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Why These 3 Canadian Cannabis Giants Shouldn’t Struggle with Oversupply

There has been a lot of hand-wringing lately about the alleged oversupply of cannabis in Canada, fear in many ways that is unjustified at this time. Beyond the obvious, there are a number of reasons why oversupply isn't going to be much of an issue for major producers like Aurora Cannabis (ACB), Canopy Growth (CGC) and Aphria (APHA). Among them are the increase in retail outlets in Canada, rapidly failing small competitors, wholesale options in the near term, conversion of dried flower to CBD, inevitable decline in black market sales, sales to research labs in the U.S., and an increase in international sales.

Because these three companies are the leaders in production capacity in Canada, they should disproportionately benefit from the increase in license retail stores being rolled out. The same goes for international sales, where all three companies have a decent presence, with Aurora Cannabis being the strongest with 25 markets it operates in.

Most of us are aware of these two elements associated with these companies. The majority of commentators and pundits base most of their ideas surrounding oversupply on those two aspects of the market. Even there they're wrong because they don't take into account the retail licensing factor, which is the major reason for weaker sales in the provinces.

Technically you could assert there was an oversupply because there is more supply than current market conditions justify, but that's not because of lack of demand, but again, lack of stores to sell product in. This is starting to be addressed, and this will provide outlets for the increasing amount of supply coming from these pot giants.

What this has also done is provide an opening for the black market, where the lack of competition has allowed them to thrive much longer than expected, as there have been many geographic regions with very limited places to buy legal pot. That's especially true in Toronto and Ontario as a whole. Legal retail outlets will put more pressure on illegal operations, and that will boost demand. It will also increase scale for the companies, presumably helping them cut costs while increasing revenue.

There is also no doubt that it won't be long before many small competitors go out of business from the lack of capital, cash burn, and the inability to ever turn a profit. When they go out of business it will open the door for these companies to make up for the supply shortfall.

Another outlet for their cannabis is converting it into different CBD products, which in turn the companies sell. I haven't seen too many people talk about this, as they look more toward recreational and medical cannabis for their supply outlook.

The other sales outlet not being considered, or if considered, being looked upon as a negative, rather than the positive option it is. One silly writer even called it "dumping" when commenting on Aurora Cannabis selling into the wholesale market during the last reporting period.

I consider it a positive because of the slow roll out of retail stores in Canada. Selling into the wholesale market while waiting for the stores to increase in number is a good use of cannabis for now. It would be irresponsible to just sit on it hoping it wouldn't rot while waiting for the stores to open.

Last, there have been a couple of deals made with research labs in the U.S. to sell cannabis to. Of the companies focused on in this article, only Canopy Growth has made that type of deal, with the other being Tilray.

How much this has an impact on Canadian cannabis producers remains to be seen, as the existing deals appear to be only one-off deals. If the U.S. approves of more facilities, it would be easy to see this being a meaningful market for not only Canopy, but Aphria and Aurora Cannabis as well.

Aurora Cannabis (ACB)

One thing I've seen mentioned concerning Aurora Cannabis is it faces an oversupply issue. Some have even suggested it's building too many facilities. I disagree strongly with that assessment, for the reasons mentioned above.

In a little over half a year Aurora is going to be the market leader in production capacity by a wide margin. While that would be a negative factor in the near term because of the appearance of too much supply for the Canadian market, but like I said, that's something that is being remedied because the demand is already there.

And when taking into account the decline in smaller competitors, the shrinking of the black market, wholesale options, and growing international demand, Aurora has plenty of outlets to sell its pot through for a long time.

The number of competitors is going to contract, not expand, and that's good news for Aurora. It's very probable that by time of the end of June 30, 2020, many will have fallen by the wayside at the time Aurora approaches full production capacity. I see this and the shrinking black market as key catalysts for Aurora in the years ahead.

The metric to follow in my view is the pace of the opening of retail stores across Canada. As more and more are operational, it will put more pressure on the black market and smaller producers who will struggle to meet demand.

