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This Tiny Marijuana Stock Could Be Better Prepared for the Coming Supply Glut Than Canopy Growth and Tilray

Keith Speights, The Motley Fool

A supply glut in the Canadian recreational marijuana market might be the last thing on everyone's minds right now. The primary concern currently relates to supply shortages. Marijuana producers can't ship enough cannabis to meet the heavy demand.

Make no mistake about it, though, a supply glut is on the way. Opinions vary on when it will hit, but it wouldn't be surprising if the Canadian marijuana market experiences a supply surplus by 2020.

The conventional wisdom is that the large marijuana producers like Canopy Growth (NYSE: CGC) and Tilray (NASDAQ: TLRY), which claim the biggest market caps in the industry, will be in the best shape when the supply glut arrives in Canada. But a tiny marijuana stock that has largely flown under the radar -- Flowr (TSXV:FLWR) -- just might be better prepared for the coming Canadian oversupply than the big boys.

Pile of marijuana leaves with one positioned on top and in the center.

Image source: Getty Images.

Yes, a supply glut is coming

A supply glut occurs when there's more than enough supply to meet demand. Canada doesn't have anything remotely close to this right now because pent-up demand for recreational marijuana is very high and producers don't yet have the capability to grow enough cannabis to meet that demand. But that's definitely going to change.

In August, my Motley Fool colleague Sean Williams put together a great analysis of how much production capacity could be on the way. Sean looked at the projections from the top-tier growers (including Canopy Growth), second-tier growers (with Tilray in the group -- despite its huge market cap, the company's capacity isn't in the upper echelon), and smaller growers. When he summed up all of these projections, Sean arrived at a total production capacity of around 3 million kilograms per year by 2020.

What about demand? Professional services firm Deloitte thinks that annual Canadian marijuana demand will be around 600,000 kilograms. That's a little lower than the official demand estimate of 650,000 kilograms per year from the Canadian Parliamentary Budget Officer, which serves a function similar to that of the U.S. Congressional Budget Office.

The most optimistic projection for Canadian marijuana demand that I've seen is 900,000 kilograms per year. This estimate was made by Colorado-based cannabis consulting firm Marijuana Policy Group.

But if you take even the rosiest demand estimate, it pales in comparison with Sean's 2020 capacity projection. Sure, Canadian marijuana growers might not be able to produce 3 million kilograms of cannabis annually within a couple of years. Expansion efforts could take longer than expected. Smaller players could run out of money. However, even if the actual annual capacity winds up being a third of what is projected (a very unlikely scenario, in my view), we're still looking at a significant supply glut in Canada.

Most likely to survive and thrive

So with a supply glut in Canada seemingly inevitable, the question is: Which companies are most likely to survive and thrive? And that's where tiny marijuana producer Flowr comes into the picture.

When supply exceeds demand, prices plunge. That's what is likely to happen in a few years in the Canadian marijuana market. Companies with low operating costs will be better able to handle a low-price environment.

In the cannabis industry, the key to achieving low operating costs is to have high yields per square foot. I recently spoke with Flowr co-founder and chairman Steve Klein, who maintained that "the most important KPI [key performance indicator]" in the industry is yield per square foot.

Flowr beats most of the major Canadian marijuana producers when it comes to crop yield. Its current yield translates to a cost per gram of 2.05 in Canadian dollars, well below Canopy Growth's and Tilray's cost per gram. Even better, Flowr thinks it can increase its yield and lower costs even more. 

Klein attributes Flowr's success at achieving great yields in large part to the company's president and co-founder, Tom Flow. Flow claims a solid track record in the cannabis industry with a "flood-and-drain" system of growing that's challenging to use but generates impressive yields. His expertise helped attract Scotts Miracle-Gro subsidiary Hawthorne Gardening to enter into a research-and-development alliance with Flowr.

But there's another reason why Flowr might be able to successfully navigate a supply glut. High quality should become even more important in a commoditized market. Flowr's products are all grown in indoor facilities and don't require irradiation. The problem with irradiation is that it negatively impacts the taste and smell of cannabis. Most of Flowr's competitors irradiate their products to meet Health Canada's safety standards. 

Most other Canadian marijuana producers are shifting away from what Flowr refers to as "ultra-premium" products. Flowr's plan is to keep focusing on high-quality cannabis while innovating in ways to improve yield and reduce costs. This strategy could give it a leg up on most peers when the overall supply glut hits.

A few caveats

There are a few things that investors should know, though. Flowr only has around 20% of its facility operational right now. Klein said that the company expects to be at 100% production by mid-2019. This means the company's revenue could be limited for a while. 

Also, we've only addressed the Canadian marijuana market. Growth in international markets should help absorb some of the supply glut that is almost certainly on the way in Canada. Larger companies like Canopy Growth, with its huge cash influx from an investment by Constellation Brands, will be in better position to compete in the global marketplace.

Canopy Growth and Tilray could weather the storm in Canada relatively well if they're able to capitalize on international opportunities. But high quality and high yields make Flowr a small marijuana stock to keep on your radar screen.

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Keith Speights has no position in any of the stocks mentioned. The Motley Fool recommends Constellation Brands. The Motley Fool has a disclosure policy.