Across the world attitudes towards cannabis are beginning to relax and in no country is this more evident than in Canada. In recent years, the view has shifted from marijuana being a dangerous drug to a viable medicine, and now to an appropriate form of recreation. Although already prescribed 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 second country in the world (behind Uruguay) to legalize recreational use of marijuana on October 17, 2018.
Major Marijuana Companies
The industry in Canada is made up of many small LPs (licenced producers) and a few large LP’s who are projected to dominate the market come legalization. Consolidation activity in the industry has seen many smaller LPs being purchased by the big players as they look to expand their growing capacity. The aftermath of numerous rounds of consolidation has seen two LPs emerge as the market leaders,
- Canopy Growth Corp. (TSX:WEED, NYSE:CGC)
- Aurora Cannabis Inc. (TSX:ACB)
Other major LP’s include
- Aphria Inc. (TSX:APH)
- Tilray Inc. (NASDAQ:TLRY)
- Cronos Group Inc. (TSX:CRON)
- CannTrust Holdings Inc. (TSX:TRST)
Government Regulation of the Marijuana Industry
As expected, the federal and provincial governments will have a great amount of control over the industry. Companies at all levels in the supply chain can expect red tape at every corner. In many provinces including New Brunswick and Quebec, the provincial government has complete control over the online and physical retail distribution channels. Other provinces including Saskatchewan and Manitoba have adopted a more liberal approach, allowing independent retailers to set up shop. In all cases, the distribution channels between the LPs and the retailers is completely controlled by the government.
Canada can expect to face many regulatory challenges when it comes to managing the new industry, one of which is pricing at the retail level. Similar to alcohol sold at government run stores, consumers can expect large sin taxes and mark-ups. The challenge for governments when it comes to marijuana is maintaining tax revenues while pricing out the black market, an issue that it does not have to deal with when it comes to alcohol.
Another regulatory consideration is product branding and advertising. Companies may find it hard to differentiate their products, as health warnings and government labels are expected to take up most of the packaging. Companies will either need to rely on the quality of their strains to create customer loyalty or simply be forced to compete on price.
Valuations of Marijuana Companies
Since marijuana companies are currently operating in an environment that is different from the one they will be operating in once legalized, valuation metrics tend to be forward looking. Popular valuation multiples include
- EV/EBITDA (forward 2 years)
- Funded Capacity/Market Cap
Forward 2 years EV/EBITDA
The current EV/EBITDA only reflects the value of a company’s medical marijuana business. In order to factor in revenues from the sale of recreational marijuana, an estimated figure two years into the future is used.
Funded Capacity/Market Capitalization
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.
With a supply shortage expected once legalization hits, valuations tend to favour companies with planned production capacity that can be realized sooner than later.
Other Considerations in Valuations
Most valuations centre around the Canadian market but analysts may also 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.
Current success in the medical marijuana space is also looked upon favourably. High patient count and patient growth signal a higher quality product that will likely still be successful in the mass market.
Cost per gram sold is another important metric that reveals how efficiently a company is producing and harvesting its product. Greenhouse growing operations have a lower cost/gram then indoor growing operations.
Given the buzz surrounding the industry, many less sophisticated investors have also entered the market, driving valuations higher. Small asset managers have responded to this demand, selling cannabis ETFs and creating cannabis funds.
Consolidation Activity in the Marijuana Industry
With the date of legalization approaching, large LPs have been racing to acquire the brands and assets of smaller LPs in order to scale up to meet demand once recreational marijuana goes on the market.
Many analysts are expecting a short term supply shortage in the months following legalization. The companies that are the most prepared to supply their product will have a better chance of establishing dominance in the market and creating customer loyalty that will last even when the market reaches an equilibrium.
One company that has been especially active in acquiring other LPs is Aurora Cannabis. Within the last year they completed two high profile deals, purchasing CanniMed Therapeutics for $1.1B at a 75% premium and MedReleaf for $2.7B (24x their 2019E EBITDA), both of which were the largest deals the industry had ever seen when they were announced. The two deals combined gave Aurora an extra 160,000kg of funded capacity.
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
Back at the end of 2017, when industry consolidation was just starting to heat up, the major Canadian Banks refused to engage on any deals related to the cannabis industry, due to internal red tape from large compliance divisions as well as risking their strong reputation on an unproven and controversial industry. This opened the door for many smaller Canadian advisors such as Cannacord Genuity and GMP Securities to become leaders in the cannabis space. Cannacord in particular has established itself as the leader in cannabis, having a hand in most of the large deals and IPOs thus far.
BMO Capital Markets became the first of the major Canadian banks to take an active role in the industry when they co-led a secondary offering from Canopy Growth. Since then, they have advised Aurora on their purchase of MedReleaf and Hiku Brands on its sale to Canopy. As of right now they are the leading cannabis investment bank among the Big 5 and their first mover advantage is likely to keep them there. CIBC has also supplied lending facilities to cannabis companies and recently co-led a $104m private placement for Canopy Rivers.
Given the fact that many underwriters and advisors have been avoiding the industry, it’s no surprise that the fees paid for these services are at a huge premium. BMO and Eight Capital each received a 7% underwriting fee for the IPO of Tilray, while the secondary offering of Canopy Growth shares saw BMO and GMP Securities each take home 4% in fees for co-leading the deal. To put those numbers into perspective, Snap Inc. paid a 2.5% fee for its IPO in 2017 and Canada Goose recently paid a 0.9% fee for a secondary offering.
Trends in the Marijuana Industry
Partnerships with Beer Companies
Although cannabis edibles and drinks won’t be legalized immediately, beer companies like Constellation Brands and Molson are betting heavily on consumer demand for cannabis-infused alcoholic beverages, investing millions of dollars into cannabis companies. For beer companies, these partnerships offer an opportunity to continue growing despite stagnating beer sales in recent years. For cannabis companies, weed-infused beverages can compliment an existing portfolio of cannabis derivatives such as edibles and oils which are expected to command higher margins than the plant itself.
After taking a 10% stake in Canopy at the end of 2017, Constellation Brands recently increased their minority stake to 38%, with enough warrants to take majority control of the company. The purchase price of $5bn represents a 51% premium over the last closing price of Canopy’s shares.
Molson Coors and HEXO Corp. have opted for a different route, forming a joint venture. The purpose of the joint venture is to perform research and develop a weed-infused beverage with mass market appeal before cannabis beverages are officially legalized for recreational use (at least a year after initial legalization).
There have also been reports of Diageo, the parent company of Guinness showing interest in partnering with an LP in the near future. With Aphria’s CCO Jakob Ripshtein being the former CFO of Diageo N.A., it is likely that Aphria will be their first choice.
Listing on American Stock Exchanges
Although the TSX will still be the primary stock exchange for the industry, we are starting to see some major LPs like Cronos, Canopy and Tilray listing on American stock exchanges.
Cronos became the first Canadian LP to list outside the TSX when their stock began trading on the NASDAQ in February. Since then Canopy Growth has made their shares available on the NYSE.
Tilray decided to forego the TSX altogether when they IPOed on the NASDAQ in July. Since then their stock price has nearly tripled after many favourable developments including impressive revenue growth in Q2 and supply agreements with multiple provinces.
These listings give American investors an opportunity to participate in a new high growth industry, while giving cannabis companies a greater sense of legitimacy outside of the Canadian market- something the industry is desperately in need of.