Ladenburg analyst Glenn G Mattson noted "While some producers are concerned about oversupply in the coming years, Aurora is taking the stance that the market has been habitually undersupplied, and that demand from things like derivatives, and the potential to export medical cannabis to places like Europe will continue to soak up supply. In the current quarter, the company was able to sell $20 million of cannabis at a 60% gross margin in the wholesale market as the industry was not able to source enough high-quality product."

The analyst added, "In the very near-term, management has stated that in Alberta, a number of new stores are coming online and have ordered product ahead of opening, and that it may take some time for that product to sell through. This creates a modest oversupply in the current quarter, but not with relation to the longer-term outlook in Canada."

Mattson rates ACB a Buy along with a $9.00 price target, which implies about 150% upside from where the stock is currently trading. (See ACB's price targets and analyst ratings on TipRanks)

Canopy Growth (CGC)

Canopy Growth is in a similar place as Aurora, with the exception of not having the international reach it has. Yet it does have the additional outlet of the research lab in America. Again, if that becomes something beyond a one-off deal, it will be a decent source of revenue for Canopy.

The ongoing concern for Canopy is its lack of a clear vision as to what type of business model it has. Not that long ago it identified primarily as a recreational pot company, and since then has talked about being a medical cannabis company.

It must get long-term leadership in place to make the vision of the company clear and show how they're going to steer the company to its desired end.

As for oversupply, Canopy is in a similar position as Aurora and Aphria as far as Canada goes, and has been doing well in increasing medical sales, even as recreational sales have declined.

Further out Canopy won't have the production capacity of Aurora, but it'll probably be several years before that becomes a factor in revenue.

For now, I don't see Canopy having much of an oversupply problem over the long term. It will probably continue to underperform until the retail stores are opened in sufficient numbers to have a significant impact on revenue and earnings.

It’s clear that Wall Street is largely divided between the bulls and the fence sitters when it comes to Canopy's market opportunity. In the last three months, the cannabis giant has landed 8 ‘buy’ ratings vs. 8 ‘hold’ ratings.That said, the consensus average price target points to $34.64, or nearly 74% upside potential for the stock. This suggests that by consensus expectations, for now, the bulls win on Canopy. (See Canopy stock analysis on TipRanks)

Aphria (APHA)

Aphria is the third-largest company in Canada as measured by production capacity, so faces the same challenges and opportunities Aurora and Canopy Growth do.

One difference it has with Canopy Growth is it was awarded five licenses in Germany to produce cannabis, as has Aurora. Canopy went a different route when it was snubbed by buying C3 CAnnabinoid Compound Company in Germany. At the time of the announced deal it was serving approximately 19,500 patients.

As for Aphria with its licensing deal in Germany, the demand growth there looks very strong, with the German medical cannabis market expected to surpass 1 million customers by 2024, according to Prohibition Partners.

While Aphria is among the big three in Canada, its full production capacity will only be about half that of Canopy Growth, and much further behind Aurora Cannabis when it reaches full production capacity.

In the near term this shouldn't be an issue though, even as the smaller cannabis companies have benefited from the slow rollout of licensed stores against their larger competitors. That is changing, and Aphria will definitely get its piece of the Canadian market as its many smaller competitors start to wilt and fall away.

Wall Street likes the risk/reward factor at play here, as TipRanks showcases a "strong buy" consensus rooting for Aphria's success. In fact, the consensus of analysts following Aphria is that this stock could soar nearly 70% over the next 12 months, rising from $5.14 and approaching $8.59 per share. (See Aphria stock analysis on TipRanks)

Conclusion

The so-called oversupply situation in Canada, in my view, doesn't exist at this time as measured by supply and demand. There is too much supply because of the low number of retail outlets, which the companies believed would be much further along in numbers, and increased capacity accordingly.

I would have a different view if demand was actually low, but that isn't the case. We really won't know the full oversupply story until the number of retail stores in Canada approach their saturation point, which is going to take awhile.

In the meantime, these three companies will have the equivalent of an increase in demand based upon the pace of store openings. Combined with the expected decline in legal and illegal competitors, they should get a much larger market share than is now anticipated.

With the other sales outlets and changing market conditions that will favor them, I don't see oversupply having any significant impact on these companies in the long term, and a limited amount in the short term.

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