Part 3. Medical Cannabis

Table of Contents

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• MEDICAL CANNABIS PRODUCTION IN CANADA: BACKGROUND
• ROLE OF VERTICAL FARMING IN CANNABIS PRODUCTION
• CURRENT MEDICAL CANNABIS INDUSTRY IN CANADA
• OVERALL TRENDS IN MEDICAL CANNABIS FARMING
• MARKET DEMAND FOR MEDICAL CANNABIS
• SEGMENTS/NICHES
• COMPETITIVE SITUATION

Key Takeaways

1. Based on current trends, the medical cannabis industry in Canada could exceed $1.4 billion in sales over the next 10 years, according to a number of industry observers
2. Based on similar analyses of the market potential in U.S. states that have decriminalized recreational use, total legal cannabis demand could double in the next decade
   1. Note that most of this would just represent a shift from current illicit consumption, but bringing cannabis into the legal economy would have far reaching effects on cultivation and consumption
   2. Current industry players in Canada are behaving as if full legalization is a done deal. In the meantime, new ventures will still need to function in the current medical use-only market, which is becoming saturated.
3. Larger, well established players appear to have little trouble accessing funding: some have turned around multiple expansion projects in very short time, while other have been able to acquire other companies operating on the periphery of the industry, such as technology and R&D.
4. In the current, high profit environment, a focus on developing brand recognition, production efficiencies, and other sources of value will be necessary for longer-term viability, especially as more suppliers are attracted to the market
5. Current construction costs for a large (over 100,000 square feet), technologically advanced greenhouse is roughly $120 per square feet. Based on current market prices and crop yields, this could result in a two- or three-year payback period

Medical Cannabis Production in Canada: Background

History and key developments

While medical cannabis has effectively been legal in Canada since 2001, it wasn’t until sweeping revisions to federal policy in 2013 that the stage was set for a rapid nationwide expansion of the legal commercial cannabis industry.

The Marihuana for Medical Purposes Regulations (MMPR) permit the cultivation and sale of traditional dried-and-cured cannabis and cannabis oil by a limited number of licensed producers to serve the nation’s medicinal market.

According to Health Canada statistics, medical cannabis sales (dried only – oil sales did not officially begin until October 2015) totaled 6,704 kg in calendar year 2015, with an estimated market value of $53.6 million (all values are Canadian dollars unless otherwise noted). This figure belies the tremendous growth since the government began reporting sales in June 2014, as shown in Figure 3 below. The sales growth closely follows the increase in the number of registered clients, which stood at 53,649 at the end of March 2016.

Figure 3. Cannabis sales in Canada (quarterly) in kilograms, 2014-2015

Source: Health Canada

Health Canada reports industry projections that the total number of registered medical users will total 450,000 by 2024. This would require roughly 49,000 additional registrations per year, which may be realistic considering the 23 percent quarterly growth rate over the past two years. Taking these projections as a given, the annual market for medical cannabis products would total roughly $1.4 billion, not counting price increases. We will examine these market trends in more detail in Part 2 of this study.

While this report focuses on medical cannabis, the year 2017 is likely to prove to be a pivotal one for the cannabis industry, as the government of Canada prepares a full scale decriminalization of cannabis in the country. We will relay some of the emerging thoughts on the direction of the industry if and when this comes to pass.

Role of vertical farming in cannabis production

• Nearly all commercial cannabis production now takes place in enclosed environments.
• As a result, new facilities and expansions all use roughly similar technologies. This has two major implications:
  • Production technology itself is not likely to be a major differentiating factor between existing companies – anyone can pay $20 million for a new greenhouse. Processes and operations management, on the other hand, could play a decisive role in a company’s success
  • Meanwhile, other factors, such as brand identity, international business development, and ancillary services are likely to make a larger impact in the future
  • Barriers to entry, on the other hand, may be significant due to high investment costs

Sources:

http://www.cannalawblog.com/whats-up-with-marijuana-in-canada-a-lot/

http://www.theglobeandmail.com/news/british-columbia/vancouvers-pot-shops-everything-you-need-to-know-about-marijuana-dispensaries/article24880914/

http://www.hc-sc.gc.ca/dhp-mps/marihuana/info/list-eng.php

http://www.hc-sc.gc.ca/dhp-mps/marihuana/info/application_steps-etapes_lp-pa-eng.php

http://www.hc-sc.gc.ca/dhp-mps/marihuana/info/faq-eng.php

http://www.raps.org/Regulatory-Focus/News/2015/08/26/23079/Canadas-Medical-Marijuana-Regulations-An-Overview/

http://www.bloomberg.com/news/videos/2016-05-17/canada-s-largest-medical-marijuana-producer-expands

http://www.nytimes.com/2016/08/16/world/americas/canada-legal-marijuana-justin-trudeau.html?_r=0

http://www.latimes.com/world/mexico-americas/la-fg-canada-pot-king-20160518-snap-story.html

http://www.hc-sc.gc.ca/dhp-mps/marihuana/compliance-conformite/2015-Q1-4-eng.php

 

