The New Kid in Town: An Analysis of the Emerging Canadian Cannabis Market, Part 1

photo: courtesy of bruce winder

photo: courtesy of bruce winder

The following is the first in a three-part analytical series of the Canadian cannabis market by retail expert, Bruce Winder.

By Bruce Winder

If one looks at the back of The Eagles fabled Hotel California album from 1976, one can imagine that the band smoked a lot of pot. Much like The Eagles members personal relationships with each other during the 1970’s, the Canadian cannabis industry is tumultuous to say the least and royally phunked up to say the most.

Being a self-proclaimed retail expert, I thought it was time to visit a few of the newly opened legal dispensaries in Toronto to see what was happening and put my two cents out in the air waves. This new retail category has garnered a tremendous amount of fanfare over the last couple of years and you can’t pick up  a mainstream business or retail publication in this country without reading about cannabis and the business opportunities and challenges it has spawned. When you step back and look at the industry it is hard not to get caught up in the romance of the lofty licensed producer (LP) valuations but one must be careful as this business feels a lot like the tech bubble from the late 1990’s and we all know how that ended.

Like the tech bubble from that period, high valuations were given to firms with growing top line but nonexistent bottom lines or profit. So I put my hair into a ponytail, put on my jeans and scuffed up cowboy boots and ventured downtown (with family in tow) to check out three shops: Tokyo Smoke, Hunny Pot & Nova Cannabis. Having experienced the three shops, I felt it prudent to summarize my findings as well as make select observations on the weed industry overall based on my review of a number of articles.

photo: courtesy of bruce winder

photo: courtesy of bruce winder

Tokyo Smoke

Located on Toronto’s action packed Yonge Street, just North of Dundas Square (our version of Time Square) the shop has a choice location. The store itself is too small though and in fairness to the retailer, it looked like it was built and merchandised in a few days after they got their retail approval granted. Tokyo Smoke took over the old 4,000 square foot, three story HMV location (old Sam The Record Man location for us Gen Xers) but has only utilized parts of the first floor.  The store feels like a cross between an Apple store (I know, they all do these days) and the new Amazon 4 Star store I toured in NYC last holiday (see link to that story). The store is segmented and merchandised well with different sub-categories of product based on user mood and what each person wants the product to do for you: Go, Rise, Equalize, Ease & Pause.

Fixtures are basic but functional and there were plenty of well trained, knowledgeable staff armed with tablets. Each patched into the industry standard COVA point-of-sale (POS) system that facilitates both product knowledge discussions and in aisle purchases (must be picked up at dispensing desk like a pharmacy). Point of purchase material was clear and easy to read and included all the details one needs to make that informed purchase for flower, oil, spray and capsule.  In addition, high margin accessories are bright and contemporary and are a far cry from the stoner head shops assortment of days gone by. Finally, Tokyo Smoke offers visitors a selfie moment with an Instagram worthy prop at the front entrance.  Affiliated with industry leader Canopy Growth, I expect bigger and better things from them in the future.

photo: courtesy of bruce winder

photo: courtesy of bruce winder

Hunny Pot

Located on hipster inspired Queen Street in Toronto, Hunny Pot looked and felt more like a club than a pot shop and was by far my favorite.  Like the other two retailers, there is a mandatory age check enforcer on the step before you can enter the store which is covered with panels so you can’t see in. Once you get into this three floor, 3,500 square foot location, you can either proceed directly to the lower level to re-up on your desired product or proceed up to the second and third floors which are showrooms. Point of purchase (POP) material is cool but less functional as pricing is on a separate screen on the wall. Fixtures are beautiful and inspiring. Staff (budtenders) are knowledgeable and like Tokyo Smoke have been trained well on the art of COVA and the tablet driven sales process.  Accessories looked great and are merchandised generously throughout the store. I really like this store and feel that is has captured the essence of the business opportunity at hand. Well done!

photo: courtesy of bruce winder

photo: courtesy of bruce winder

Nova Cannabis

Located on Queen Street but just West of Spadina, the shops location was OK but not prime in my opinion. Partnered with Alberta’s Alcanna, Nova Cannabis’ 2,900 square foot space felt like a combination post office, drug store and delicatessen. Don’t get me wrong, it works well all things considered.  The store is bright and spacious and has a good vibe about it. The self-serve electronic product knowledge kiosk had a big “temporary out of service” sign taped to it, perhaps a metaphor for the industry overall. Fixtures and signage are OK at best. Functional but dull. You can feel the brands trying desperately to create awareness and differentiate themselves with posters and digital screens.  The highlight of the store is the delicatessen style glass counter at the side of the store that showcases assortment and pretty good inventory position on many products. Finally, akin to McDonalds, the store boasts an order processing screen that shows shoppers sequence of order number being processed. Love the footprint of the store but some definite areas for improvement.

