than $100MM, and many above $500MM, expectations are reasonably aggressive coming into today. If investors grow concerned about the performance of companies, they could trade out of stocks and sit on the sidelines to see how this shakes out. Or buy U.S.-based companies going public in Canada. The fact that there will be far more diverse ways to play cannabis publicly can only hurt the mediocre companies who will try and keep up with the 5-7 true leaders in Canada. A prolonged buyer’s strike could take the froth out of Canada but also kill some amazingly innovative companies in the crib, particularly private companies who now will see the IPO window start to close as U.S. companies line up for the more liquid capital market. It will also put a lot of pressure on companies, who really haven’t had organizational stress over the past two years as seemingly every deal got funded, to fight for dollars as bankers and investors get more discerning. The effect of this on smaller, less well-run companies could be profound.

On the massively positive side, an important effect of all this will actually be to separate the winners from the losers in Canada in a profound way as smart companies find meaningful ways to succeed, adopt, invest wisely (in the U.S. and Canada) and thrive. That is what excited me to spend the last 30 days reading every single shred of digital and hard ink on the coming Canadian market and why we want to lay out some of the friction points so that you can analyze and predict which companies will run away from the pack, which smaller companies will leap past their peer group, and which companies will fall flat.

One of the core attributes of Merida’s process involves the “behavioral taxonomy” we build of management teams specifically because one of the great predictors of success is the ability to fail forward, as company’s learn which feedback mechanisms are true positives and which are true negatives. Over the next few months, Canadian-based companies are going to face challenges they never imagined, and we simply want to lay out a framework that allows the broader community to see through the noise to the signal which benefits us all by creating a stronger industry.

Here, we will try and contextualize the biggest dislocating factors for the Canadian market over the next six months, when we predict the information on which companies have missed their targets will start to become clear in their earnings reports. You can only use the IFRS biological asset trick so long before it becomes clear that you are wildly missing your projections. April 1, 2019 could be looked at as "Confession Day", as companies start to hint that Q1 isn't living up to the hype or margins are suffering or something of a negative nature is occurring. Don't let the joke be on you next April Fool's Day. There is very little chance we predict everything perfectly, but we tried to compile a reasonable list of what we are watching and why:

1. Where are the Dispensaries?

As we hinted at above, dispensaries are not going to magically appear with stocked shelves on October 17th. Due to rules around how transactions are processed, lines are sure to be long and there will be no lack of breathless coverage of the long lines at dispensaries. Retail investors will then get freaked out that they are missing the biggest opportunity since Dutch tulips and will buy any stock they can find. Expect the big Canadian equities to have some wild swings. The reality is that dispensaries are in a state of flux and most Canadians will have to travel pretty far to move from medical online sales to an in-face dispensary experience. It's obvious that with rules changing, local provincial law and municipality planning and zoning, opening dispensaries is not a 10-day process; it’s a multi-month adventure. Which leads to the next friction point.

2. Rules, Rules, Changing Rules

Changing rules, shifting requirements, and the ordinarily slow governmental responses to course correcting when rules make no sense are going to make it very difficult for smaller operators to react and compete with hugely capitalized entities who will throw huge gobs of money at every problem relating to governmental oversight or compliance. Look for those smaller companies to hit a wall five to seven months from now as the effect of big money “solutions” weighs on companies who cannot spend a tremendous amount to solve issues. California has seen the same thing as small companies have lagged in spending on compliance, licensing maintenance, and operational tools that can actually save them time, money and reduce risk because they don’t have time or money to explore these tools. We also think that Canadian regulators are likely to be far less forgiving with rule-breaking as scrutiny in Canada will be intense due to the enormous attention on the first G-7 country to legalize.