Current medical cannabis industry in Canada

The existing players in the medical cannabis cultivation industry have been expanding at a dramatic pace over the past two years, investing hundreds of millions of dollars in production space, which consists of high-end greenhouses as well as high-density indoor growing operations.

Compared to indoor-grown fresh produce, the medical cannabis and pharmaceutical crop markets are relatively more focused, due to a combination of regulations and industry practices that limit the type of viable business models at the moment. Currently, the only options available to Canadian cannabis producers are the cultivation and/or mail order sales of dried product and oil. This has prompted producers to differentiate themselves through the development of new strains, the acquisition of information service firms (such as the purchase of CanvasRx by Aurora Cannabis), fine tuning logistics and delivery services, or by developing export markets (medical cannabis can be sold internationally if the receiving country also permits medical use).

There has been a flurry of expansion activity in the Canadian industry to meet anticipated demand. For example, recent developments in the Canadian medical cannabis industry include:

• Aphria Inc’s $24.5 million expansion of its production facilities. The announcement of this 200,000 square foot expansion comes only months after the company completed a previous expansion. In less than two years, the company will be able to supply the needs of nearly 50,000 medical patients.
• Several other producers are telegraphing their desires for expansion by purchasing sizeable parcels far larger than their current needs.
• From the scale of these expansions, it is clear that companies are operating under the assumption that full legalization is a fait accompli and are sizing their operations to meet the eventual recreational demand.

For the purposes of this study, medical cannabis market potential is currently limited to Canada, due to complications related to the continuing status of cannabis as a highly regulated Schedule 1 drug in the United States. Demand is shown at the province level, based on the estimated number of registered medical cannabis patients in each. Canada has been more forward thinking in its nationwide approach to cannabis regulation than some other countries, and as such the rules for patients and growers are the same in each province. Adding to the uniformity is the requirement that all medical cannabis be shipped to customers, which has created an active online market for producers to provide detailed product information and other services to clients.

Overall trends in medical cannabis farming

Industry observers cite the following major trends in medical cannabis farming:

Market trends (medical cannabis)

• Highly constrained by current law. No retail or opportunities until fully decriminalized.
• Reputation and brand affiliation are areas of innovation
• Positioning for eventual decriminalization
• Fine-grained differentiation of strains based on chemical content
• Currently, other niche products (e.g., edibles) remain illegal in Canada, though they are still consumed in dispensaries operating outside the law in selected cities. Based on early indications from the cannabis legalization task force, any products in the legalized market are likely to be highly regulated

Business management considerations

• Rapidly decreasing costs and improvements in lighting technology
• Increased use of robotics and automation, enabled through improvements in monitoring and control technology. Note: this partially negates the “local jobs” justification sometimes required for eligibility for community development funding

Market demand for medical cannabis

Identification/evaluation of cannabis business models

Given the current cannabis marketing constraints in Canada, firms have still responded to customer needs by providing additional services, such as detailed product information and professional  customer service.

Operating models are currently limited to cultivation, sales, or both. As long as this remains the case, firms can benefit from investing in technology, process design, and training, with an eye on reducing production costs and optimizing the logistics side of their operations.

While cannabis products themselves are also limited, firms differentiate themselves in other ways, through the development of new strains, providing educational and informational services, and easing the transaction process.

Partnerships also have the potential to help companies generate higher returns, provide access to funds (such as grants) that may not be available to the private sector, enter the market with higher visibility, and access emerging technologies earlier than competitors. In some cases, provincial governments may be interested in supporting development of local cannabis operations as a jobs-creation strategy, similar to recent developments in New Brunswick, where a supplier received $4 million in incentives to open a medical cannabis facility in the town of Atholville.

There still appears to be an operating window where the limitations on legal cannabis sellers and the strong growth in demand can provide suitable returns to sellers who have successfully navigated the licensing process.

