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Canada Leads the Global Cannabis Paradigm Shift Initiating Aphria and Canopy at Outperform May 2018 Tamy Chen, CFA Peter Sklar, CPA, CA Cannabis Analyst Retailing/Consumer Analyst BMO Nesbitt Burns Inc. BMO Nesbitt Burns Inc. (416) 359-5501 (416) 359-5188 tamy.chen@bmo.com peter.sklar@bmo.com This report is intended for Canadian & EU distribution only. Unauthorized reproduction, transmission or publication without the prior written consent of BMO Capital Markets is strictly prohibited. This report was prepared by an analyst(s) employed by BMO Nesbitt Burns Inc., and who is (are) not registered as a research analyst(s) under FINRA rules. For disclosure statements, including Analyst’s Certification, please refer to pages 50 to 53. 16:00 ET~
This report is intended for Canadian & EU distribution only. Unauthorized reproduction, transmission or publication without the prior written consent of BMO Capital Markets is strictly prohibited.
Table of Contents
Initiating BMO Cannabis Coverage ................................................................................................................... 2
Executive Summary .......................................................................................................................................... 4
Legal Environment Favours Canadian LPs ........................................................................................................ 6
Initial Recreational Market Outlook ................................................................................................................. 7
Current Medical Market in Canada: Opaque .................................................................................................. 13
Near-Term International Medical Opportunity: Germany ............................................................................. 15
Long-Term Industry Outlook ........................................................................................................................... 16
Company Snapshot: Our Current Coverage Universe ..................................................................................... 24
Company Coverage: Aphria ............................................................................................................................ 25
Company Coverage: Canopy ........................................................................................................................... 35
Comparable Companies - Cannabis................................................................................................................ 46
Comparable Companies – Alcohol & Tobacco ................................................................................................ 47
Glossary ........................................................................................................................................................... 48
Cannabis | Page 1 May 28, 2018
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Initiating BMO Cannabis Coverage
Aphria: We are initiating coverage of Aphria (APH-TSX) with an Outperform rating.
First Mover Advantage: We believe Aphria will be one of the few licensed producers (LPs) with sufficient
product to supply the initial recreational demand and we believe such a “first mover” advantage should
enable the company to quickly capture significant share and generate attractive unit economics in an
undersupplied market.
Leading Low-Cost Producer: We believe Aphria could emerge as a leading low-cost cannabis producer
given the significant commercial-scale greenhouse cultivation expertise held by the management team,
and the infrastructure and greenhouse culture that is inherent in the Leamington, Ontario community.
Scale Is Critical to Long-Term Growth: We believe Aphria’s scale will facilitate meaningful investment in
long-term growth opportunities such as brand development, value-add format manufacturing, the
gradual legalization of international medical markets, and advanced pharmaceutical applications.
Valuation: Our target price of $17 is based on a projected enterprise value that is about 17x our Base
Case fiscal 2020 EBITDA estimate. We note that our Base Case fiscal 2020 EBITDA estimate assumes that
Aphria’s facility expansions are only at 65% of full ramp potential versus management’s expectation
that the facilities will be close to 100% ramp by that time. If these facilities were to reach full ramp by
fiscal 2020 and Aphria experiences firmer selling prices, our implied target multiple would be in the
high-single-digit range. See Aphria company section for details.
Canopy: We are initiating coverage of Canopy (WEED-TSX) with an Outperform rating.
First Mover Advantage: We believe Canopy will be one of the few LPs with sufficient product to supply
the initial recreational demand and we believe such a “first mover” advantage should enable the
company to quickly capture significant share and generate attractive unit economics in an undersupplied
market.
Head Start in International: We consider the company’s current international operations to be more
advanced versus most other players, and Canopy appears to be laying the groundwork in markets where
medical is not yet legalized, but may soon be. The approach to develop cultivation in “hub” regions like
Denmark for export to Germany and eventually Australia for export to the Asia-Pacific region provides
the company longer-term access to these markets.
Long-Term Global Branded Leader: Canopy could emerge as a leader over the long term given that the
company’s scale will facilitate meaningful investment in long-term growth opportunities such as brand
development, value-add format manufacturing, the gradual legalization of international medical
markets, and advanced pharmaceutical applications. We believe Canopy’s strategic alliance with
Constellation Brands (STZ-NYSE; US$216.81; Outperform rated by Amit Sharma, BMO Capital Markets
Corp.) could prove to be a significant advantage as the industry evolves into value-add formats, and
particularly, into cannabis-infused beverages.
Valuation: Our target price of $45 is based on a projected enterprise value that is about 20x our Base
Case fiscal 2020 EBITDA estimate. Our target multiple reflects our view that Canopy has a relative head
start in brand development and international expansion, and could emerge as a leading global-branded
company in the long term. We note that our Base Case fiscal 2020 EBITDA estimate assumes that
Canopy’s facility expansions are only at 65% of full ramp potential versus management’s expectation
that the facilities will be close to 100% ramp by that time. If these facilities were to reach full ramp by
fiscal 2020 and Canopy experiences firmer selling prices, our implied target multiple would be 11x. See
Canopy company section for details.
Cannabis | Page 2 May 28, 2018
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Relative Positioning
Canopy Growth Aphria
• Could emerge as a large, • Could emerge as a leading low-
branded player cost contract cultivator
• Potential to gain “first
• Strategic alliance with mover” advantage in • Continues to establish strategic
Constellation Brands could prove initial recreational relationships in international
to be a significant advantage as market markets, but appears slightly
the industry evolves into value- behind compared to Canopy
• Scale should facilitate
add formats meaningful investment • Supply agreement with
• Current international operations in long-term Shoppers Drug Mart broadens
appear more advanced versus opportunities medical distribution reach
other LPs; strategy to develop • Pressure on the stock following
cultivation hubs abroad for controversy with Nuuvera
international export could acquisition, resulting in lower
provide longer-term market valuation vs. other LPs and
access provides better return
opportunity
Source: BMO Capital Markets.