3. Canadians Know Diddly About Dispensaries

How many legally operating companies have ever operated a dispensary in Canada? Zero. How many have shipped products to a dispensary? Zero. How many have sold in any way other than to medical patients online? Zero. That is scary. Whether it’s shipping product to a retail location, or training staff at a dispensary they may own themselves, no company in Canada has a clue about the small friction points that come with operating a dispensary or selling through a dispensary. While operating phenomenal online sites, no Canadian grower has ever had to interact face-to-face with their consumers or compete for attention at a dispensary shelf. Patients who are on a current provider's website self-select where they get their medicine and are pretty easy consumers. Dispensary shoppers, particularly newer cannabis users, will take a long time browsing labels and looking for products they like. That means longer initial transactions, longer lines and the potential for operators to wildly miss their numbers in Q4 as the dynamic at the counter unfolds.

Imagine for a second that each dispensary consumer takes just two minutes longer for their transactions over the first two months. That could be the difference between seeing 1,000 consumers or 800. With an average spend around $100, that’s $20,000 in lost sales a day. In a place like Toronto which has large population concentration but will only have a few open retail locations on 10/17, 10 dispensaries missing $20K in sales is $200K per day or $6MM for the first 30 days. Nota Bene to those who have never been in a legal U.S. dispensary (b/c Canada has never had them); transactions often are very slow due to the required scanning of product and the fact that pre-packaged product must be retrieved from an inventory room. That takes time.

If you are behind a newer user asking a thousand questions, like one of Merida’s partners did at Lightshade in Colorado, it could feel like an eternity. We won't make a point of it, but it drove some of our more experienced partners a bit cray cray to listen to the hundred questions. Multiply this effect across a large base and the numbers could be significantly lighter until the dispensary business normalizes. If that takes 90 days, Q1 projections for Canada are going to miss by a mile and it won’t be because of a shortage.

4. Uncertainty in Dispensary Coverage=Delays in Ordering

As dispensaries grapple with regulations and the short time horizons to opening, they have to carefully consider whether they are even allowed to pre-order product under their certification license. It's not clear that every province has uniformity on this point and therefore dispensaries, along with the challenge of managing their local real estate, local licensing and provincial licensing must deal with federal code. That almost certainly means that the better prepared dispensary licensees can order a better supply of product and less prepared licensees will limp into the market with smaller supply of lesser products.

5. The Black Market Knows Dispensaries…Well

If you are searching for products on 10/17 and want to make sure you can access a plethora, the only sure bet you have is the black-market dispensaries that have been functioning for a long, long time. Vancouver, Toronto and Quebec have dozens of dispensaries that are unlicensed and while there are strong economic disincentives at play, we don’t see these operators abandoning their clients at a time when they have a massive advantage over the legal market. The verbiage from authorities has been quite authoritative on this front but it's hard to imagine a scenario where there is adequate manpower to totally shut down dispensaries. In addition, these operators know much more about dispensary operations, having developed that muscle memory in the pre-10/17 world and would be well positioned to fill any gaps in product over the short term. That will definitely put a huge dent in projections of grandeur that originally came out about Canadian legal sales, especially if black market growers flood the market with cheap product like what occurred in California in late 2017.

6. Variety is the Spice of Life

Cannabis consumers love product variety. They love trying a few different products every time they walk into a dispensary. Walk into any California or Colorado dispensary and the first thing you notice is the colorful and varied packaging. Whatever is available on the shelves day 1-90 in Canada will pale in comparison to the “pop-up” illegal dispensaries and online retailers from whom Canadians have been buying for quite some time. It also doesn’t seem like the RCMP is that interested in stopping it.

From a CBC article on illegal websites:

"The RCMP's Federal Policing program focuses its resources and activities against the most significant criminal threats and risks facing Canadians."

That sounds a lot like, "we aren’t going to do a thing unless forced to." Low priorities for clamping down on the black market in Canada would be another example of the government not caring if cannabis companies are profitable. And so it's fair to assume that consumers are going to find the products they want and if they cannot get it legally, then they may seek it illegally. Which will be exacerbated by the fact that...

7. Product Categories are Limited

It's unfortunate that many of the product categories other than vape cartridges are not currently allowed in Canada. Canadians are going to want to buy everything they have been hearing about, and everything they can get on the black market. Edibles and stronger forms of concentrate (shatter, resin, wax and dabs) will not be allowed on the first day of adult-use. This will slow the adoption of adult-use buyers as they chase their preferred form of banned products which will only be available from non-legal sources.