Major Players in Medical Cannabis

Current producers

The medical cannabis industry in Canada currently includes the following suppliers:

Table 10. Licensed medical cannabis suppliers

Source: http://www.hc-sc.gc.ca/dhp-mps/marihuana/info/list-eng.php

Suppliers

In addition to a number of the suppliers listed in the vertical vegetable farming report, there are additional companies working on greenhouse cultivation systems that are targeting cannabis growers:

Greenhouses and Hydroponic Systems

Growlife (Kirkland, WA) – http://growlifeinc.com/

• Full service supplier of hydroponic equipment, lights, nutrients, and growing media
• System design services

GGS Structures (Vineland Station, Ontario)  – http://ggs-greenhouse.com/services

• Greenhouse and indoor grow systems

Business management Applications

• Ample Organics – ACMPR-compliant management software - https://ampleorganics.com/

Segments/niches

Emerging segments

As long as the range of medical cannabis products are limited by law to dried-and-cured and cannabis oil, it will be difficult to define emerging niches. While we will not attempt to prognosticate on the legislative proposals to legalize recreational cannabis in Canada, the government’s policy approach being taken for legalization aims to:

“Establish and enforce a system of strict production, distribution and sales, taking a public health approach, with regulation of quality and safety (e.g., child-proof packaging, warning labels), restriction of access, and application of taxes…”[1]

Based on this statement, and the cautious approach already taken with the medical market, we expect government leaders will attempt to avoid some of the perceived mistakes that occurred after voters in Washington and Colorado legalized recreational use in those states, such as public health and safety concerns related to edible products, as well as sales taxes that, in Colorado at least, hampered the growth of the legal market.[2] Presumably, this is not good news for the dispensary-type operations currently operating in some Canadian cities.

Size and growth of each segment

The estimated size and growth rate of the medical cannabis market are reported in Table 11, below:

Table 11. Estimated North American market and growth rate for medical cannabis, 2016

Source: Based on Health Canada projections

Profitability of market segments

The profitability of the medical cannabis market is summarized in Table 12, below.

Table 12. Market outlook for medical cannabis in Canada, 2016

Major channels – Other segments

The situation in cannabis is also straightforward compared to the food sector, as sales are direct to the consumer. While individual growers and sellers may make supply arrangements between themselves, this is likely to be on an ad hoc basis, and as with pharma crops, there is no strategically important sector in the middle of the supply chain.

Competitive Situation

Most of the available information about Canada’s medical cannabis producers comes either from filings of publicly-listed companies or from investor pitches, so this information must be taken with some amount of skepticism. We assume that the reported topline numbers – sales revenues, pricing, and customer counts – are mostly accurate when referring to quarterly performance. In every case we examined, companies reported double digit sales growth in every quarter over the past year, though these figures are notably lower than what these same companies were forecasting in 2015.

Firms are taking various approaches to the market, given the regulatory limitations. These might be broken down into a few categories:

• Medical – including a focus on issues like safety and purity.
  • Aphria
  • Bedrocan
  • CanniMed
  • CannTrust
  • Delta 9 Bio-Tech
  • Emerald Health Botanicals
  • MedReleaf
  • The Natural Remedy
  • THC BioMed
  • WeedMD
• Healthy/sustainable lifestyle – firms that emphasize “natural” aspects
  • ABcann
  • Aurora
  • Broken Coast (packaging resembles trail food products)
  • Canna Farms
  • Green Relief
  • Green Organic Dutchman (“We’re Farmers, not Pharma”)
  • MariCann
  • Mettrum
  • OrganiGram
  • Peace Naturals
  • Whistler Medical Marijuana Corporation
• Connoisseurs – firms that focus on highbrow aspects of cannabis consumption
  • Hydropothecary (fancy tobacco-style packaging)
• The sports merchandise model – for lack of a better term, the marketing style of some cannabis companies resembles that of sports marketers.
  • Tweed
• Some companies do not appear to have an easily identifiable marketing strategy
  • AMMCan (photos of their greenhouse)
  • Canada’s Island Garden
  • Emblem Corp.
  • In the Zone Produce (mix of natural and medical)
  • RedeCan Pharm
  • Tilray
  • United Greeneries

Other elements of marketing strategies include pricing – including discounts for medical users facing financial hardships – and indirect promotion via industry media.

Pricing strategies are subject to a number of factors: first, what the market will bear on the high end, and second, how producers can sell lower priced product and still remain profitable. In one investor pitch, a startup company stated its desire to pursue the high-value market, claiming this was because product development costs are the same no matter how “desirable” a strain may be.

This is a mistaken assumption. Higher priced product, almost by definition, is going to represent a smaller market. Depending on the price elasticity of consumers (based on the availability of substitutes as much as the perceived quality of that company’s strains), higher prices may simply drive demand to other sellers. The lesson is that a high-end strategy can work, but this requires significant additional investment in R&D, consumer research, and brand development.