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Executive Summary
Near-Term Outlook
First Mover Advantage for Larger LPs: Initially, demand/supply dynamics will favour the larger
LPs. Anticipated demand from the initial recreational market in Canada is expected to
considerably exceed industry production as only a handful of the larger LPs will have sufficient
cannabis output at that time to meaningfully fill the distribution channels. As a result, this “first
mover” advantage should enable the larger LPs to benefit from the favourable pricing
dynamics expected in an initially undersupplied market. See Exhibit 3.
In addition, this “first mover” advantage should enable the larger LPs to initially dominate
retail shelf space in the recreational market, which would provide a head start for brand
development.
Value-Add Formats Will Mitigate Dried Flower Price Compression: We anticipate in year two of
our forecast that supply will begin to catch up to demand, which will result in some pricing
pressure on dried flower. However, our Base Case projections anticipate that in year two,
federal regulators will begin legalizing value-add product formats, which should carry much
higher pricing on a grams-equivalent basis and mitigate the pricing pressure that arises in
dried flower (see Exhibits 3 and 4).
Our Base Case forecast assumes that the industry growth rate for medical patient acquisition
slows when the recreational market is legalized. Some existing medical patients, and potential
future patients, could prefer the recreational market when legalized. However, this may be
more than offset if more employers begin to include medicinal cannabis under insurance
coverage plans.
Near-Term International Opportunity Favours Larger LPs: For the international export
opportunity, we expect that only a handful of the larger LPs will be able to secure the licensing
and certification requirements, and develop the necessary distribution infrastructure in those
regions.
Longer-Term Outlook
Supply Catches Up in Year Two of Recreational Legalization: We project that dried flower supply
will begin to catch up with demand in year two, and potentially exceed demand in the third or
fourth year following recreational legalization in Canada.
It is not clear if this projected supply/demand imbalance will weigh on the cannabis prices
realized by the LPs as there will be the opportunity to export increasing volumes of medical
cannabis to international markets, and the introduction of additional value-add product formats
should provide higher pricing to compensate for price compression in dried flower.
Evolution Into Either Branded Players or Low-Cost Cultivators: As dried flower prices continue to
settle, we believe the Canadian market will rationalize into a handful of larger, branded
players and a handful of low-cost contract cultivators. Beyond the branded companies and low-
cost contract growers, it is not clear to us how the many other LPs, outside of niche brands,
will survive under this pricing environment.
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Near-Term International Export Opportunity Is Temporary: We believe the current international
opportunity for Canadian LPs, which is the ability to export products into other markets at
favourable economics, will prove to be transitory. As a result, we believe the long-term global
opportunity for Canadian LPs is developing intellectual property and brands.
Long-Term Medical Market Opportunity in Pharmaceutical Applications: We believe the
distribution model for medical cannabis in Canada will eventually expand beyond the current
channel of direct-to-patient. In addition, we consider that Canadian LPs could eventually be in
a position to make efficacy claims that are supported by clinical trials. At that point, medical
cannabis could qualify for a Drug Identification Number, which we believe would be a
significant catalyst to accelerate growth of the medical market.
Scale Is Critical to Long-Term Growth: Over the long term, we anticipate that only a handful of
LPs will be attributed a premium valuation. These long-term industry leaders will be those that
capture sizable shares of the near-term recreational market, and possess the scale and
resources to invest in the long-term opportunities such as brand development, value-add
format manufacturing, the gradual legalization of international medical markets, and advanced
pharmaceutical applications.
It is also possible that these LPs could ultimately be acquired by large CPG players in the
beverage and tobacco industries or pharmaceutical companies given the potential disruption
cannabis-infused products could present.
The Blue Sky Scenario Beyond Our Forecasts: An additional long-term upside would be if other
jurisdictions consider recreational legalization, and we understand that Malta is currently
drafting legislation to legalize recreational use. If Malta establishes and implements a
framework legalizing the recreational market, we believe this could set a precedent that
encourages potential recreational legalization in other European countries. Under such a
scenario, Canadian LPs would have to establish cultivation in those markets in order to
participate as UN treaties prevent international trade of cannabis for non-medical purposes.
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Legal Environment Favours Canadian LPs
In Canada, medical cannabis was legalized in 2001, following court decisions, with the Marihuana
Medical Access Regulations (MMAR). Under this framework, approved individuals could grow cannabis or
appoint a designated person to grow for them. The MMAR framework was replaced by the Marihuana
for Medical Purposes Regulation (MMPR), which only permitted Health Canada approved commercial
licensed producers (LPs) to grow cannabis. Following a court ruling in 2016, the MMPR was replaced by
the Access to Cannabis for Medical Purposes Regulation (ACMPR), which is the current regulation
governing Canada’s medical market. The ACMPR framework allows patients to either purchase medical
cannabis from LPs or grow a limited amount on their own.
Following the election of the Trudeau government in 2015 and the report of the McLellan Task Force on
Legalization in December 2016, Bill C-45 was drafted as the proposed regulatory framework to legalize
recreational cannabis. On June 7, 2018, the Senate is scheduled to hold a final vote on Bill C-45.
However, there are a number of issues that could delay legalization. Provincial governments will receive
a period of eight to twelve weeks following the effective date of Bill C-45 in order to secure supply and
establish retail locations. In addition, some members of the Senate are recommending the federal
government delay Bill C-45 for up to a year to address concerns related to Indigenous communities,
although Prime Minister Trudeau has indicated that there will be no delay. We believe it is unlikely that
the recreational market will be legalized before the fall.
