We have long spoken about how bad the Canadian retail market was going to be. It was always going to be a disaster. Badly planned, horribly executed, and with changes in legislation coming almost monthly leading up to October 2018, and the supply shortage from the LP's looming, the retail market was never going to be ready. It is quite incredible think just how badly this was all planned.
The full impact of Canada's legalisation of recreational marijuana won't hit home until people can shop at their neighbourhood cannabis store."
– Trevor Fencott, CEO of Fire & Flower
To start, there was almost no actual brick and mortar retail outlets. In fact, there were only 57 stores open on Day 1 across the entire Canadian landscape. That's a cool 615,000 Canadians per store. Stores open on Day One per province:
That was brick and mortar. Online was even worse. Most of the online retail is going to be government run. What this means is no competition, and that government gets to set the wholesale price of cannabis for the retail market.
This means that the retail outlets are going to have a limited amount of margin. There is only so much you can charge per gram for retail cannabis, otherwise the black market becomes a cheaper option, and will continue to thrive for some time to come. Having the government run the online store means that the retailer misses out in two keys areas.
The first is their addressable market. Research from mature US states such as Washington and Colorado show that about 35% of cannabis sales are made online. This means that the retailer could lose a significant portion of their addressable consumer market.
In addition, it means that they need to make all of their money running only retail stores which traditionally come with higher staffing costs. If one then considers the cap on the number of retail outlets in the various Provinces, this issue is compounded with a lack of opportunity to gain the benefits of economies of scale.
What cannabis stores can sell and how they can sell it are also heavily regulated.
For example, there's no browsing among aisles of merchandise, and products must be kept out of the reach of customers until they are purchased. Advertising that promotes cannabis is not allowed, and all shopping experiences are be captured on high-definition video, for security purposes. It's onerous and expensive.
Then there is the limited supply. There was no way that the LP's were going to be able to produce enough cannabis to meet the recreational demand set free from October 17th last year. Estimates put the amount of legal cannabis on hand in October at around 80,000 kilograms. Sounds like a lot, except that the estimated demand for Canada's cannabis market is around 800,000 per annum.
And finally, the limited product lines on offer. Canada legalised recreational cannabis in the form of flower and low potency oils only. That's like lifting the prohibition of alcohol and only allowing you to buy beer and light beer. "Real legalsation" is set to take place in October this year when Canada allows for edibles and extracts. Estimates put the black market for vapes in Canada at a billion dollars a year.
Now that you have the lay of the land, let's consider just how each province is treating recreational cannabis and the differences between them, as they are several, and vast in many areas.
Alberta and Ontario
These two privies have caused most of the confusion and problems since legalisation. They both have the same set of rules in place governing retails stores, online stores, homegrown and where cannabis can be consumed. The real differences come in the age limit (Alberta 18, Ontario 19) and the caps imposed on the retail licenses.
Ontario initially announced that the government was going to run the retails stores. Then they changed their minds and announced that retail would be privately run, with an unlimited number of licenses being issued. The maximum number of licenses any one operator could hold would be 75.
But it was to change again. They then announced that the LP's would not be able to open retail outlets in Ontario, which was a massive blow to the cashed-up LP's. This was a fantastic opportunity for the retail operators until in December Ontario announced that only 25 licenses were to be issued via a lottery system. 17,000 applicants paid $85 to be put in the hat and 25 lucky names were pulled out.
Many of the applicants saw this as an opportunity to make a quick buck and thought they would easily flip the license to a cannabis business for a hefty price. But they didn't realise that this was not as easy as that. The license holders must actually pay to complete the tire and only once opened can they have any transfer of ownership.
Still, only 25 licenses for the whole of Ontario is ridiculous. Toronto with a population of 2.7 million people will only have 5 stores. To make it even worse, the province is only giving the lottery license winners 90 days to get their store open for business. To put this in perspective, from the time they identify the location to opening the store take Starbucks, on average, 6 months. This simply is not going to happen.
Alberta started as the most promising retail environment. They capped the total number of licenses in year 1 to 250 and capped the maximum any one operator could have at 15% of the total or 37 licenses. However, Alberta then went on to throw a spanner in the works. Only one month into legalisation, Alberta placed a moratorium on issuing any new licenses. With only 65 stores open across the province, this was a big blow for the retailers, most of whom have signed leases and fitted out their stores.
On Day 1, British Columbia opened with only 1 store, and by January 2019 this number had only grown to 4. Pathetically slow, and add the 8 stores per company cap, and you have one of the worst provinces to operate retail in. 8 stores are nowhere near enough for companies to operate any sort of economies of scale, and given the cap on retail pricing, this will make for a lot of work with very little upside.
This is the only province that allows for private distribution, and also comes with private management of the online channels.
This province has much potential but is also very restrictive on where cannabis may be consumed, banning almost all public areas. This is also the only province to restrict homegrow. It does, however, allow for private online sales which is a much better environment for the retail stores to operate in.
The bottom line
Almost all of the provinces are running horribly behind schedule. Ontario and Alberta have made the retail outlook (for the moment) bleak and unprofitable.
Margin pressure is going to be a key issue for the retail market moving forward. With the government controlling the wholesale price, they have placed severe limits on the margins the retailers can achieve, although extracts and edibles (which have higher margins and premium pricing) should alleviate some of that issue.
Add to this the ridiculous retail caps in most of the provinces will mean that operators are going to struggle to gain economies of scale and with it, even lower operating margins. The black market continues to thrive as they undercut the retail market (given they don't have to pay taxes), all of which stymies retail growth.
The planning was shite, the execution even worse (I don't have a word worse than shite). The limited product range, "where's Wally" scarcity of retail outlets, and the current supply shortages, makes this retail market a difficult and mine-ridden place for investors to venture.
The legalisation of edibles in October and the oversupply due in late 2019 will certainly alleviate some of these issues. We continue to believe this market holds tremendous long term value for investors. For the moment though, tread carefully.