Unique value proposition/advantages may include a wide availability of strains, superior customer service, and related items like quality control/purity, and organic production methods. Since the product space is limited to development of strains for the moment, companies with active breeding programs or partnerships with breeding companies will have an advantage over those relying on non-proprietary varieties. Given the high costs of the new generation of growing systems, it may be a short leap to obtain organic certification, though soilless systems do not currently qualify for organic certification.

Strengths and weaknesses are difficult to determine, due to the tightly-controlled nature of information about firms, but some publicly-available information may allow some inferences. These are grouped into the following categories:

• High cost structure – many firms have issued press releases showcasing major investments in their operations. Simple arithmetic and some assumptions about growing costs may actually show this to be a cause for concern. For example, the average cost of new growing space is estimated at around $345/sq ft. Assuming this is true, any company touting its new, $12 million, 30,000 square foot growing space (e.g., Green Relief) is essentially broadcasting to the world that it is paying well over two times the industry average for growing space. Also of note is that neither of the two highest-cost growing spaces are likely to attain a higher yield. While current sales revenues may support this burden, given the long-term fundamentals of excess growing space, additional market entrants, and slower-than-anticipated user growth, the situation in five years may be very bleak for companies stuck with expensive assets. In fact, taking the two highest-cost growing spaces out of the calculation results in an average cost per square foot of $249 per square foot. Expressed in terms of costs per gram, this amounts to about 60 cents of total costs for operators with higher-cost facilities, compared with 25 cents for lower-cost producers.
• Limited number of products – The wide range of uses and personal preferences for cannabis strains is expressed in the current market, with over 100 strains available at any given time. There is no fixed rule for the optimal number of strains for any one seller, though the logic is that a larger number allows for a greater opportunity to capture specific niches. A counterargument to a greater number of choices is that each choice becomes somewhat less valuable – think of the choices at a Walmart versus a high end department store. A larger number of products may also complicate production planning, and require the dumping of poor-selling products at undesirable prices.
• Poor customer service is difficult to quantify, due to the difficulty in capturing customers’ decision making processes, but turnover may be an issue if the customer experience is taken for granted. Delta 9 Bio-Tech claims that 25 percent of its new business comes from customers unsatisfied with a previous supplier. Even if there are other reasons for customers to change, such as dissatisfaction with varieties or simply shopping around, switching suppliers does not appear to be seamless, so goodwill may turn out to play a significant role in retaining customers.

Profitability – today and tomorrow. As discussed earlier, there are a number of warning signs about the future profitability of medical cannabis – and cannabis in general. First and foremost is demand growth. Current growth trends in registered patients are strong, as described in Part 1A of this study, but must continue at these same rates for the next decade in order to meet the forecasts from a few years ago. It will be difficult to know whether this trend will continue or not for another year or so, as new patient data are reported by Health Canada. If the most of the latent demand has already entered the market, then we would expect growth to slow considerably compared to expectations. The number of announcements dealing with production scale backs and companies backing out of deals in recent months seems to suggest that the demand picture is not as positive as some initially thought.

Some firms, such as Aphria and OrganiGram, appear to be profitable today, while others, such as Tweed, are still operating at a loss but could be profitable at higher sales levels. Still, the market risks (i.e., sluggish demand) must be noted.

A second warning comes from the sheer amount of excess supply the market is capable of producing. Inventories ballooned over the past two years as producers were licensed and entered the market. This is reportedly easing somewhat as demand catches up with supply, but cannabis is still a perishable product and a perception that “old” product is in the pipeline could have a detrimental effect on pricing. A much larger concern in the long term is the amount of expansion space already available. A recent report stated that Canadian production space for cannabis is approaching one million square feet. Buried in the same report is a chart suggesting an expansion area of nearly 2.8 million square feet.[3] While all of this area cannot be mobilized overnight, the mere existence of this space in the hands of existing players should be a cause for concern for those still seeking licensing.

One final comment must be made related to the eventual legalization of cannabis in Canada: based on the experience of U.S. states that have legalized recreational use, there could be considerable downside risk on cannabis pricing. Firms that are clearing substantial profits at a price of $8 per gram must plan to also be profitable when prices are closer to $4 per gram. It is not clear that this is the case, as the following section explores.

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[1]http://healthycanadians.gc.ca/health-system-systeme-sante/consultations/legalization-marijuana-legalisation/document-eng.php

[2] “Colorado lawmaker seeks marijuana tax review amid disappointing sales.” Denver Post. August 12, 2014

[3] https://news.lift.co/canada-approaches-1-million-sq-ft-of-medical-marijuana/

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