In the U.S., cannabis is considered by the federal government as a Schedule 1 narcotic, although several
states have legalized medical and recreational use. This federal-state conflict exists, in part, as a result
of the Ogden and Cole memoranda issued by the U.S. Department of Justice during the Obama
administration that deprioritized enforcement of the U.S. federal cannabis prohibition in certain
instances. These memoranda were rescinded pursuant to a memorandum issued by Attorney General
Jeff Sessions on January 4, 2018. As a result of the federal status of cannabis, U.S. cannabis companies in
legalized states are unable to supply international markets.
The international flow of cannabis, which is considered a controlled substance, is governed by three
United Nations treaties, and only permitted for medical purposes by countries with a legal federal
framework. Several countries have legalized medical cannabis, including Germany, Denmark,
Netherlands, Italy, and Australia, and more countries are expected to progress towards medical
legalization over the next several years. However, we note that Canada is the only developed country
with a comprehensive regulatory framework, permitting both medical consumption and domestic
cultivation. The lack of domestic production in many countries with legalized medical use has created
the opportunity for Canadian LPs to supply international markets.
Sizing Up the Industry in Canada
No. of Licenses1 104
Industry production in 20171 81k kg
Industry revenue in 20171 $239 mm
Prices in medical market4 $8 to $9 / g
Prices in illicit market4 $7 to $9 / g
Avg. annual yield for indoor3 100 to 300 g / sq. ft. / yr.
Avg. annual yield for greenhouse3 60 to 120 g / sq. ft. / yr.
Cost of production5 $1 to $2 / g
Note (1): Statistics Canada.
Note (2): Deloitte.
Note (3): BMO Capital Markets.
Note (4): Statistics Canada, company filings.
Note (5): Company filings. Excludes shipping & packaging.
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Exhibit 1: Top 10 Publicly Traded Companies (by Market Capitalization)
Market Cap.
Company Ticker C$ mm Overview
Canopy Growth WEED $8,697 Facilities across Canada and a portfolio of medical and recreational targeted brands.
Constructing three hybrid facilities in Alberta and Northern Europe.
Aurora Cannabis ACB $4,793
Announced acquisition of MedReleaf.
Aphria APH $3,198 Operating greenhouses in Leamington, focused on becoming a leading low cost producer.
MedReleaf LEAF $2,809 A premium-branded medical supplier. Announced it will be acquired by Aurora.
Cronos CRON $1,673 Indoor facilities in Ontario, recently established facility in Israel.
Hydropothecary THCX $1,179 Quebec-based, signed 5-yr Quebec supply agreement.
Early-stage. Developing first facility to grow organic cannabis.
The Green Organic Dutchman TGOD $1,040
Signed uptake agreement with Aurora.
CannTrust TRST $877 Licensed producer. A leading player in the medical market.
Organigram OGI $788 NB-based, has a partnership with Colorado-based The Green Solution.
Cannabis investment company.
Cannabis Wheaton CBW $716
Provides LPs with resources in exchange for financial or product uptake.
Source: BMO Capital Markets, company filings, FactSet.
Note: BMO Capital Markets is restricted on Aurora Cannabis
Initial Recreational Market Outlook
We believe initial demand in the legal recreational market will likely be below many industry estimates.
This is based on our view that several factors will initially temper the level of illicit market displacement
(see Exhibit 2 below). For example, several provinces are only establishing a modest number of retail
stores in the first year of legalization, and it is not clear to us how prevalent e-commerce sales will be
initially. In addition, we are concerned that many of these stores will be situated in locations that are
too far from convenient urban centres (i.e., Ontario’s first four sites). Finally, we note that initial
recreational legalization will only permit three product formats: dried flower, oils, and gel capsules,
which is relatively limited compared to the breadth of categories available in the illicit market.
We believe meaningful displacement of the illicit market will take several years, but over the long term,
we expect consumers will participate in the recreational market due to the legality, safety, and
convenience of product formats that will be offered.
Exhibit 2: Key Factors Influencing Illicit Market Conversion
The uptake in demand from existing illicit market users
could be lower than expected if:
-There is an insufficient number of stores initially
-Stores are in inconvenient locations (such as the first four
sites in Ontario)
-Other formats in the illicit market (edibles, concentrates)
will not be permitted initially
-If retail prices are not competitive with the illicit market
Slower illicit market displacement could be
countered by:
-New users who did not want to participate in the illicit
market
-The migration of some medical patients whose
underlying use was recreational
Source: BMO Capital Markets.
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We have developed three forecast scenarios for initial recreational market demand: Base, Upside, and
Downside cases. Our demand forecast is based on detailed assumptions and demographic data
regarding the size of the illicit market by province (as provided by StatsCan). For year one of recreational
legalization, our Base, Upside, and Downside scenarios assume 40%, 50%, and 20% illicit market
displacement to the legal market, respectively. In year two, our Base, Upside, and Downside scenarios
assume 60%, 80%, and 35% illicit market displacement, respectively. We have made assumptions
regarding the frequency of cannabis occasions and typical per-occasion cannabis consumption levels
based on a number of factors, including the type of user (existing illicit market user versus new
participant) and the scenario we are considering (Base, Upside, and Downside). For example, in year
two of recreational legalization, for a user displaced from the illicit market, we are assuming two and a
half occasions per week and one gram per occasion on average. See Exhibit 3 below.
