PwC Canada's cannabis series

Chapter 6 - Restructuring: The growing pains of a new industry

Post-legalization correction?

Investors piled into cannabis companies in the lead-up to legalization, driving up the value of cannabis indices by more than 140 per cent in the 12-months prior. However, since legalization the market has suffered a 20% fall in those same indices.1 With the adult-use cannabis market now legalized the reality of overcapacity in the marketplace, weak business structures and inexperienced management teams have begun to become more apparent. Company valuations may continue to fall as they have post legalization, and many of the unsophisticated retail investors who have shored up the industry could walk away disappointed.

Market forces (described in chapter 1 of this series) will drive a swift separation of winners and losers in an industry already undergoing rapid transformation. The survivors are likely to be companies that acted early to position themselves to profit from the turmoil and protect themselves from the risks.

The new landscape will be comprised of larger cannabis players supported by niche businesses offering specialized products and services.

Source: 1 Percent change in the Horizons Marijuana Life Sciences index taken from Yahoo Finance; post-legalization decline calculated from October 17 to November 12, 2018.

Too much of a good thing?

Most licensed producers (LPs) have been pursuing aggressive expansion plans with the hope of securing a large share of the early market. Assuming all growth and expansion plans are executed on time and as advertised, by 2021 annual production capacity will reach over 2,000 tonnes. However, according to our estimates total Canadian demand for both recreational and medicinal cannabis will only reach between 900 and 1,200 tonnes per year. The effects of this oversupply could be further exacerbated by black market purchases, especially if the federal and provincial governments set taxes and minimum pricing levels too high or are too heavy-handed with regulations.

Many Canadian LPs are expanding into international markets to take advantage of the liberalization policies in South America, Europe and Australia. But the extent to which exports will support overcapacity in Canada remains unclear, particularly in the face of rising protectionism and a current preference for domestic production in overseas markets.

Green leadership

The industry’s rapid growth and regulatory complexity has left cannabis companies scrambling to implement sustainable business systems, develop adequate governance and reporting structures, and recruit experienced talent to a new and non-traditional sector. Some management teams lack the business acumen or experience to handle the large acquisitions occurring in the sector as well as the expertise to satisfy shifting compliance and accounting regulations, as highlighted in recent negative headlines caused by non-compliance. In many instances, the stewards of LPs that have been appointed to oversee the launch of the adult-use industry are equally ill-equipped for the task, with limited experience handling issues such as rapid business growth, complicated production and supply chains and high levels of regulation.

The right executive leadership supported by robust governance will separate the winners from the losers, ultimately creating stronger businesses.

A harsh reality

It may take up to two years before investors gain the production and financial data they need to properly assess the market dynamics of this nascent industry and the subsequent company-level performance. However, this insight will bring greater pressure on LPs’ strategy, profitability and cash generation as sound fundamentals will replace speculation as the key driver of valuation and access to capital. Early retail investors who sought quick gains may face disappointment, and their exit from the market will make it harder for LPs to raise capital.

At the same time, a more measurable industry will attract more sophisticated institutional investors who will begin to offer new forms of equity and debt, and impose greater scrutiny and performance standards on businesses. With the rise in alternative debt products in the market, a concern for LPs will be to preserve the collateral value of their business as the value of the previous Access to Cannabis for Medical Purposes Regulations (ACMPR) license decreases and more LPs receive Health Canada certification. We see the potential for future insolvencies in the sector, caused by liquidity shortfalls driven by a lack of traditional bank financing and working capital constraints.

Sustainable business infrastructure

Cannabis companies need to be proactive to address challenges if they are to emerge as winners from the coming industry shakeout.

In the rush to market, many LPs have taken shortcuts, incurred too much risk and are spending too many hours trying to address issues as they occur. It is now essential to create strong foundations on which long-term success can be built.

A sustainable business platform that includes a management structure with appropriate supporting systems and personnel brings three key benefits:

  • Reduced risk of falling afoul of regulators and compliance requirements;
  • Greater managerial and financial capacity to plan for where the company should be and how to get there; and,
  • Reduced risk of shareholder activism in the face of lagging capital market performance.

Operational restructuring

Already, some M&A deals in the sector appear to lack operating efficiencies and have instead created inflated cost bases. LPs should conduct comprehensive reviews of their selling, general and administrative expenses in order to remove duplicate and unnecessary activities and to optimize profitability. As part of this process, they could consider adopting centralized back-office services and using outsourced solutions.

As market requirements and insights into competitors’ capabilities become clearer, businesses may consider a strategic refocus that could include the disposal of non-core services as well as the acquisition of other assets that improve their cost bases and create value. To best take advantage of opportunities, businesses should:

  • Model the financial implications of various revenue and cost levers to determine the types of investment that will deliver optimum benefit;
  • Identify target opportunities, either through distressed investing or growth by acquisition, that complement their business model and strategy; and,
  • Seek advice to make sure transactions are executed and integrated effectively.
Cash management

Available capital has been plentiful during the early days of the cannabis industry, but as discussed above, that will change as investors grow more discretionary. Companies should prepare for this new climate in several ways:

  • Invest in systems and personnel to provide accurate cash flow forecasting and business planning;
  • Utilize working capital by looking beyond just payables to include receivables and inventory. This will free up cash and also help manage customer risk, payment flows and days of inventory—working capital is a cheap source of cash that helps a business stay competitive and invest in new technology; and,
  • Access alternative sources of debt and capital at the best possible terms.
Crisis management

Industry players are operating in a highly connected yet disparate market that’s saturated with competition. Pressure is only going to increase as investors and consumers become more discerning. To cope, businesses will want as much time as possible to deal with problems. This will require effective planning, systems and processes to identify and address issues early and with minimal disruption.

Once problems are identified or happen, management should bring in situational expertise to help manage affairs and stakeholders quickly and effectively.

New rules

Only by establishing a seamless, efficient and agile operating model will companies free up the cash and resources necessary to stay ahead of rivals. In the months and years ahead, access to capital will become the enabler of innovation. The players who are flush with cash, have a clear strategic plan and the supporting business infrastructure to deliver, will be those able to capitalize on opportunities in a consolidating marketplace. Otherwise, companies will likely be consolidated or enter bankruptcy.

Canadian LPs have a unique, but narrow, window of opportunity to take a leadership position in the emerging global cannabis market. In chapter 7 of our cannabis series, we look at some of the opportunities, as well as tax and regulatory risks, associated with international expansion.

This publication is made available by PricewaterhouseCoopers LLP (PwC) for educational purposes only as well as to give you general information and a general understanding of the cannabis landscape, not to provide specific financial, investment or other advice. By using this publication you understand and agree that there is no client relationship between you and PwC, or any of its member firms. The publication should not be used as a substitute for competent financial, investment or other advice from a professional services firm.

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