What's Next for Pot Stocks After Capacity Expansion?

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Last year featured a number of big changes for the marijuana industry. We witnessed Canada becoming the first industrialized country in the world to legalize recreational weed, had the U.S. Food and Drug Administration approve the first cannabis-derived drug, and witnessed multiple Canadian pot stocks uplist, or even go the initial public offering route, on a major U.S. exchange.

In lieu of the budding pot industry, marijuana stocks have mostly spent the past 12 to 18 months on expanding their production capacity. Since this is an industry that could see global sales grow to between $50 billion and $75 billion by the end of the next decade, producers want to have enough cannabis at the ready to meet recreational and/or medical demand.

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Mapping out the maturation of the marijuana industry

But keep in mind that capacity expansion is merely the first step of a very long maturation process for marijuana stocks. While there's no concrete step-by-step guide to success in the weed industry, since there's never been any precedent of a legal pot industry before, there are a number of "next steps" that pot stocks will be moving onto once their capacity expansion projects are complete. Here are five boxes that'll likely be checked off next.

1. Brand building

Arguably the most logical thing to tackle first is going to be marketing and brand building. It's not enough to simply be a major cannabis producer when there are dozens upon dozens of licensed producers in Canada and in various U.S. states. In order for marijuana stocks to stand out, they're going to need to develop a story behind their brands or simply acquire new brands that already have an impressive following.

Within Canada, no brand is better known than Canopy Growth's (NYSE: CGC) Tweed. Canadians' familiarity with the brand is a big reason behind Canopy's industry-leading marijuana revenue on a quarterly basis.

Meanwhile, Aurora Cannabis (NYSE: ACB) chose to pony up around $130 million to acquire Whistler Medical Marijuana in British Columbia earlier this year. Whistler does bring a little bit of added production into the picture for Aurora, but the deal primarily benefits Aurora by bringing a well-known West Coast cannabis brand into the fold.

2. Portfolio diversification

Next, it's all about diversifying product portfolios beyond just dried cannabis flower, which has shown a tendency to be oversupplied and commoditized over time, at least in select U.S. states.

For its part, regulatory agency Health Canada has stated that a number of new consumption options will be legalized on or before the one-year anniversary of adult-use legalization (Oct. 17, 2019). This means derivatives such as edibles, vapes, topicals, nonalcoholic cannabis-infused beverages, and concentrates, will all be given the green light for sale in Canada. Since these derivatives offer much better margins and firmer pricing power than dried flower, growers are encouraged to diversify their product portfolios.

Recently, HEXO (NYSEMKT: HEXO) signed a two-year agreement with Valens GroWorks that'll see Valens extracting resins and distillates that HEXO can use in the development of derivative products. This comes in addition to HEXO's 579,000 square feet in Belleville, Ontario, that's devoted to extraction and research and development, as well as its 57.5%-42.5% joint venture with Molson Coors Brewing to develop cannabis-infused beverages (Molson has the majority stake).

Similarly, Atlantic-based OrganiGram Holdings (NASDAQ: OGI) announced an investment of 15 million Canadian dollars in a production line to make chocolate cannabis edibles, and is actively looking for a nonalcoholic cannabis-infused beverage partner. These high-margin derivatives are too lucrative an opportunity for cannabis growers to pass up.

3. Domestic supply deals

Aside from producing as much marijuana as possible, growers also need to seek out buyers for their product. Otherwise, their margins could suffer. More specifically, nabbing as many domestic provincial supply deals as possible means securing at least some amount of steady annual cash flow.

To date, four growers have managed to land supply deals with all of Canada's provinces: Canopy Growth, Aphria (NYSE: APHA), CannTrust Holdings, and OrganiGram Holdings. While the magnitude of these deals often remains a mystery, Canopy Growth has divulged that at least 70,000 kilos per annum are promised, in aggregate, to Canada's wholesale (i.e., adult-use) market.

Then again, not every province is needed to land major supply deals. HEXO signed a five-year agreement with its home province of Quebec in 2018, which will account for around 30% of its production over the next five years, inclusive of its Newstrike Brands acquisition. All told, HEXO will supply Quebec with at least 200,000 kilos of aggregate output through 2023, with the amount being supplied increasing with each successive year.

4. Overseas expansion

Beyond domestic supply deals, growers also need to think about what they might do if and when the Canadian landscape becomes oversupplied with dried flower. Although supply chain issues are unlikely to abate over the next 12 to 24 months, there's a very good possibility that supply will handily outpace demand by 2022 or 2023, leading pot stocks to look overseas to move their excess product.

No marijuana stock has been more successful in orchestrating international production and/or distribution deals than Aurora Cannabis. Including Canada, Aurora is operating in 24 countries around the world, which isn't too shabby considering that there are just over 40 countries globally where medical cannabis is legal in some capacity. Then again, leaning on the international market isn't a huge surprise for Aurora Cannabis given that medical pot patients are its focus.

Canopy Growth has also been successful in securing around a dozen production and/or supply deals in overseas markets. Should oversupply get out of hand in Canada, companies like Canopy will have external sales channels to offload their product.

5. Consolidation

Lastly, marijuana stocks are liable to start looking at ways to improve their operating efficiency, which is most easily done by making complementary acquisitions.

Without beating around the cannabis bush, there are far too many growers in Canada and way too many U.S. dispensary operators. By consolidating, the remaining businesses should have better pricing power, and the cost synergies from joining two similar companies together should lead to improved operating margins.

Aurora Cannabis has been the most active on the acquisition front, by a longshot. Since August 2016, it's acquired 15 businesses, which has played a big role in making it the largest projected producer in Canada.

Aphria has also been an active acquirer. Aside from being of the few companies to have supply deals with every Canadian province, its purchase of Nuuvera in March 2018 opened up eight new foreign markets to the company. For Aphria, these external sales channels, and its current access to roughly one dozen international markets should help move excess supply over the next couple of years.

All told, that's a lot of boxes for pot stocks to check in the coming years.

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Sean Williams owns shares of CannTrust Holdings Inc. The Motley Fool owns shares of Molson Coors Brewing. The Motley Fool recommends CannTrust Holdings Inc, HEXO., and OrganiGram Holdings. The Motley Fool has a disclosure policy.