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Nov 22, 2018

New Highs In The Cannabis Market: High Past Returns, High Hopes, And High Valuations

by Barkha Rani

Barkha RaniThe marijuana industry recently saw its biggest ground-breaking deal when Constellation Brands (STZ traded in the U.S.) announced a $3.8 billion equity investment in Canopy Growth to up their stake from 9.9% to 38%. The price Constellation paid per share was at a 51% premium to where Canopy had closed a day prior to the deal announcement. STZ also holds warrants in Canopy which could bring the stake to over 50%, if exercised. This deal followed Aurora Cannabis agreeing to acquire MedReleaf Corp for $2.9 billion in May and CanniMed Therapeutics in January for roughly $1 billion. These deals have shaken up the sector. Needless to say, activity in the cannabis sector is “high”.

With the anticipated legalization of recreational marijuana in Canada, the industry is seeing increased consolidation and financing activity to capitalize on this new, growing market. There are now 80 publicly listed Canadian cannabis companies with a total market value of about $25 billion. Canadian cannabis companies, with their industry knowledge, regulated production and cost of capital, are also set to expand internationally. Canada is the first of the G7 countries to legalize recreational marijuana, and it should translate into a jump-start for Canadian cannabis players compared to their global competitors.

Investors have yet to see much concrete data on what revenues and profits will look like and with retail sales in Ontario being pushed back to allow for private businesses to enter the market (albeit allowing for online sales), it will still take some time for these companies to really show their revenue generation potential. This risky appeal is still attracting many investors who are looking for “the next big thing”. The interest in this sector has been so much that the total market cap of Canadian cannabis companies has risen to be three times more than the estimated size of the Canadian cannabis market. This kind of valuation can intimidate new investors and shake the confidence of current investors. Much of these valuations price in the ability to expand internationally, contracts with provinces, ability to diversify product offerings and increased production to a lower price per cost basis. However, the Canadian cannabis producers will have to show significant revenue growth and an ability to keep new entrants out to justify their market capitalizations. The largest players in terms of sales (or anticipated sales) include Canopy Growth (WEED), Aurora Cannabis (ACB), Aphria (APH), Cronos Group (CRON) and The Green Organic Dutchman Holdings (TGOD).

The Canadian federal government is yet to approve the sale of cannabis derivative products such as edibles and infused-beverages. Parliament is expected to discuss and pass amendments on the sale of edibles and beverages next year. Extension into other product categories will materially increase the market size and is likely the real gem that companies such as Constellation, Molson Coors and Diageo want a piece of.

Three Cannabis Investments To Keep On Your Radar

Canopy Growth (TSX:WEED)

To summarize the last two weeks, Constellation Brands paid $5 billion dollars for 38% of Canopy, which had a market cap of $8 billion. Intriguing, right? Clearly, there’s more than what meets the eye. This investment is going to transform the industry and make Canopy the dominant player in not just flower sales, but also product derivatives. The proceeds of the investment, which means Canopy has more than three times cash than the next four largest competitors combined, are to be used for Mergers & Acquisitions (M&A) and product development. WEED currently has a market cap of $12.3 billion, which puts it in line with companies such as Bombardier and Canadian Tire. Now the wait and see game for Canopy investors will include watching how the management executes on capital deployment and allocation decisions.

Regardless of the market potential, an investor needs to consider how much of that potential is already priced in. We think the answer in terms of Canopy is ‘a lot’. Looking forward 12 months, the company trades at 23 times enterprise value to sales. Given the growth potential, some premium is justified but we have little insight into what the profitability picture will look like. The industry does not have much operating history to look at and it’s hard to know what the competitive landscape will be, meaning investors really need to trust that Canopy can capture a lot of growth and recycle that into profits. For context, Alphabet (formerly Google) trades at five times sales, Facebook trades at seven times sales and Amazon trades at 3.5 times sales.

Where Canopy may make sense in a portfolio is for an investor who wants a large cannabis company that is likely to move in tandem with the overall market to some degree. Add in a strengthened balance sheet and a very interesting partner through Constellation and a case can be made but the risks need to be clear: This stock, and the space in general, is very volatile with 5% up or down moves a high probability any given day. Another strategy could be to own Constellation Brands in the US which effectively owns over half of Canopy at this stage while allowing an investor to also own a successful alcohol business.

Supreme Cannabis Company (TSX:FIRE.V)

Supreme primarily focuses on the cultivation of dried cannabis to target the premium flower segment. It currently operates in a portion of a 342,000 sq. ft hybrid greenhouse facility located on a 16-acre property in Kincardine, Ontario. FIRE has announced plans to shift its business model for the Canadian recreational market. It will now be working with a direct sales model to provincial distributors and retailers versus its former business-to-business strategy. FIRE has applied for retail listings in provinces across Canada. It will be positioning its brand 7-ACRES as a high-quality brand with premium pricing. With the current Kincardine facility in construction and expected to be completed by Dec. 2018, the company is expected to double its in-place capacity to ~10,000 kgs. FIRE has been executing well on its expansion and strategy focus. The expansion is likely to be after the first round of orders filled by the provinces.

While FIRE just started generating revenues in mid-2017, analysts expect this company to generate $53 million in sales by year-end 2019. The company carries $78 million in cash and total debt of $30 million. In contrast to Canopy, FIRE trades at a more agreeable valuation of 6 times forward sales.

Horizons Medical Life Sciences Index ETF (HMMJ)

HMMJ seeks to replicate, to the extent possible, the performance of the North American Medical Marijuana Index. The fund offers more of a passive exposure to the space and is likely the most investable fund focused on the space in terms of asset size, with assets under management of roughly $961 million. For an investor who wants some broad exposure to the space without trying to determine which companies will live up to the hype, this is probably the best option. The total expense ratio as of year-end 2017 was 0.94%. It is important to remember though that just because it is an Exchange Traded Fund (ETF), does not mean volatility will be low. An investor should still expect wild swings from this fund.

Most, including us, would agree that this space is trading at a very high and difficult to justify valuation. The industry is realistically a commodity one (low margins) with low barriers to entry and no apparent way to market a brand for differentiation. It would also appear that much of the value being awarded to these companies is not just for the flower itself but trying to price in the potential from derivative products. Of course, the further into the future we try to look, the more likely we are to be wrong, which adds uncertainty in a space with very little “knowns”. The space is not for everyone and a long, hard look should be taken before making any investment in the space. We believe that if you are not willing to hold on to a 50% decline in an investment, then the cannabis sector is not for you. Volatility aside though, it never hurts for an investor to sharpen their pencils and at least be informed on the investment opportunities out there. At some point the space will stabilize and if an investor understands the market, they can then act quickly. While the cannabis sector may not be appropriate for many investors at this time, it is also one that should not be ignored outright, and whether you like it or not, will become a part of everyday Canadian life more and more over the next few years.

 

Barkha Rani, Investment Analyst at 5i Research. barkharani@5iresearch.ca, @5iBarkha