Rise of the Medical (and Recreational) Cannabis Industry
Around the world attitudes towards cannabis are beginning to relax. In recent years, the view has shifted from marijuana being a dangerous drug to a viable medicine. Although already commercially sold for medical use, recreational use is increasingly seeing decriminalization and non-black market commercialization.
On the back of an election promise made by Prime Minister Justin Trudeau, Canada will become the first country in the world to legalize marijuana for recreational use in late 2018. The Toronto Stock Exchange has already opportunistically seen listings by several marijuana companies and a subsequent run-up in the “weed” stocks.
An industry that began with many small LPs (licensed producers) is now lead by four large LPs (Aphria, Canopy Growth, Aurora, and MedReleaf) who are looking to cash in on a potentially lucrative industry.
A survey conducted by Deloitte in 2016 revealed that only 22% of the 5,000 adults surveyed consume recreational marijuana on an occasional basis, with most of them being millennials.
Many analysts are projecting the size of the market to grow post-legalization. Cannabis derivative products such as edibles and oils, usually in low doses of THC will also be introduced to cater to new users and appeal to a wider market.
Canadian Marijuana Companies
Aphria Inc. (TSX:APH)
- Headquarters: Leamington, ON
- Market Capitalization: 2.258B
- Patients: Undisclosed
- Growing Space (Planned or Under Construction): 127,000 sq ft (2,300,000 sq ft)
Aphria is a large Canadian LP based out of Leamington, ON. The company operates in both the retail and wholesale space and attempts to differentiate themselves through cost efficiencies and growing 100% of their cannabis in greenhouses using natural light.
Major Transactions for Aphria
Acquisition of Broken Coast Cannabis for $230M in cash and stock
On January 15, 2018 Aphria entered into a binding agreement to purchase 100% of Broken Coasts Cannabis’ outstanding shares. The two companies both prioritize low cost production evidenced by positive adjusted EBITDA last quarter by both companies.
The combined company will become the largest LP based on EBITDA and the second largest based on revenue. The deal is in line with Aphria’s geographic expansion strategy and will add 4500 kgs of production capacity immediately. The company will also benefit from Broken Coast’s cultivation expertise. Other synergies that are hoped to be realized include supply chain efficiencies, broader product portfolio, and integrated operations. The deal was closed on February 13, 2018 for $217M.
Acquisition of Nuuvera for $826M in cash and stock
On January 29, 2018, Aphria entered into a definitive agreement with Nuuvera to purchase 100% of its issued and outstanding shares. The $8.50 Aphria expects to pay per share represents a 30.5% premium on the price of Nuuvera shares as of January 26, 2018.
Aphria will benefit from Nuuvera’s expertise in cannabis derivative products as well its international presence. The combined company will have agreements or relationships in 11 countries, 8 of which were added through Nuuvera. The merger also provides Aphria access to Canada’s only research facility which is licensed to conduct commercial scale activities regarding cannabis and its derivatives.
On February 20, 2018 Aphria reduced the cash portion of its offer. Nuuvera shareholders will now receive $0.60 and 0.3546 of an Aphria share rather than $1 and 0.3546 of an Aphria share under the amended agreement.
Canopy Growth Corp. (TSX:WEED)
- Headquarters: Smith Falls, ON
- Patients: 69,000
- Market Capitalization: 5.08B
- Growing Space (Planned or Under Construction): 600,000 sq ft (5,000,000 sq ft)
Canopy Growth is the largest producer and distributor of medical marijuana in Canada with multiple brands under its portfolio. Its largest brands include Tweed, Spectrum, and Bedrocan.
Through a first-mover advantage, Tweed has become the most recognized brand of marijuana in the world. The Spectrum brand is the companies second largest and was acquired through the Mettrum acquisition.
Major Transactions for Canopy Growth
Acquisition of Mettrum Health Corp. for $430M in stock
On December 1, 2016 Canopy Growth Corp entered into a definitive agreement with Mettrum Health Corp to purchase 100% of its issued and outstanding shares. Through the acquisition, Canopy is able to add Mettrum’s popular Spectrum brand to its portfolio of medicinal cannabis brands, as well as expanding its hemp business by integrating Mettrum’s hemp brand, Mettrum Originals.
Other revenue and cost synergies which hope to be realized include supply chain efficiencies, cross selling through a wider product range, and combined research capabilities. The deal closed on January 31, 2017 for the agreed upon amount, with Mettrum shareholders owning 22.3% of the pro forma company.
Aurora Cannabis Inc. (TSX:ACB)
- Headquarters: Vancouver, BC
- Patients: 23,000
- Market Capitalization: 4.76B
- Growing Space (Planned or Under Construction): 95,000 sq ft (1,850,000 sq ft)
Aurora Cannabis Inc. is the second largest LP(and may become the largest after the closing of the CanniMed acquisition). It’s two primary markets are in Canada and Germany. In Canada, the company is focused on its retail operations, supplying Canadians with dried medicinal cannabis and cannabis oil. The company’s wholesale business is strongest in Germany. Aurora recently acquired CanniMed for 1.1B in the largest deal in the history of the marijuana industry.
