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Posted by Nawan Butt on Jul 10th, 2020

Cannabis 1H update: U.S. momentum shifts into higher gear while Canada left in neutral

With the first half of the year wrapped up and the deepest impact of the shutdown behind us (hopefully), we can circle back to our long-term thesis and breakdown the forces at play in the cannabis industry on both sides of the 49th. Recall that we have been overweight US relative to Canada, preferring strong balance sheets to weak and rewarding market share consolidation in both markets.

We continue to see strong trends in the US for patient counts and positive momentum in cannabis-related politics as well. Canada, on the other hand, remains a challenging market. However, we are starting to overcome many of the distribution hurdles which plagued market growth since legalization in 2018.

Let’s start with the most promising opportunity – the US. Patient counts are a great metric to start off evaluating the health of the US medical cannabis industry and there is positive news coming from a number of individual states.

Florida: patient registration has shown strong growth over the past few years and has further accelerated in 2020. Active patients are now above 350,000, a number which has grown by about 51% year-to-date. These patients represent approximately 1.7% of Florida’s population, whereas mature markets are expected to have penetration in excess of 3%.

Ohio: patient count has grown 7% month-over-month this year and tipped over the 100,000 mark in April, representing a cumulative total of only 0.9% of the population. This nascent market has experienced an annualized run-rate of $200-million in sales for the month of April.

Pennsylvania: since inception of the medical program in late 2017, over 350,000 patients have registered for it. There continues to be positive signs from regulators for adult-use legalization as well, as the state’s Governor publicly declared support for legalization and the legislature is under increased pressure to find alternative sources of tax revenue.

New Jersey: with over 77,000 patients now registered, the state is much more interesting for its adult-use optionality. New Jersey is one of a handful of states which will have marijuana legalization on the ballot in November. Given the support we have seen for cannabis through polls, the ballot is expected to pass comfortably in favour of legalization. New Jersey is central on the Eastern seaboard and provides a large potential catchment area for adult-use cannabis.

New York: patient count is above 117,000 in New York with steady growth levels. New York is also particularly interesting because of Governor Andrew Cuomo’s explicit support for the legalization of adult-use cannabis. The state legislature is also in support of legalization as they push to put through a bill in the coming year.

These are some of the key states we are watching for growth and positioning as we follow multi-state operators (MSOs) which we believe have a shot at becoming market leaders. Cannabis is a fragmented industry in the US, but scale and cost of capital are very important for this industry. Therefore, we like to follow large MSOs which have presence in the above states and have the ability to expand their operations deeper into these states as well.

On the federal level, we are also seeing positive tailwinds for the cannabis sector even though the two presidential nominees have not explicitly stated their platforms on marijuana reform. There is incredible inertia for cannabis reform in the US House of Representatives, which had previously passed through the SAFE Act with ease.

In latest news, the SAFE Act has been attached to the back of the Democrat’s fiscal proposal for COVID-19 relief. In addition, marijuana reform is becoming a key topic in the policing debate, which continues in the US House and Senate. The pursuit to decriminalize and even legalize marijuana is expected to decrease the imprisonment of minority communities in the US. Both these paths lead to a much wider acceptance of medical and adult-use cannabis while massively increasing the accessibility of investment to US institutions.

Lastly, we would point to the pent-up demand that rests with US institutions for the growth that is currently offered by the cannabis industry. Because of their inability to invest in US cannabis, US investors have found the next-best associated growth vertical, which rests in the ancillary industries for cannabis. These ancillary companies continue to see record growth of revenues tied directly to the cannabis industry.

One example would be Scotts Miracle-Gro, which increased its revenue guidance for the coming year with its cannabis service division expected to see revenue growth in excess of 45%; the stock is up 27% year-to-date as investors pile into the name. Another example would be recent equity financings done by Industrial Innovative Properties (IIPR; a leading cannabis greenhouse REIT) and GrowGeneration (GRWG; cannabis hydroponics supplies). Both these financings closed on June 29 and were 5x and 3x oversubscribed, respectively.

And then there is Canada. A significant consolidation is currently underway in Canada with a handful of bankruptcies already accounted for and many licensed producers (LPs) running on fumes. It’s been a difficult six months for all LPs, large and small, with cost cutting coming from all the major players such as Canopy Growth, Aurora Cannabis, Organigram, Hexo, Tilray and Sundial, to name a few.

In our opinion, the pathway to success will be a function of increased distribution in Ontario and market-share consolidation, which will come via price wars in the months ahead. There will be very few winners and plenty of losers. Investors must look deep into variable cost structures and balance sheet strength to distinguish those LPs which will be around in a few years’ time.

In Purpose Marijuana Opportunities Fund (MJJ), we have exposure to Canada via low-cost LPs with strong balance sheets, such as Aphria and Village Farms, in addition to cannabis manufacturers such as Valens Co. The majority of the fund remains geared towards the US, with a balance of large, established MSOs, such as Curaleaf, Green Thumb, Trulieve and Cresco Labs, but also emerging players with strong teams such as TerrAscend and Columbia Care. With several political initiatives currently being debated, we think the US is only one big catalyst away from a complete re-rate of the sector.

Nawan Butt, CFA, is one of the portfolio managers of Purpose Marijuana Opportunities Fund.

All data sourced from Bloomberg unless otherwise noted.

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Nawan Butt, CFA

Nawan has spent 5 years with Purpose developing a deep understanding of client needs with the product team before applying his skills sets in portfolio management starting in 2018. Nawan combines in depth fundamental research with quantitative overlays in contribution to the security selection processes for the firm. Working closely with the CIO, Nawan is also responsible for the implementation of asset allocation across multiple mandates. Nawan earned his MSc in Finance from Simon Fraser University and is a CFA charterholder.