Cannabis: the world in 2030

-- | 21/09/2020

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Kristoffer Inton: Cannabis stocks saw some of the biggest gains and declines over the last couple of years. Even with the increased scepticism, we see a lot of change coming in the next 10 years. In 2020, cannabis consumption already exists in a very big way, but most of it exists in the illicit black market. Long considered illegal with no real benefit, attitudes on cannabis are starting to change. In Canada, where medical cannabis had already been legal since the early 2000s, recreational cannabis was legalized in 2018. In the US, 11 states have legalized recreational cannabis and 33 additional states have legalized medical cannabis.

Nationally, cannabis with high levels of THC, the cannabinoid that creates the euphoric high, remains illegal. However, low-level THC, high-level CBD is legal nationally. CBD doesn't create euphoria but is anecdotally known to provide various pain and relaxation benefits. Obviously, there's a bit of legal disconnect between state and national laws in the US, but the federal government has chosen a policy of nonenforcement for states that have strong regulatory frameworks.

So, at present, the legal US market is estimated at more than US$10 billion. In the legal Canadian market, at about US$2 billion. By 2030, we estimate the US market will reach more than US$80 billion and the Canadian market will reach more than US$14 billion.

We think that the growth is coming from three different fronts. First, we estimate additional states to legalize THC cannabis, particularly in the Northeast. The coronavirus pandemic likely accelerates this trend as states look for new tax dollars to plug budget gaps.

Second, we estimate more and more users entering the legal market from the black market. There's been some friction here in the early stages as legal market prices tend to be higher. We think value and safety will eventually bring users into the regulated legal market. An example of this is the vaping crisis last year, as investigation suggested that much of the cases came from black market THC vapes.

Lastly, growth will come from consumers who are non-users when cannabis was illegal but become consumers upon legality. Many of the US multistate operators, or MSOs, cite these consumers as some of the most important target markets. Lastly, by 2030, we forecast a change to US federal law. Rather than national legal legalization like we saw in Canada, we think the US will pass a state's rights form of bill, basically allowing each state to decide cannabis' legality within its borders. This is somewhat similar to how fireworks are regulated. For example, if you cross the border to Indiana, you could purchase fireworks legally, but you can't bring them back over into Illinois.

The legal market's set for massive growth benefiting all cannabis producers. However, we note that the industry is still going to look a lot different than it is today. Today, flower is the most dominant form of consumption. By 2030, we think that concentrates and edibles are going to be far more popular, as it allows consumption of cannabis without the risks of smoking. This has big implications for the industry for a couple of reasons. First, we think black market consumers are much more likely to convert to the legal market for value added products. Safety and quality are much more observable in value added products, so legal markets' higher prices are more justifiable. Second, the move away from flower to value added goods creates the opportunity for consumer branding.

We cover seven cannabis producers, and we see five companies as undervalued. Curaleaf and Green Thumb Industries are the only US producers we cover. We think the US market is going to be the biggest and most attractive. And these companies have already reached EBITDA profitability. If you're playing the US market, we recommend these two stocks. The other five companies we cover are Canadian, and due to US federal prohibition, they can't operate in THC cannabis in the US We see Aphria as the most undervalued cannabis company we cover. Compared to other Canadian companies, it's been a lot more deliberate and careful about expanding, which has led it to be the first Canadian to reach EBITDA profitability. Additionally, Aphria is particularly focused on the higher priced international medical export map market, adding to its attractiveness.

We also think Aurora is undervalued, but note our extreme Uncertainty Rating for the company. The company has had to rely on dilutive equity raises to fund its cash burn, but we think it's making solid progress on stemming cash burn while maintaining its low production costs. Lastly, we think Canopy Growth is undervalued. Canopy has a financial backing of giant alcohol producer, Constellation Brands, reducing the financial risk we see in many other companies. It's very focused on becoming the consumer-branded company of the cannabis industry.

Lastly, we see Cronos and Tilray as fairly valued. Cronos is very focused on the US CBD market, which we see riddled with competition. And then lastly, Tilray wants to become the consumer-branded company of cannabis, like Canopy, but the lack of a major financial backer and heavy cash burn weigh on our outlook for the company.

This report appeared on 2022 Morningstar Australasia Pty Limited

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