Exhibit 3: BMO’s Forecast of Initial Recreational & Ongoing Medical Demand
Year 1 of Rec. Legalization Year 2 of Rec. Legalization
Base Upside Downside Base Upside Downside
Medical Market in Canada
# of Patients 325,000 350,000 250,000 375,000 390,000 300,000
Avg. Grams per Patient per yr. 240 240 240 240 240 240
Annual Demand (kg) 78,000 84,000 60,000 90,000 93,600 72,000
vs. Current
# of Patients 269,502
Volume Sold in Apr. to Dec. 2017 (kg) 41,280
Recreational Market in Canada
Est. Illicit Market Users in Canada (mm) 5.6 5.6 5.6 5.6 5.6 5.6
Illicit Market Displacement1 40% 50% 20% 60% 80% 35%
Est. New Market Participants in Canada (mm) 0.8 1.4 0.3 1.4 2.0 0.8
Total Participants in Legal Market (mm) 3.1 4.2 1.4 4.8 6.5 2.8
Annual Demand (kg)2 259,402 477,278 95,456 477,278 749,085 185,247
Vs. Deloitte Forecast (kg) 600,000
Vs. Govt of Canada Forecast (kg) 378,000 to 1,000,000
Total Canadian Demand (kg) 337,402 561,278 155,456 567,278 842,685 257,247
BMO's Production Outlook - Base Case
3
"Big Three" (kg) ~125,000 ~540,000
We believe the other 100+ LPs will contribute minimal production in year one and a modest amount in year two.
Pricing Scenarios
Oversupply of Dried Flower? No No No No No Yes
More Product Formats Legal? No No No Yes Yes No
New Formats Share of Market Modest Modest None
Flower + Oil Share of Market Majority Majority All
Net Effect on Pricing from Year 1 - - -
4
Blended Wholesale Price for LPs ($/g) $4.50 - 4.75 $5.00 $4.00 - 4.40 $5.50 $6.00 $4.00 - 4.40
Source: BMO Capital Markets.
Note (1): The percentage of the illicit market that will transition to the legal market.
Note (2): See section immediately preceding this chart for details regarding usage assumptions for participants.
Note (3): Aphria, Aurora and Canopy. Assumes MedReleaf is acquired by Aurora.
Note (4): See Exhibit 4 following.
Note: BMO Capital Markets is restricted on Aurora Cannabis
Despite Our Conservative Demand Outlook, We Still Expect a Supply Shortage in the
Near Term
We note there is significant execution risk across the industry as LPs have never cultivated cannabis on a
mass commercial scale. We understand that all the phases of the cultivation process cannot be initiated
in a new facility at the same time and that there is a natural ramp schedule that will take at least a
number of months before the entire facility is up and running. In addition, based on our recent visits to
most of the larger Canadian LPs’ facilities, we have determined that ramping an indoor or greenhouse
(see Glossary for definitions) cultivation facility is a highly sophisticated process. Areas of complexity
include securing the genetics and appropriate soils and fertilizers, developing a suitable nutrient and
water delivery system, establishing a robust climate (heat, lighting, humidity, carbon dioxide, etc.) to
optimize the plant’s development, and processing the plant materials post-harvest (drying, trimming, oil
extraction). At the same time, these environments are highly susceptible to contamination from mould,
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mildew, and bugs. As a result, we believe the majority of LPs, many of which are still developing their
facilities or waiting for licenses, will not have the inventory or production capacity to meaningfully
supply the initial recreational market.
Notwithstanding that our projection for demand is lower than other industry expectations, we would
expect that provincial governments will seek to fill the retail channel with a meaningful inventory level,
and on balance, we believe the initial recreational market will experience a supply shortage. We are
also concerned that some LPs that have been awarded supply contracts could experience difficulties
meeting their supply obligations in the near term. As a result, our view anticipates that the select few
LPs with sufficient inventory will be able to sell all that they can produce in the near term.
After the initial fulfillment of the provincial retail channels, our industry supply and demand outlook for
both medical and recreational markets indicate that total domestic demand will still exceed industry
supply in the second year post recreational legalization. As a result, we believe the LPs should be able to
continue to sell all that they can produce and pricing should be firm. We anticipate in year two of our
forecast that industry supply will begin to catch up to demand, which will result in some pricing pressure
on dried flower. However, our Base Case projections anticipate that federal regulators will begin to
legalize expanded product formats, such as vape pens, edibles, and beverages, which should carry much
higher pricing on a grams-equivalent basis. As a result, our Base Case scenario projects that blended
pricing per gram for the LPs will improve modestly in the second year of our forecast period (see Exhibit
4 below).
Exhibit 4: Product Mix on Blended Pricing
Dried Oil & Gel Other Value-add
Flower Capsules Formats Blended
Year 1 of Rec. Legalization
% of Market 90% 10% Not Legal 100%
Est. Wholesale Price (per gram) $4.50 $6.00 Not Legal $4.65
BMO Base Case from Exhibit 3 $4.50 - 4.75
Year 2 of Rec. Legalization
% of Market 70% 20% 10% 100%
Est. Wholesale Price (per gram) $4.00 $6.00 $15.00 $5.50
BMO Base Case from Exhibit 3 $5.50
Source: BMO Capital Markets.
Provincial & Territorial Supply Contracts Are Critical to Participate in the Recreational
Market
Overseeing the distribution of recreational cannabis will be the responsibility of the provincial/territorial
governments. Most provincial/territorial governments will purchase cannabis from LPs on a wholesale
basis to distribute into the retail channel, which includes both e-commerce and physical stores. As a
result of this regulated supply chain, securing provincial/territorial supply contracts will be critical for LPs
to access recreational markets.
We understand that there will be two typical avenues for LPs to access the provinces/territories: either
with a direct supply agreement with the province/territory, or by wholesaling to another LP that has a
provincial/territorial supply contract. We would assume that wholesaling to another LP generates lower
economics relative to a direct supply agreement, but we believe the majority of LPs will ultimately need
to wholesale to other LPs in order to participate in the provinces’/territories’ recreational markets. This
is based on our view that in the near term, provincial/territorial governments are primarily focused on
securing sufficient inventory and scope of product offerings to meet initial demand, a criterion that
should favour the larger LPs. We also believe the contractual wholesale price in these
provincial/territorial supply agreements could vary among the signed LPs as we understand that pricing
is determined through a negotiated process.