Major Transactions for Aurora Cannabis
Acquisition of CanniMed Therapeutics Inc. for 1.1B in cash and stock
On January 24, 2018 Aurora Cannabis entered into a support agreement with CanniMed Therapeutics to purchase all outstanding shares that it does not already own for a 75% premium over CanniMeds January trading price, making it the largest deal in the history of the industry.
The hostile turned friendly deal will expand Aurora’s patient base to 40,000 and allow it to enter markets in South Africa, Australia and the Caymen Islands. Cannabis oil output is also expected to increase as CannniMed will take advantage of Aurora’s extraction partner Radient Technologies.
- Headquarters: Markham, ON
- Patients: Undisclosed
- Market Capitalization: 2.04B
- Growing Space: 266,000 sq ft
MedReleaf is an R&D-driven LP based out of Markham, ON The company was voted Top Licensed Producer at the 2017 Lift Canadian Cannabis Awards. They operate two ICH-GMP and ISO 9001 certified facilities in Ontario. MedReleaf is focused on serving medical patients, but is also expanding its brand offering in anticipation for the recreational market. MedReleaf is the only one among the top four cannabis companies that is yet to make a major acquisition.
Drivers of Consolidation in the Weed Stock Space
As the number of licensed producers (LPs) continues to grow, the market has seen a large increase in M&A activity. Larger LPs are racing to expand their business in order to compete not only with one another, but also with the black market and other healthcare/pharmaceutical companies moving into the industry post-legalization.
In a fragmented industry where companies are offering a mostly homogeneous product, the need for consolidation to create economies of scale and other cost synergies becomes magnified. A survey conducted by Ernst and Young in Q4 of 2017 revealed that the strategies of most LP’s are centred around vertical integration, scaling production, customer service, and obtaining patents. All of these concerns can be addressed through a suitable consolidation strategy.
Valuation of Marijuana Companies
In valuing a marijuana company, many of the traditional valuation metrics cannot be applied. This is because these companies are operating in an environment that is different from the environment they will operate in post legalization. As such, the valuation multiples used by analysts tend to be forward looking. Some standard industry valuation multiples include:
- Forward two years EV/EBITDA
- Funded Capacity(Kgs)/Market Cap
As valuations are already rich, analysts may embed risked upside into the equation by valuing potential future markets – countries likely to legalize in the future where established players will expand due to their first mover advantage in scaling up and moving ahead on the learning curve.
Markets can include countries with similar demographics and political philosophies to Canada including Australia and Western European countries. These cash flows are discounted heavily as real options.
Two Years Forward EV/EBITDA
Rather than use current EBITDA which only takes into consideration the earnings from medical marijuana sales, analysts will take the projected EBITDA value two years from now which takes into account earnings from both the recreational and medical markets.
As one would expect, predicting the earnings of a company two years from now is not easy. Especially a company which will be operating in a market that has never been observed. As such, valuations which hinge on these projected figures are flimsy. For example, when it was announced in mid-February 2018 that legalization may be delayed a few months, marijuana stock prices fell as forward looking projections had to be adjusted.
Funded Capacity/Market Cap
Funded capacity refers to the amount of marijuana (in Kgs) that a company will be able to harvest annually once their current expansion plans have been completed. Since the industry is still in its infancy, companies are not yet producing at their full potential capacity.
Valuations tend to favour companies who have taken efforts to expand their production capacity, either through building new growing facilities or buying existing ones.
Other Considerations in Marijuana Company Valuation
Two metrics that can be examined without the need for forward looking projections are patient count (and more importantly patient growth) as well as cash cost/gram sold.
A high and steadily rising patient count shows that the company is offering a superior product and customer service to its medicinal patients, a customer segment that will continue to drive revenue even after legalization.
A low cash cost/gram sold points to prudence and cost efficiencies in the growing and harvesting process. With the price of marijuana set to be pegged around $10 post legalization, any cost advantages a company can take advantage of will widen their margins and make them more profitable.
Acquisition Financing for Marijuana Stocks
M&A activity in the industry thus far has been funded by stock and cash. The absence of reliable cash flows hurts the creditworthiness of these companies, making it challenging to issue debt at any spread.
With companies issuing equity for each new acquisition, share dilution is somewhat of a concern but equity at current valuations remains the most attractive currency (unless investors are supremely bullish on the industry).
Cash and stock will be the leading sources of financing for the foreseeable future.
Leading Investment Banks in the Marijuana Space
With the big 5 banks avoiding the industry, most of the M&A activity has been driven by smaller Canadian investment banks. Cannacord Genuity has had a role in most of the largest deals thus far, including advising Aurora on their $1.1B acquisition of CanniMed and Nuuvera on their merger with Aphria.
On the other side of the Aphria-Nuuvera merger, Aphria was advised by Cormark Securities. Eight Capital(formerly Dundee Securities) advised Canopy Growth on its $282M acquisition of Mettrum Health as well as Aurora’s acquisition of Liquor Stores NA. Other banks that have been active in the industry include GMP Securities and INFOR Financial.
BMO Capital Markets recently became the first major Canadian bank to participate in the space, co-leading Canopy Growth’s recent $175M bought deal. Going forward, we should expect to see the other big banks begin underwriting and advising future deals.
Related Readings for Marijuana Companies