Cannabis Investing Strategy: Canadian Retailers and Extraction Specialists

Cannabis Investing Strategy: Canadian Retailers and Extraction Specialists
Cannabis Investing Strategy: Canadian Retailers and Extraction Specialists

As marijuana stocks continue in their trough, value opportunities stand out for two groups of companies in particular: Canadian extraction specialists and Canadian cannabis retailers.

Why?

It’s not rocket science. As the media clamor for early profitability in the emerging cannabis sector builds, these sub-sectors stand out for two reasons.
 
  1. Strong revenue growth.
  2. Robust margins.

Put the two together and it equals an early transition to profitability. And some of these companies are already profitable.

The retailers and extraction specialists share high revenue growth potential and strong margins, but they achieve this via different paths.

While high-end cannabis cultivation (craft cultivation) can still preserve strong margins, bulk cultivators are seeing their margins being squeezed – from two directions. Greater competition from other legal cultivators and the need to compete with the cannabis black market are pressuring cultivators to lower wholesale prices.

This is being exacerbated (over the short term) by the failure of several of Canada’s provinces to open sufficient cannabis retail stores. It has created a supply bottleneck.

In contrast, the cannabis retailers are at the end of this bottleneck. In markets, like Ontario which are woefully under-licensed for retail stores, those stores that are operating benefit from overflowing demand. However, even in Alberta which leads Canada with over 270 retail locations, retail margins remain strong.

The extraction specialists are perhaps even better positioned. They operate at the first value-added stage in the production of manufactured cannabis products: extracting the cannabis oils that are the foundation for these products.

With Cannabis 2.0 – Phase 2 of legalization in Canada – a wide array of value-added products are now legal. These include concentrates, edibles and infused beverages. All require cannabis oil extraction as a preliminary step in manufacturing.



Even better, these extraction companies can service the entire Canadian cannabis market. This means they have been able to aggressively scale-up their operations. These economies of scale also position Canada’s extraction leaders to service international markets as cannabis exports open up.

Conversely, the cannabis retailers offer an advantage that the extraction specialists lack: brand development. Along with the companies producing branded cannabis products, cannabis retailers are in line to capture the additional margins that come with all branded consumer products.

In both these sub-sectors, leaders have already emerged. The Seed Investor has profiled these companies previously.

Among the extraction specialists, the current industry leaders are Valens GroWorks (CAN:VGW / US:VGWCF) and MediPharm Labs (CAN:LABS / US:MEDIF). Valens has current annual extraction capacity of 425,000 kilograms of dried cannabis and MediPharm has annual capacity of 300,000 kilograms. Each is continuing to aggressively expand on their extraction capacity.

Both companies are demonstrating very strong revenue growth. Both reported becoming fully profitable in their most recent quarterly results, reporting net income of CAD$5.9 million and $4.1 million respectively.

Yet Valens and MediPharm are also trading well off their 52-week highs. At CAD$4.28 (as of this writing), MediPharm is over 42% off its previous high of $7.39. Currently at CAD$3.18, Valens is 35% below its 2019 high of $4.90.

Following in the footsteps of Valens and MediPharm as extraction-focused cannabis companies are Neptune Wellness Solutions (US:NEPT / CAN:NEPT), Nextleaf Solutions (CAN:OILS / US:OILFF), and Radient Technologies (CAN:RTI / US:RDDTF). Indeed, based on announced expansion plans, once Neptune’s current, fully funded expansion is completed, it would become the new extraction leader with annual capacity of 1.5 million kilograms of dried cannabis.

Many of Canada’s LP’s have also announced plans to develop substantial extraction capacity. However, there are several different extraction processes on the market today. Different end products are better suited to particular extraction methods.

Valens itself employs four extraction processes. There is also the level of expertise involved in producing the highest quality extracts. For these reasons, the extraction specialists appear to be positioned for continued growth going forward.

On the retail side of Canada’s cannabis industry, several leaders have also emerged. In terms of pure retail, three companies are currently setting the pace in Canada and providing the best opportunities for investors.



National Access Cannabis (CAN:META) is the clear industry leader in cannabis retail at present. META currently has 35 licensed cannabis stores, with 33 already open.

The company recently reported some very strong numbers: over CAD$60 million in revenues in Year 1 of legalization, strong margins (gross margins of 32%) and positive adjusted EBITDA (CAD$2.3 million). Even as META aggressively increases its number of stores it is also transitioning to profitability.

Fire & Flower Holdings (CAN:FAF / US:FFLWF) is also well-positioned. Bolstered by strategic partner, groceries giant Alimentation Couche-Tard, Fire & Flower has perhaps the most financial clout among Canada’s cannabis retailers. It strongly bolstered its operations recently when it added 8 more retail stores for an aggregate purchase price of only CAD$5.65 million.

Also a strong contender among Canada’s cannabis retailers is Choom Holdings (CAN:CHOO / US:CHOOF). Like National Access and Fire & Flower, Choom has been rapidly building its retail network across Canada.

Choom is presently developing 43 “retail opportunities” and has opened 4 new stores in Alberta alone over the past 2 months. Since the beginning of August, Choom has also acquired an additional 8 stores across Alberta, British Columbia, and the Yukon Territory.

Another significant player in Canadian cannabis retail is High Tide Inc (CAN:HITI / US:HITIF). But it has primarily chosen the franchise route for retail penetration. This significantly eats into its topline revenue potential.

Several of Canada’s major LP’s have greater or lesser footprints in cannabis retail. But they are not pure plays in retail and (for reasons above) are facing greater challenges in overall operating margins.

As with the extraction specialists, Canada’s cannabis retailers offer a stellar value proposition for investors. These companies are also trading well below previous highs. We did some number-crunching here previously and came up with some very bullish estimates.

Over the longer term, strong investment opportunities exist across the cannabis sector. However, in the current environment, with sentiment weak and valuations compressed, we see the extraction and retail specialists as being best positioned to lead the industry higher in Canada.



DISCLOSURE: Choom Holdings is a client of The Seed Investor