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Certain regional LPs could also be well positioned to secure direct supply agreements in their home
province/territory as a result of the economic development created from their operations. However,
these regional LPs may be challenged to secure direct supply contracts in other provinces/territories,
which would limit their ability to grow on a national scale. The announced LP suppliers for Quebec,
Newfoundland & Labrador, New Brunswick, Prince Edward Island (PEI), and Yukon appear to support our
view that the LPs best positioned to secure direct supply agreements with the remaining
provinces/territories are likely to be the ones that can demonstrate an ability to supply a significant
amount of volume and/or are contributing to economic development in that province/territory. See
Exhibit 5 following.
The largest recreational markets should be Ontario and Quebec given the significant population in these
two provinces. However, we believe the opportunity to access the Quebec market through a direct
supply contract is now unavailable over the next few years for LPs other than the six that have entered
into agreements with the province: Aphria, Aurora (Restricted), Canopy, Hydropothecary, MedReleaf,
and Tilray. Only Hydropothecary has disclosed additional details of its supply agreement (see Exhibit 6
following). We also note that only Hydropothecary has a five-year contractual term to supply the
province, with an optional sixth year renewal at the government’s discretion.
Exhibit 5: Hydropothecary’s Expected Economics in Quebec
Term 5-year
Frequency of purchases 4 orders / year
Product Offering Full range1
SKUs 63 initially
Expected Product Mix - initial 80% flower
Expected Product Mix - Later 30% flower
Per Gram Economics
Wholesale price2 $5.40
Less excise tax (1.00)
Revenue to Hydropothecary $4.40
All-in Cost - now $2.60 Margin
Est. EBITDA - now $1.80 41%
All-in-Cost - mgmt's outlook $2.00
Est. EBITDA - mgmt's outlook $2.40 55%
Source: Company press release.
Note (1): Dried flower, oils, Elixir spray product, capsules.
Note (2): Weighted average by product mix. Pricing could
change in later years depending on demand.
Unlike other provinces, the Ontario Cannabis Store (OCS) will secure supply through periodic product
calls, whereby the OCS will select LPs to purchase SKUs under contractual terms. On April 11, the OCS
announced the commencement of its first product call process. Selected LPs will be eligible to
participate in the OCS’s product calls over a contractual two-year term, but the OCS will not make any
volume commitments. Pricing will be set at a predetermined amount for the term.
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Exhibit 6: Supply Chain for Recreational Market by Province/Territory
British Columbia Alberta Manitoba Saskatchewan Ontario Quebec Newfoundland
Private. Regulated by Govt (OCS) via product Private. LPs will sell
Distribution Govt (BC LDB) Govt (AGLC) Govt (LGA) Govt (SAQ)
govt (SLGA). calls. directly to stores.
Aphria, Aurora, Canopy,
First product call Hydropothecary (QC-
Announced Suppliers None announced None announced None announced None announced Canopy
process under way based), MedReleaf,
Tilray
Retail
Govt. Partnered with
Online Govt. Govt. Private. Private. Govt. Govt.
Shopify.
Private. Licenses issued Govt. 150 stores by
Govt and private. Private. 250 licenses lottery-style. Only 51 2020. 40 openings in
Private. Announced 41
Stores Unlimited private expected in the first Private. licenses in 32 2018, 40 in 2019. Govt. Initially 15 stores.
licenses.
licenses. year. municipalities, which can Announced first 4
opt-out (5 have). locations.
New Brunswick Nova Scotia PEI Yukon North West Nunavut
Distribution Govt (NB Liquor) Govt (NSLC) Govt (PEI LCC) Govt. Govt. Only NWTLC. No info yet.
Aphria, Canopy,
Canada's Island Garden
Hydropothecary,
Announced Suppliers None announced (PEI-based), Canopy, Canopy, Tilray None announced None announced
Organigram (NB-based),
Organigram
Zenabis (NB-based)
Retail
Online Govt. Govt. Govt. Govt. Govt. Will have online platform.
Govt. Allow co-location
Govt. Initially inside
Govt. All 20 initial with alcohol. 9 sites in At least 1 govt-run Govt and private. No
existing liquor stores.
Stores locations have been urban hubs announced. Govt. 4 sites only. location. May allow physical stores expected
Stand-alone stores are
announced. More stores possible in private. in 2018.
possible in the future.
future.
Source: Government websites. Note: BMO Capital Markets is restricted on Aurora Cannabis
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Read-Throughs From Quebec and Ontario Supply Arrangements
In the near term, we believe the retail price (pre-HST) for dried flower will generally range
between $7 and $9 per gram and the wholesale price to LPs will range between $4 and $5 per
gram.
We believe the provinces will need to make several significant adjustments over the near term
in the quantity and type of products they purchase as they develop a better understanding of
consumer preferences as a result of actual point-of-sale purchases. This presents a risk to LPs if
demand for their product SKUs is materially lower than anticipated.
Who Will Win in the Near Term? Will Branding Help?
Heading into the recreational market, we note that the strategy being adopted by most LPs is to
establish brands through “lifestyle” associations to experiences such as the outdoors, health and
wellness, music, art, or to specific celebrities. There is a view among LPs that branding, particularly if
communicated to consumers before legalization, will create brand recognition and encourage in-store
purchase when the market is legal.