As mentioned above, the cannabis industry is in significant flux. One could use the descriptors of cluster phunk, schitt show, gong show, p parade or what have you to describe the current state of affairs and you might not be far off.  One could argue that we all would have been better off if The Trailer Park Boys had managed this whole thing instead of the suits involved. 

illustration by bruce winder

illustration by bruce winder

Industry Dynamics – Fast Times in Marijuana Retail

Political Challenges

Government approval process has been late, turtle slow and too opaque - understanding the governments need to regulate this industry and protect society from potentially negative impacts to minors and other people, it feels like the regulatory and approval process has been too slow and too vague. From the outside looking in, it appears that the current federal government was not ready and/or did not provide enough firm guidance early enough for the October 17, 2018 launch date. Regulations need to be vetted much earlier in the process and offer specifics so all industry participants can manage to them. In addition, regulations should enable Canadian producers to compete with US producers without jeopardizing our society at large. My personal political views are agnostic in this situation.

BRIAN HARRIMAN, CANNABIS NB PRESIDENT AND CEO, DISPLAYS SOME CANNABIS PRODUCTS AT A CANNABIS NB RETAIL STORE IN FREDERICTON, N.B., ON TUESDAY OCTOBER 16, 2018. THE CANADIAN PRESS/STEPHEN MACGILLIVRAY

BRIAN HARRIMAN, CANNABIS NB PRESIDENT AND CEO, DISPLAYS SOME CANNABIS PRODUCTS AT A CANNABIS NB RETAIL STORE IN FREDERICTON, N.B., ON TUESDAY OCTOBER 16, 2018. THE CANADIAN PRESS/STEPHEN MACGILLIVRAY

Canadian LPs are starting to lose first mover advantage vs. US multi-state producers (MSPs) – as reported in an interesting article by Vanmala Subramaniam (2019), Canadian LPs are starting to feel the heat from US multi-state producers (MSPs). MSPs see the glut in oversupply coming on stream in Canada over the next three-to-five years. In addition, MSPs aren’t shackled by legislation that prohibits brand development and advertising like Canadian LPs are. The next big shoe to drop in the US is the potential legalization at the federal level (see below). If that happens it will be very hard to compete with the strongest MSPs due to size of market and the general larger investment market (venture capital, private equity, institutional investors, banks, etc.) south of the border. Much like other large mature industries you will probably see the majority of the major players in the industry being US entities.

You may see one or two major Canadian LPs still standing when the merger & acquisition and consolidation dust settles but the balance will be American or maybe European (if they make pot legal en masse).  Canopy Growth (the market leader by market capitalization) is already partially owned by Constellation Brands with its $ 5 BN investment in the company. As reported in Bloomberg, Canopy is not waiting around to be disrupted. They announced a deal to buy a $ 300 M option to purchase US Acreage Holding Inc. with its powerful board including Brian Mulroney and John Boehner for $ 3.4 BN if weed is legalized federally in the US (Owram, 2019). Canopy has also announced that they will be looking to spend approximately $ 2 BN over the next two years in US hemp assets. Mans be all in!

VIC FEDELI, ONTARIO’S FINANCE MINISTER, AND ATTORNEY GENERAL CAROLINE MULRONEY TALK TO THE MEDIA AFTER ANNOUNCING ONTARIO’S CANNABIS RETAIL MODEL ON AUG. 13. THE CANADIAN PRESS/CHRISTOPHER KATSAROV

VIC FEDELI, ONTARIO’S FINANCE MINISTER, AND ATTORNEY GENERAL CAROLINE MULRONEY TALK TO THE MEDIA AFTER ANNOUNCING ONTARIO’S CANNABIS RETAIL MODEL ON AUG. 13. THE CANADIAN PRESS/CHRISTOPHER KATSAROV

Tougher to leverage low cost countries (LCCs) for global supply of finished goods – my understanding is that most countries do not allow the exporting or importing of cannabis. Therefore, if a grower has an operation in a given county it must be used to serve that country. Sort of like the days before NAFTA (or USMCA if it becomes ratified) and globalization. This becomes problematic if one wants to utilize low cost countries (LCCs) to grow weed and distribute it into the developed world where legalized grass is emerging.  Some folks say this is a moot point as the differential in gross margin % is negligible due to its already high rate even in developed countries. Overtime though, as retail prices drop and investor thirst grows it is not hard to imagine LCC sourcing becoming a necessity to position oneself in the top quartile of performers in this industry. As reported in The Financial Post, many LPs such as Aphria, Canopy, Tilray and Aurora have interests in Latin America to take advantage of lower labour rates, year round growing and greater plant density to export CBD to other countries. THC may be a little tougher to move across borders

photo: aurora cannabis via facebook

photo: aurora cannabis via facebook

Economic Challenges

Existing valuations of big name LP’s are way overpriced – this one has been talked about a lot. LPs have valuations in the billions but have not made any money yet. This flies in the face of basic finance. I know that companies are valued based on a number of methods including current and future discounted free cash flow, book values and comparable firm valuations and what not. But come on this is crazy! A lot of people are making money but a lot of people are going to lose money too. The industry is moving so quickly with various mergers and acquisitions that is has become hard to keep track of who owns whom, what they paid for them and what the real financial benefit will be.  