8. Privacy

Online ordering is far more private than going to dispensaries. That alone will deter some consumers from engaging in the adult-use market. While this may not seem like a large driver of behavior, there are numerous consumer studies that show that behavior can be driven by how consumers believe they will be perceived in their purchases. We know from behavior in stricter medical markets that many patients will avoid cannabis partly because they must go into a dispensary to acquire it. Mail order or home delivery solves that. With long lines at every dispensary, it's not clear how much attention will be devoted to delivery of adult-use products electronically at first.

9. Product Competition Will be Intense

Consumers will be standing in front of a wide variety of products for the first time. They will likely buy a variety of products in order to see what they like. Rest assured there will always be a significant amount of experimentation but in the early days, this will be the biggest consumer behavior driver, leading to a period of several months where lesser products will still sell as consumers begin to figure out what they want. Long term, it's very important that investors stay vigilant not to judge a company’s prospects (positive or negative) based on the first 30/60/90 days of sales.

10. Price Competition Will Be Intense

With product competition comes price competition. Add taxes into the mix and it's likely that profit margins for everything but the highest demand products will suffer significantly and disappoint projections. We can learn a lot from the U.S. medical markets on consumer elasticity when it comes to pricing. Medical markets have lagged when prices are too high which means the taxes charged and the mark-up from dispensaries are likely to dent demand for mediocre products, which will need to be priced aggressively to sell. This is a highly under-analyzed component of the new Canadian market that could have profound effects on the smaller companies, which will find it hard to compete on the broad, high-volume product categories and must find profitable categories in which to specialize.

11. Online to Dispensary Shift

There was a funny, ironic tweet a week ago about Amazon eventually opening “distribution centers” on the outskirts of towns where consumers can pick up their orders. Some people thought it was serious and said it existed already. Clearly it was a joke; of course it exists - it's called Walmart or Target. Importantly, what this highlighted is that people who order online behave a certain way and like the ease and convenience of not having to drive to a store. While there is no doubt that demand will pick up with the recreational market launch, it's unclear if that increased demand will more than make up for medical sales declining. It's unclear how this shift could effect sales, and whether Canadian rules are reasonably created to address this enormous change. Did we mention that uncertainty puts stress on smaller companies but typically helps better funded, more diverse organizations?

12. The Changing Consumer Paradigm

Lastly, and most importantly, shifts in consumer behavior in this marketplace are going to test the flexibility of companies. Large, well-capitalized businesses should be able to adapt to the new consumer paradigm, whatever it might be. It's not clear that smaller Canadian companies are prepared for these changes. The Canadian medical market has necessitated that companies develop certain skills. When new skills, products, or methods must be invested in and these companies find capital markets more constrained, it could prove to be difficult for companies to thrive, further stressing their capital positions. Smaller companies that have been conservative in their spending and approach will find themselves succeeding and picking up market share as their peers struggle. The really large companies with huge war chests? They are going to go shopping and the companies that acquire smart pieces complementing their existing businesses will do incredibly well.

We aren’t the only ones to think this. An analyst report that came out this week from VIII Capital said as much. We have also spoken privately to other Canadian-focused bankers who have expressed similar sentiment over the last 3 months.


October 17th is indeed a historic day for Canada and the world. Canada has made it possible for other countries to envision a legal framework under which cannabis can be regulated. Research will accelerate, helping the medical vertical along. Non-violent “criminals” who have done nothing more than possess cannabis will see their records expunged. Freedom to choose will have won out over regressive beliefs about this amazing plant, many of which are 100% untrue.

It is hard to truly appreciate how important that is. The most important consideration for investors should be to focus on the changing landscape in Canada and what we can learn from this seminal event. Over the next 90 days, we will begin to see how companies perform, and that should be a good indicator of the winners there as well as how that could affect the U.S. market going forward.


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