However, we believe federal regulations will restrict the marketing reach of products intended for the
recreational market. For example, we note that MedReleaf cancelled the Quebec launch of its San Rafael
’71 brand in April 2018 following concerns from the provincial government that the brand’s lifestyle
positioning may be in violation of proposed Bill C-45 regulations. In addition, recent proposals from
Health Canada, if enforced, would materially impair the LPs’ ability to convey their brand in-store via
packaging (see Exhibit 7 below). Finally, federal regulations will limit the ability to advertise brands via
various media platforms.
Exhibit 7: Health Canada’s Proposed Packaging Format
Source: Health Canada.
If there is limited product packaging differentiation in-store and limitations on marketing initially,
having more shelf space may be the key driver to gaining a greater share of the initial demand and to
establish a head start in brand development. As a result, we believe the LPs that have adequate
inventory and production will be best positioned to generate significant revenue and earnings by
participating in an undersupplied market at favourable unit economics. There would be further potential
upside for these LPs if others are unable to meet the volume commitments stated in their
provincial/territorial supply agreements.
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It is also likely that restrictions on marketing and packaging could cause a large portion of consumers to
simply seek the highest-potency strains (i.e., high in THC and/or CBD). In this scenario, LPs with more
product offerings in high-potency strains could be better positioned to capture more demand. If
Canadian consumers focus on specific strains, the recreational market will be comparable to Colorado,
where dried flower branding is at the strain level and differentiation is based on qualities of that strain,
including efficacy, potency, and consistency. We note that popular strains in those states are able to
command premium pricing. If differentiation in the Canadian recreational market is based on strains, it
could undermine the branding strategies of many LPs.
On the other hand, there is a view that strain-level branding is unique to Colorado due to the state’s
fragmented landscape of regional producers specializing in specific strains and regulations that facilitate
a “deli-style” retail environment. Dried flower is not pre-packaged and instead, is placed in containers
for customers to purchase, much like a deli counter. In Washington, where dried flower is pre-packaged,
there are company-level brands, similar to ones being developed by Canadian LPs. As well, we believe
strain-level branding will become less relevant as value-add products with cannabis extracts, such as
vape pens and consumables, are introduced.
Branding Power May Be Limited In-Store; Can Budtenders Bridge the Gap?
While brands could develop consumer awareness and influence in-store purchasing, we believe
branding power may be limited if it is not communicated or promoted by the in-store sales staff (also
known as budtenders). When we visited cannabis dispensaries in Denver and LA, we found that
budtenders play a crucial role in consumer education and product recommendations, which are based on
personal experiences and third-party user feedback.
Specific to Canada, where packaging designs could be limited and consumers may be focused on specific
strains, it would be the budtender’s role to differentiate the products, and in particular, highlight the
variances of otherwise genetically similar strains grown by different LPs. We note that several LPs could
be cultivating the same strain for the recreational market and while the strain’s core genetic profile is
the same, qualities such as potency, efficacy, and consistency may differ as a result of the particularly
environment it is grown in (also known as the plant’s phenotype).
We are concerned that initially, budtenders may not have sufficient knowledge to effectively
communicate the differences between products and segment them based on perceived quality. In
addition, we believe there is a risk that provinces/territories could limit the channels in which LPs can
establish partnerships with the sales staff. For example, we understand that Ontario’s regulations will
prohibit budtenders from making brand recommendations, although they will be permitted to provide
factual information about the product such as the terpene profile and potency level. As a result of the
restrictive regulations on marketing, branding, and budtenders, we believe the initial successful LPs will
be companies with sufficient products to fill the retail channel and maximize shelf space.
Current Medical Market in Canada: Opaque
According to Statistics Canada, there are currently 269,500 registered medical cannabis patients in the
country. A widely disclosed metric by LPs is the number of patients they have onboarded as there is a
perception that the number of patients registered with an LP is indicative of the company’s share of the
Canadian medical market. However, we believe this metric alone is a misleading measure for market
share as patients can register with more than one LP, a patient may be registered with the LP but not
actively ordering products, or a LP could have fewer registered patients but higher average consumption
per patient. In addition, we believe there is currently no standardized definition of an “active” patient.
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As a result, we believe it is important to consider the volume sold, reported revenues, number of
registered patients, and implied average consumption per patient (see Exhibit 8 below).
Exhibit 8: Key Publicly Traded Players in the Canadian Medical Cannabis Market
Last Quarter Last Quarter
Volume Sold Share of Share of Grams per Avg. Selling
(kg) Volume # Patients Patients patient Price ($ / g)
Canada 15,616 269,502 58
Canopy 2,330 15% 69,919 26% 33 $8.30
Aurora 1,353 9% 45,776 17% 30 $7.99
MedReleaf 1,263 8% n.a. n.a. $8.64
Aphria1 ~1,000 6% ~40,000 15% 25 $8.30
CannTrust 982 6% 40,000 15% 25 $7.63
Source: Company filings.
Note (1): Excludes wholesale to other LPs.
Note: BMO Capital Markets is restricted on Aurora Cannabis
We find the current Canadian medical market to be opaque with respect to patient acquisition and
churn. Physicians can either directly prescribe their patients for medical cannabis or refer them to a
cannabis clinic. In the former, the physician will prescribe a specific dosage, and can also provide product
recommendations. Alternatively, the physician can refer the patient to a cannabis clinic where the
patient can access further information about which products would be most suitable for their needs.
We understand that both prescribing physicians and cannabis clinics are typically receiving “education
fees” from LPs. This may prove to be an inappropriate payment that will eventually be addressed by
medical regulators. The challenge in assessing the prevalence of this fee is the lack of disclosure,
including the amount typically charged by clinics and physicians. Our view is that since cannabis is closer
to an alternative natural health product than a pharmaceutical drug and has no clinical trials, the primary
channel for LPs to acquire patients is to encourage physicians through strategic partnerships and
cannabis clinics. As a result, we believe these education fees likely represent significant patient
acquisition costs for LPs and we have heard anecdotally that they can represent about 15% of the LP’s
selling price.