LPs and other investors are throwing around money like drunken sailors from an old war movie. Trying to buy scale and distribution advantages as quickly as possible. This appears rather reckless from an outsiders view. Eventually high flying LPs will be held to account for every acquisition in terms of benefit to shareholders vs cost to purchase. Remember, the quicker firms grow and the more complexity they add, the greater the risk of chaos and inefficiency.

Get ready for some goodwill write-offs in the future as these deals become part of the operations of LPs. It reminds me of Saturday night in the 80’s at the infamous O’Tooles chain of bars. The last dance would play and everyone would be running crazy trying to find a partner, any partner, so they would not go home alone.   Eventually though, they had to wake up the next morning, nurse a hangover and make conversation with their new friend. A sober reflection on choices from the night before.

Wesleaf+1.jpg

It’s still cheaper to buy weed on the black market- when I break open my MBA notes and reference the priests teachings from the Temples of Syrinx (Michael Porter’s 5-Forces model via Queen’s Smith B-School), I think about how buyer power eclipses supplier power in this industry. Why? The Canadian Press cites an April 2019 Statscan report that indicates that weed on the black market has decreased from an average of $ 6.79 per gram pre-legalization to $ 6.28 per gram in early 2019. Alternatively, the price for legal weed has increased from $ 9.89 per gram to $ 10.52 per gram (Martin, 2019).

There is less reason to buy weed from legitimate sources. Sure, the argument can be made that legal weed is safer, higher quality and more consistent. In addition, one need not worry about breaking the law with legitimate product. This may work for new users but previous users see limited advantage by buying from authorized providers. Long-time users have been living with the negative aspects of the black market for decades. 

superette photo: jesse milns via lEAFLY

superette photo: jesse milns via lEAFLY

A recent development reported in The Canadian Press may prolong higher prices further by lowering competition. The Federal government announced it was changing its licensed producer process to only consider granting licenses to those firms that have existing infrastructure (Ligaya, 2019). That is, you can no longer get a license to produce and then line up investors and build a facility, in that order. This creates much larger barriers to entry for new LPs and thus increases the power of existing suppliers.

Assuming a good chunk of illegal weed is grown outdoors (in more tropical climates) the cost is hard to beat. As reported in The Financial Post, some say outdoor weed can be grown for 3 cents to 20 cents per gram. Compare that to 90 cents to $ 2 per gram indoors. A lot of legitimate folks have applied for Canadian outdoor growing permits. Critics of outdoor pot growing say that it will be very difficult to meet Health Canada regulations. In addition, year round growing is a non-starter due to Canada’s weather.

PHOTO: FIRE AND FLOWER VIA FACEBOOK

PHOTO: FIRE AND FLOWER VIA FACEBOOK

Retail flower pricing is expected to drop – based on history in the US, retail weed prices dropped after launch. This makes sense. As competition heats up and users balk at sales through legitimate channels due to higher prices, legal firms respond. It may also be due to producers obtaining more experience growing legally. Either way, Canadian LPs and retailers will need to follow suit to keep top line growth intact. This will obviously put pressure on gross margins and magnify investor pressure to meet already inflated valuations. There will probably be an adjustment to the Canadian industry as share prices will drop and weaker players will be acquired by larger firms in Canada or the US.

A US hedge fund has started shorting Canadian LP stock – as reported in Bloomberg, Measure 8 Venture Partners LP is launching a fund on June 1 that intends to go long on US cannabis firms and short on Canadian producers (Owram, 2019). Not a huge vote of confidence for our boys and girls in the Great White North right? What’s that expression, you haven’t made it until you have haters? (Subramaniam, 2019) but CBD appears to be easier to move around the world, if not in bulk form.

Visit Retail Insider again later this week for the second instalment of Bruce Winder’s analysis of the Canadian cannabis market.

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Bruce Winder is a retail expert, speaker, professor and entrepreneur. He has been interviewed dozens of times on main stream media such as BNN - Bloomberg, CBC, CTV News, CP24, Breakfast TV and more. Bruce has also been quoted hundreds of times in publications such as The Washington Post, BBC, The Globe & Mail, The Financial Post, The Toronto Star, Strategy, Adweek and many more. Bruce has 25 + years experience in big retail, manufacturing and consulting and holds an MBA from The Smith School of Business at Queen's University. He offers keynote, session and moderator services on topics such as: retail, e-commerce, online shopping, consumer trends, cannabis and Amazon.

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