Like other new markets, the cannabis industry is characterized by rapid growth, increasing capital investment, and the potential for massive returns. According to BDS Analytics, worldwide consumer spending on legal cannabis grew an estimated 28% to $12.2 billion in 2018, with growth rate forecasts reaching a heady 38% to $16.9 billion for 2019.¹
As cannabis use and acceptance grows, producers are jockeying for competitive position by expanding operations with massive high-tech (and high-cost) cultivation facilities. Cannabis is still a growth story, and not surprisingly, most companies in the space are showing operating losses while they scale to meet pent up demand.
Without a history of operating results and only nascent EPS on which to lean, investors are using soaring revenue and production capacity measures as key performance indicators (KPIs) to support valuations. At the close of 2018, five U.S. multi-state operators reached valuations of over $100 million each, with a combined market cap of $5.5 billion; five of Canada’s licensed producers reached an eye-watering combined market capitalization of nearly $20 billion.²
While these metrics reflect the massive sales growth in the industry currently, they do not account for the approaching product oversupply expected within the next 12 to 24 months. Consensus estimates put annual Canadian demand for cannabis in the range of 730,000 to 800,000 kilograms. Expected production from some of Canada’s largest producers, including Canopy Growth Corporation, Aurora Cannabis, and Aphria inc., is expected to reach 1,500,000 kilograms by the end of 2020.³
While a handful of overseas markets for medical cannabis could absorb some of the excess, oversupply is still expected to exceed 500,000 kilograms in the Canadian markets over this period. To be sure, this will decimate prices, with producers scrambling to manage overcapacity and high operating costs, with operational profitability becoming more elusive than ever.
The companies that will survive the glut will be those that have pursued growth productivity rather than growth capacity as a path to profitability. This is an important distinction. In times of oversupply and falling prices, additional capacity (to grow more plants) only exacerbates the problem. In order to keep revenues afloat and costs down, each plant will need to be producing more product.
Cannabis can be viewed within a real estate context, much like rent, in that it is the key productivity measure of the real estate asset. Likewise, crop yield, or yield, is defined as the quantity of cannabis produced per square foot of facility space, and is the primary KPI investors should watch to assess future profitability.
Importantly, yield is first a revenue driver and secondarily a cost reducer. More product generated from the same space translates to greater sales, with fixed costs distributed across greater output, thereby reducing product unit costs. This means more product to sell, at higher gross margins for increased profitability. In the cannabis industry, yield is generally connected to a cost per gram of cannabis produced. The lower the production cost per gram, the greater the yield.
As supply overages grow, managing yield will become increasingly important to successfully navigating the impending lower price, highly commoditized cannabis market. In this environment industry leadership will require ongoing research and development to continuously improve efficiencies and ultimately progress to a differentiated product suite.
One company that seems to be heading in the right direction is Flowr Corp. (TSXV:FLWR) (OTC:FLWPF). This (relatively) small Canadian producer enjoys one of the best crop yields in the industry today. According to Flowr co-founder and chairman Steve Klein, “the most important KPI in the industry is yield per square foot.”
Flowr attributes much of its success to its innovation in growing methodologies, including the “flood-and-drain” system that boosts yields significantly. In addition, because Flowr grows all of its product indoors the company avoids irradiation, a process which negatively affects the smell and taste of cannabis. This focus on increasing yields, reducing costs and producing a high quality product differentiates Flowr, and better positions the company to reach profitability faster and have more sustainably than many of its larger competitors. Other cannabis growers and enthusiastic investors would be wise to follow its lead.
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