We also consider churn to be a key metric in assessing the competitive dynamics of the medical market.
However, there is a lack of disclosure by LPs on this measure and any approximation is challenged by
the continued growth in the overall Canadian medical market. Based on our understanding of the
industry, we believe churn could be quite high as cannabis products have a wide range of efficacy
depending on the individual, and it is likely that patients are trialing numerous LPs’ products to
determine the best one(s) for their needs.
Supply & Demand in the Medical Market When Recreational Is Legal
We believe there could be some material changes in both the level of supply and demand in the
medical market when the recreational market is legalized. Some existing patients, and potential future
patients, could prefer the recreational market given that the latter provides relatively easier access to
cannabis than the medical prescription process. However, this may be more than offset if more
employers begin to include medicinal cannabis under insurance coverage plans. In addition, medical
expenses are tax deductible above a certain threshold. Overall, our Base Case forecast assumes that the
industry growth rate for medical patient acquisition slows when the recreational market is legalized. On
the supply side, we believe there will likely be a tighter market for medical cannabis in the near term as
we expect that most LPs will prioritize their inventory to gain a share of the recreational market.
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Near-Term International Medical Opportunity: Germany
There is considerable focus on the international opportunity for Canadian LPs as the country’s tenured
federal medical framework, expected national legalization of the recreational market, large number of
LPs with cultivation experience, and access to capital markets puts Canada at the forefront of the global
cannabis opportunity.
In the near term, we believe Germany’s medical market is the primary international opportunity for the
Canadian LPs due to its medical legalization, size of population, and a favourable insurance coverage
outlook. In a recent report by Prohibition Partners, a cannabis-focused market intelligence firm, the
long-term German medical cannabis market opportunity was estimated at €10 billion.
We understand that prior to medical legalization there were only about 1,000 German citizens with
permission to use cannabis for serious medical conditions. Since medical legalization in 2017, the
country’s three large insurance companies disclosed that there have been 20,000 medical cannabis
claims, of which 13,000 were approved for reimbursement. In addition to these claims, there are also
private cannabis prescriptions where the patient covers the expense. We understand that German law
requires health insurance coverage for medical cannabis, although we have heard that the associated
paperwork is onerous and often a grounds for a patient to not qualify for coverage.
Germany’s current medical cannabis framework does not permit domestic cultivation. As a result, the
country relies on imports to meet demand. Initially, Germany imported exclusively from a Dutch
producer called Bedrocan, but a few Canadian LPs are now focusing on the country. Canadian LPs must
wholesale their exports to the pharmacy distributors as only pharmacies are permitted to dispense
medical cannabis prescriptions. Currently, retail and wholesale prices (the price shared by distributors
and Canadian LPs) in Germany can be as high as $25 and $15 per gram, respectively, due to the supply
shortage from a lack of domestic cultivation and prior administrative issues that delayed international
companies from being able to import into the country. As a result, Canadian LPs exporting into Germany
are receiving much higher wholesale prices than they are receiving in the Canadian medical market. See
Exhibit 9 below for LPs that have secured the licenses, Good Manufacturing Process (GMP) certification
and distribution partners, and are either already or will begin exporting into Germany.
Exhibit 9: Current Players in the German Medical Market
Canadian LPs Distributors
Aurora Pedanios
MedReleaf CannaMedical
Canopy Growth SpektrumCannabis
Cronos Group Pohl Boskamp
Maricann Maricann GmbH
GmbH
Tilray Noweda
Paesel + Lorei
Dutch LP
Dutch
Bedrocan Government
Source: Company filings.
Note: Aphria is awaiting GMP certification.
Note: BMO Capital Markets is restricted on Aurora Cannabis
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Asterisks Behind the German Opportunity
Notwithstanding these favourable dynamics, we believe the German market opportunity for Canadian
LPs should be evaluated carefully. We expect only a handful of the larger LPs will be able to secure the
licensing and certifications requirements, and develop the necessary distribution infrastructure in the
country. Canadian LPs need an export license from Health Canada, be GMP-certified, and have a
distributor partner to supply the fragmented German pharmacy landscape.
We note that achieving GMP certification is a significant undertaking for an LP. In addition, there are
varying forms of the GMP standards, some of which may not be recognized in certain jurisdictions. We
believe the challenges associated with GMP certification represent a significant hurdle in terms of capital
and other investments for the smaller LPs to meet.
We also understand that unlike the Canadian medical market, cannabis producers and distributors are
not permitted to communicate directly with patients and education fees are prohibited. In Germany, the
prescribing doctor has sole discretion in selecting the LP for the patient, and pharmacies cannot
substitute for another producer’s product when dispensing the prescription. As a result, we consider the
focus by some Canadian LPs on the number of German pharmacies their distributor partner has
relationships with is somewhat misleading as these distributors can supply to any German pharmacy,
and it is the doctor who ultimately determines which LP’s product will be prescribed. We believe
establishing relationships with doctors is critical in order to become a meaningful player in the German
medical market, and such an investment presents another hurdle for the smaller LPs. We understand
that there are about 100,000 doctors and 27,000 pharmacies in Germany.
Finally, it appears that favourable economics from German sales have yet to materially contribute to
earnings for the participating Canadian LPs. Current exports into the German medical market only
represent a modest portion of sales for the handful of Canadian LPs that are able to sell products there.
Long-Term Industry Outlook
Oversupply Expected in the Long Term but Impact on Pricing for LPs Is Uncertain
Based on our outlook for industry demand in Exhibit 3 and our forecast for production output by the Big
Three LPs, which we believe will represent the majority of industry supply, we project that supply will
catch up with demand in year two and potentially begin to significantly exceed demand likely in the
third or fourth year following recreational legalization. It is not clear if this projected supply/demand
imbalance will weigh on the cannabis prices realized by the LPs as by then there will be the opportunity
to export increasing volumes to international markets, such as Germany, and the introduction of
additional product formats (such as vape pens, edibles, and beverages) should provide higher pricing
and margins per gram equivalent to compensate for price compression in dried flower.
