This VC firm predicted big cannabis would shrink. What happens next?

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Narbe Alexandrian did not see COVID-19 coming, and that’s okay. As chief executive officer of the cannabis venture capital firm Canopy Rivers (RIV.TO), he’s not in the business of predicting pandemics. 

What he did see prior to 2020 were cracks forming in the business model that has dominated legal cannabis in Canada since its inception: vertically-integrated licenced producers. 

Many of the largest cannabis players were having a tough 2020 before the economic wallop of COVID-19. So far, the year has been marked by mass layoffs and lacklustre financial results. Producers face scarce financing options, unforgiving capital markets and resilient illicit sales. 

Plans for global expansion and trial-backed pharmaceuticals years in the making have been shelved as investors demand tighter controls on spending and clearer paths towards consistent profits. Just about everyone is pulling back.

For Alexandrian, it’s proof of something he’s been saying for a while now.

“Vertical integration doesn’t work,” he told Yahoo Finance Canada in an interview. “Prior to legalization, because of how the public markets were valuing these companies, everyone had to increase their footprint as quickly as possible. They invested in cultivation, extraction, consumer packaged goods, pharma with clinical trials, pet health, biosynthetics, and they bought retail stores as well. You can’t be everything to everyone.”

For pot industry heavyweights like Canopy Growth (WEED.TO)(CGC), Aurora Cannabis (ACB.TO)(ACB) and Tilray (TLRY), the retail investor frenzy that preceded recreational legalization in Canada fuelled a period of rapid expansion now being dismantled to match the realities of today’s smaller-than-expected cannabis market.

“You can do a lot of things when capital is flowing freely, and you can raise hundreds of millions of dollars,” Alexandrian said. “As soon as that capital starts drying up, you really can’t service every single part of the value chain with the strength that you’d want. They are starting to thin out.”

He predicted big cannabis companies without major investments from outside the sector, such Constellation Brands’ (STZ) $5 billion investment in Canopy Growth, would struggle to manage seed to retail pot empires spanning multiple continents. As it happens, the booze-backed Smiths Falls, Ont.-based weed giant is now among the major producers reining in its operations in a bid to cut costs.  

Canopy Rivers has not been immune to the thinning trend. In the quarter ended March 31, the Toronto-based firm reported a $30.5 million net loss and $11.2 million in impairment charges tied to its portfolio of equity investments. In May, the company slashed compensation and headcount with the goal of shrinking spending by 35 per cent. 

“Every day feels like a week,” Alexandrian said when asked to sum up the first half of 2020 in the cannabis sector. “The industry is moving very quickly. It could be different a month from now.”

For the time being, the firm mainly plans to sit on its nearly $47 million cash pile. But with valuations on the decline and capital in ever shorter supply, Alexandrian said there’s no shortage of deals crossing his desk. 

Here are some of the trends he’s watching.

Consumers love cheap pot

HEXO (HEXO.TO)(HEXO) is widely credited with kicking off the value cannabis category last fall with its Original Stash line priced to compete with the legacy market. Now, most major licenced producers are fighting to lure budget-conscious buyers with prices in the $5 per gram range.

“You look back to Q4 of 2019, or even Q3 of 2019, value brands are about six per cent of total sales within the Ontario Cannabis Store. Fast-forward to now, we’re at 23 to 24 per cent,” Alexandrian said. 

“That’s taking market share away from the blackmarket. If you go back to Q3 of 2019, the legacy market made up about 92 per cent of the entire market. Now it’s at about 81 per cent of the entire market within Ontario.”

Gummy goodness

Canopy Growth, the most prolific pusher of pot beverages, owns a roughly 27 per cent stake in Canopy Rivers. But the venture capital firm sees a bigger opportunity in another cannabis 2.0 category: gummies.

“Gummies represent 50 per cent of any mature market. They had a stocked out rate of 90 per cent when they first came online (in Canada),” Alexandrian said. “There is a huge demand for gummies, and there is not enough supply for it in the market today.”

Canopy Rivers’ latest portfolio addition was a stake in infused gummy-maker Dynaleo. The Edmonton-based company recently received a processing licence from Health Canada and expects to begin supplying retailers shortly.

Valuations plunge, institutional money & Fortune 500 firms flee

Canopy Rivers invests in both private and public companies. Alexandrian said valuations have softened considerably as cash-strapped firms run short on financing options. The flip side, he said, is the institutional money and blue chip companies that tend to propel the sector when they buy into pot are increasingly retreating to the sidelines.

“We need that kind of capital coming into the industry,” Alexandrian said, referencing Canopy’s deal with booze giant Constellation Brands. 

Cannabis entrepreneurs are adjusting to the new normal as well.

“We still see some valuations that we think are absurdly high. They find out quickly that they can’t raise at that number. They come back a week or two later and say, ‘We’re 50 per cent lighter than what we told you,’” he added. “If you look at our statistics through our database of who is pitching to us, the median raise was at $4 million prior to COVID. Post-COVID, it’s gone down to about $2 million.”

Jeff Lagerquist is a senior reporter at Yahoo Finance Canada. Follow him on Twitter @jefflagerquist.

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