News / 11.14.2016

Canadian marijuana producers eye U.S. market to have their weed and smoke it too

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FINANCIAL POST

Sunny Freeman 

The groundswell of American states that bent toward legalization last week may give a big boost to Canada’s marijuana industry — not because Canadian producers want to move south, but because the drug’s murky U.S. legal status positions them to have their weed and smoke it too.

California, Nevada, Massachusetts and Maine voted to legalize recreational marijuana last Tuesday and four more states voted in favour of medical marijuana use.

The vote sent cannabis stocks in Canada and the U.S. soaring. Shares of Los Angeles-based Pineapple Express Inc. rose 29 per cent Wednesday while the legalization news pushed Canada’s largest marijuana company, Canopy Growth Corp., to a billion-dollar valuation.

One in five Americans now live in states where pot is legal for adult use and the U.S. market for recreational marijuana is twice the size of Canada.

However, U.S. producers face a major problem with their product: It is still on the federal government’s list of Schedule I narcotics, alongside heroin and LSD.

Marijuana companies in the U.S. are hamstrung by their federal outlaw status, which prevents them from receiving corporate tax breaks and exporting products across borders. Conflicting U.S. laws also dissuade investment in research and development — which could help determine potential benefits and side effects — because patents are federally issued.

That disconnect between state and federal laws presents Canadian companies with a unique competitive advantage.

“The longer it takes for U.S. federal law to deem marijuana legal, the longer the Canadian licensed producers have to establish more international partnerships and create higher barriers to entry,” said Dundee Capital Markets analyst Daniel Pearlstein. 

With U.S. competitors weakened by regulatory risks and Canadian companies already leaders in the nascent global marijuana market, Canada’s marijuana producers are well-positioned to become the pre-eminent marijuana multinationals, Pearlstein said.

“Canada is probably three to four years ahead of any other country in terms of the scale of companies that we’ve been building,” he said.

Canada’s large-scale commercial medical marijuana program is the most sophisticated in the world, which has created demand for Canadian licensed producers to share their expertise in exchange for fees, royalties or shares of their businesses.

As legalization takes hold south of the border, Canadian companies have a massive opportunity to export their knowledge — if not their product — to the U.S., said Brendan Kennedy, CEO of Privateer Holdings, which holds a portfolio of marijuana-related companies including Vancouver Island-based Tilray.

“Canadian firms are able to operate at a scale that doesn’t really exist in the United States, where no one is willing to invest that amount of capital,” he said.

“Canadian companies have expertise in business operations, in cultivation, in regulatory compliance and other intellectual property that is applicable in the U.S.,” Kennedy added. “So that’s a huge opportunity for Canadian firms.”

Tilray and others have been approached by U.S. companies for partnerships and licensing deals. Some, such as Toronto-based cannabis luxury brand Tokyo Smoke, already have licensing deals in U.S. states.

Still, the risky regulatory environment limits Canadian business opportunities in the U.S., which adds to the incentive to concentrate expansion efforts elsewhere, said Khurram Malik, head of research at Jacob Capital Management Inc.

“The only thing Canadian companies can do in the U.S. is send their know-how down and earn royalties — the whole franchise model,” he said. “If they start getting exposure to the U.S. market that could make some of their U.S. investors skittish.”

Investors have long preferred funding Canadian cannabis startups, drawn to the ability to invest in a completely legal system.

Donald Trump’s surprise victory Tuesday night has added another level of uncertainty for U.S. companies, as his stance on marijuana is unclear. The president-elect has said he supports medical marijuana and softened his stance on recreational use during the campaign, saying the issue should be left up to each state. However, he is also surrounded by tough-on-crime politicians and plans to appoint conservative Supreme Court judges.

“The prospect of Donald Trump as our next president concerns me deeply,” Ethan Nadelmann, executive director of the Drug Policy Alliance, wrote in a post-election press release. “His most likely appointees to senior law enforcement positions — Rudy Giuliani and Chris Christie — are no friends of marijuana reform, nor is his vice president.”    

The Obama administration practiced non-interference, with the federal justice department issuing a notice in 2013 advising local authorities to take a hands-off approach except in dangerous situations. But if Trump were to reverse that position, it could further chill investment, which could lead to increased interest in Canadian companies.  

California was among the states that voted to legalize marijuana on Tuesday and, at 39 million, it has a population comparable to Canada’s. California’s proposed recreational regulations — which some have called the “gold standard” of policies — appear similar to Canada’s in that it would require industry standards and a licensing system for sellers. It also plans to reinvest government profits into anti-drug programs.

Canada’s Liberal government announced last year that it plans to table legislation this spring that will make recreational marijuana use legal. The Canadian recreational market, expected to be operational by 2018, has been estimated to be worth as much as $10 billion.

Knowledge transfer can work both ways, Malik said, and Canada can learn to avoid the mistakes of recreational markets that came before it.

“From a regulatory standpoint I think California and Canada are looking at it to see who does what and how they move forward, because there are some pretty strong parallels,” Malik said.

Despite the increased number of states tipping toward legalization, Bruce Linton CEO of Smiths Falls, Ont.-based Canopy Growth isn’t convinced the U.S. is a good place to expand any time soon — at least as long as Trump is in the White House.

“Mr. Trump has been pretty clear there may be a medicinal platform he thinks is reasonable and practical, but there’s no chance he thinks recreational has any place in society,” Linton said. “So when you have a poor boundary between medical and recreational, it’s going to continue to be fractured and chaotic.”

Linton pointed to the healthy black market operating in Colorado, one of the first U.S. states to legalize recreational weed, where companies considered legitimate at the state level are still considered illegal at the federal level. While they have to pay federal taxes, they can’t claim tax breaks the way other companies can.  

“That’s a pretty material disadvantage (compared to) the criminals who pay no taxes let alone 100 per cent tax rate,” he said.

The companies also cannot use legitimate auditors such as Deloitte because their businesses are technically illegal.

“Any publicly-traded company that wants to become active in America will find that they have a portion of their statements that can’t be reviewed by an auditor, which makes for a difficult time to become a reliable public reporter,” Linton said.

The riskiness of investing in the U.S. also compels Canadian companies to focus expansion efforts on countries where the drug is legal at the federal level, including Germany, Italy, Czech Republic, Brazil and Australia, marijuana analyst Pearlstein said.

“You are already seeing Canadian licensed producers establishing partnerships elsewhere in the world to take advantage of progressive regulation in different countries that aren’t the U.S.”

Canopy, for one, is focusing its international expansion efforts in countries like Brazil and Germany, Linton said.

“Why not use that as the basis to create distinct offerings which become copyrighted ,trademarked or intellectual property in some fashion, all properly preserved?” he said.

“Then when America is ready, we can enter with strength rather than participate in the evolution of a frayed market.”

Financial Post


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