The analysis in Exhibit 10 following outlines our view that in the long term, the Canadian market will
shift from a supply shortage to significant oversupply of dried flower as Canadian LPs complete their
facility build-outs. Exhibit 10 highlights that just the production capacity currently being developed by
the Big Three LPs will account for eight million of the estimated 11 million square feet of production
space required to satisfy total Canadian demand. We note that the eight million square feet does not
consider the facility expansions of the other LPs, many of which we understand are also undertaking
significant facility developments.
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Exhibit 10: Long-Term Oversupply
1
Potential long-term demand in Canada (kg) 1,000,000
Avg. Annual Yield from Greenhouse1 (g / sq.ft.) 90
Industry Production Capacity Needed (mm sq. ft.) 11
2
Big Three Production Capacity (mm sq. ft.) 8
(not incl. other 100+ LPs)
Source: BMO Capital Markets.
Note (1): Long-term estimates. Long-term demand includes recreational and medical.
Note (2): Estimated cultivation space (excludes corporate space). Assumes
Aurora acquires MedReleaf.
Note: BMO Capital Markets is restricted on Aurora Cannabis
Over the very long term, as dried flower prices continue to settle, and as margins are eroded from the
agricultural growing aspect of cannabis, we believe the Canadian market will rationalize into the
handful of larger, branded players capable of generating earnings and cash flow through strong brands
and quality value-add product formats. In addition, as the industry rationalizes, we believe a number of
low-cost producers will evolve into contract cultivation and will supply the large, branded companies.
Beyond the large, branded players and low-cost contract cultivators, it is not clear to us how the many
other LPs, outside of niche brands, will survive under this pricing environment.
In terms of the types of grow facilities, our view is that indoor cultivation will be challenged in a long-
run environment with significant pricing headwinds in dried flower. We understand from our industry
discussions that both capital and operating costs of a greenhouse could be substantially less than those
of indoor facilities.
Further Long-Term Scenarios
Over the long term, we believe consumers will develop a better understanding of cannabis and be able
to segment products based on perceived quality. As a result, although a strong brand may encourage
initial trial, there must be perceived product quality and a consistent user experience to validate the
brand and generate repeat purchases.
Although we believe the majority of the dried flower category will become a commodity, we highlight
some potential industry developments over the long term that we believe could mitigate some of the
pricing headwind from an oversupply of dried flower:
If many LPs experience challenges in ramping their facilities, it would delay the onset of an
industry oversupply and enable LPs participating in the early recreational market to continue
earning favourable unit economics for a longer period of time.
If LPs are able to establish strong brands and consumers perceive their products to be high
quality, these LPs could potentially have some leverage on pricing.
The eventual legalization of value-add formats such as vape pens, edibles, and beverages
would create areas for more product differentiation. In addition, additional formats could
appeal to new cannabis users and expand the size of the recreational market. See “New
Product Formats” section following.
Demand from international markets could alleviate some, and potentially all, of the anticipated
oversupply in Canada. Several EU countries with a legal medical framework are already
importing products from Canada. In addition, there are other jurisdictions progressing towards
legalizing cannabis for medical use. See “The Path to Global Legalization…” section following.
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New Product Formats
In Washington, for example, while dried flower still remains a sizable portion of the market in terms of
sales, the value-add product formats (derived from cannabis extracts) have experienced notable growth
and are capturing a greater share of industry sales (see Exhibit 11 below). There is a view that current
product mix in U.S. states may not fully reflect the potential of the future Canadian market as many
value-add formats in the U.S. are generally considered poor quality, which may be limiting uptake.
Exhibit 11: Product Mix in Washington (% of Sales)
Source: Analysis of WA LCB seed-to-sale. Carnegie Mellon University Heinz College.
We believe the Canadian industry’s investment in large-scale greenhouses is both a strategy to reduce
production costs and also a belief that consumer demand will shift significantly from dried flower to
value-add formats derived from cannabis extracted oils. If these product derivatives ultimately capture a
sizable of the market, most dried flower will be extracted and under such a scenario, the aesthetic
features of dried bud would become less important, and cannabis cultivation in greenhouses would be
more cost effective than indoor.
An opportunity from legalizing these formats is the potential for a significant expansion in the user base
of the recreational market. We note that vape pens have become a fast-growing category in U.S.
markets as novice and first-time users prefer the product for its discrete and easy-to-use format. As well,
there could be a further broadening of the recreational market to non-users of the traditional flower
format if mainstream product mediums, such as cannabis-infused beverages, are legalized.
Value-add formats could also potentially offset the decline in dried flower pricing on LPs’ profitability by
allowing more market segmentation and premium branding, and those with perceived better quality
could command premium pricing, which we found to be the case in Denver and LA. We believe this
price differential arises from the level of processing know-how and innovation required to manufacture
these formats and the resulting ability to develop stronger brands.
However, we note there are some risk factors associated with the value-add product categories:
If Canadian regulatory delays preclude these formats from the recreational market for longer
than expected, it would exacerbate the scope of dried flower oversupply as LPs would be
unable to divert excess dried flower to be extracted and processed into these other formats.
Relative to the proliferation of formats in the U.S. markets, the legal Canadian market has only
been permitted to produce and sell dried flower and oils. As a result, we believe there is a risk
that the level of expertise and technology possessed by Canadian LPs to develop quality value-
add formats is limited, which could result in poorly made formats that discourage consumer
adoption for some time.
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