SINGAPORE (Nov 19): On Oct 17, Canada became the second country in the world after Uruguay to legalise recreational marijuana. Canadian medical marijuana producers have signed supply agreements with government-approved cannabis wholesalers in the country. However, the medical marijuana market remains the cannabis producers’ main focus for the time being.

In its results announcement for the ­July-September quarter, Canadian cannabis producer Aurora Cannabis says the international medical market for marijuana has significant growth prospects, and is expected to grow to 10 million kilograms per annum. Arcview Market Research estimates total cannabis market spending in North America will grow from US$9.2 billion ($12.7 billion) in 2017 to US$47.3 billion by 2024. For the rest of the world, it is expected to grow from US$52 million to US$2.5 billion in the same period.

No surprise then that companies are falling over themselves to address this market. Canada-based Tilray listed on Nasdaq in July. The company is developing and distributing medical marijuana to over 10 countries, with Canada being its biggest market. Tilray’s main products are dried cannabis and cannabis oil, which are predominantly used in the medical marijuana industry.

Tilray significantly overvalued

Speculative buying and investor interest drove Tilray’s share price to a high of US$214 per share on Sept 19, many times its IPO price of US$17 per share in July. Prices have since retreated to US$102.88 as at Nov 14.

For its 3QFY2018 ended Sept 30, the company’s net loss rose 10 times y-o-y to US$18.7 million. This is despite quarterly revenue rising 85.8% to US$10 million in the third quarter and 78.9% to $27.6 million year to date. Our discounted cash flow (DCF) projections show the fair price of Tilray is at US$59.80, while based on the quality of assets, it should be US$17.20. For Tilray’s share price, the way down towards its true valuation could be long and arduous.

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The positive in the company’s earnings announcement is a surge in sales. Total kilogram equivalents sold increased over twofold to 1,613kg during the quarter, from 684kg in the same period last year, the company said. Average net selling price per gram was US$6.21 (C$7.98) compared with US$7.53 for the three months ended Sept 30, 2017. The lower price was largely due to an increase in bulk sales as a percentage of total revenue.

The surge in net loss was because of non-cash stock-based compensation charges of US$11.2 million during the third quarter. Excluding non-cash compensation, net loss was US$7.5 million, or eight US cents per share. Adjusted earnings before interest, taxes, depreciation and amortisation was a loss of US$7.4 million compared with a loss of US$1.7 million in 3Q last year. This was blamed on higher operating expenses, and one-time costs related to the IPO.

Key risks faced by Tilray include uncertainty in the medical marijuana industry, particularly in Canada. Both the recreational marijuana and medicinal marijuana sectors are subject to regulation, and the company’s prospects are likely to be tied to deregulation. At present, clinical studies and research on the efficacy of medical marijuana is limited.

The Canadian Cannabis Act, which was implemented in October, legalises adult-use marijuana. It is uncertain as to how much market share Tilray will be able to capture in this segment, as there are many competitors and this ultimately could lead to an oversupply, which would cut margins for the company significantly. Foreign laws and jurisdictions are also likely to impact the outlook for its products.

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Visibility from acquisitions for Aurora Cannabis

Toronto Stock Exchange- and New York Stock Exchange-listed Aurora Cannabis announced a 260% y-o-y rise in revenue to C$29.7 million ($31 million) for its 1QFY2019 ended Sept 30, and a 55% increase q-o-q. Revenue grew due to the acquisitions of CanniMed and MedReleaf, and an increase in the average net selling price of dried cannabis, and product diversification. Net profit for 1QFY2019 was 10 times higher y-o-y and 131% higher q-o-q to C$104.2 million because of unrealised mark-to-market gains.

On July 25, the company completed the acquisition of MedReleaf. On Sept 30, it completed the acquisition of 100% of Canni­Med, in which it had bought an 87.2% stake in March.

Its other acquisitions include Anandia, completed on Aug 8; ICC Labs on Sept 10; UAB Agropro and UAB Borela on Sept 10; and HotHouse Consulting on Aug 7. Aurora Cannabis also acquired stakes in Wagner Dimas and Rthm Technologies. The company announced a pro-forma 1QFY2019 revenue of $35,752, including MedReleaf (consolidated as of July 25), Anandia (consolidated as of Aug 8) and Agropro (consolidated as of Sept 10).

Our own DCF projections indicate that Aurora Cannabis would be fairly valued at C$9.30 based on previous acquisitions and future prospects; the margin of safety analysis, which assesses the quality of assets, suggests a price of C$4.10. Aurora Cannabis closed at  C$8.16 on Nov 14.

The average net selling price of cannabis sold by Aurora Cannabis was C$9.19 per gram in its latest quarter, flat q-o-q, but up 12% y-o-y. It sold 2,676kg of dried cannabis and cannabis extracts in 1QFY2019, up 65% q-o-q and 201% y-o-y.

The company has established significant early-mover advantage. It has a presence on five continents, and says it is currently Europe’s largest distributor of medical cannabis. As at Sept 30, Aurora Cannabis owned two of the seven cannabis production facilities in the world that are EU GMP (Good Manufacturing Practice) certified. Key risks are rising expenses and a supply glut as more players enter the market.

Constellation buoys Canopy Growth

Toronto-listed Canopy Growth is viewed as the largest cannabis producer in Canada by production capacity. Yet, it is struggling with operational and bottom line losses. Its net losses for the three months to June 30 rose 10 times to $90.8 million. The after-tax net loss for 2QFY2019, inclusive of non-cash share compensation expenses, fair value impacts and other non-cash expenses, rose exponentially to C$330.6 million, or C$1.52 per share, compared with a net loss of C$1.6 million, or C$0.01 per share, in 2QFY2018. Still, its financials indicate that turnover and balance sheet have expanded, indicating business growth. Our DCF valuation, which prices in both Canopy’s historical performance and future prospects, indicates a fair price of C$38.80; the margin of safety, which is the indication of the quality of assets, prices Canopy Growth at C$43.30. On Nov 14, Canopy Growth closed at C$45.14.

Despite its losses, Canopy Growth has attracted a suitor. In August, NYSE-listed beverage company Constellation Brands, which makes Corona beer, raised its stake in Canopy Growth to 38% from 9.9% previously. Constellation has the option of raising its stake to as high as 50%. It is looking to develop a cannabis-based beverage. Separately, Euronext-listed The Heineken Co has articulated plans to make non-alcoholic beer from cannabis.

As the largest Canadian cannabis producer, Canopy Growth is also the market leader in Canada for medical cannabis. In addition, the company has a presence throughout the entire marijuana value chain. Spectrum Cannabis, its medical cannabis brand, has seen the number of its patients grow by almost 200% in the last six financial quarters. Canopy Growth has a strong foothold in the recreational market as well — it has already signed eight supply agreements for recreational use in Canada. This represents 36% of the total share of supply agreements in Canada, and more supply agreements are expected to be added.

If Constellation does not raise its stake in Canopy Growth to 50%, its share price could react towards its DCF valuation of C$38.80. Other risks include a dilution in market share, as the medical cannabis industry is extremely susceptible to market sentiment. In-house company research suggests that the black market for home-grown and unlicensed cannabis in Canada is around C$5 billion to C$9 billion. In addition, given the influx of cannabis-related businesses following the legalisation of recreational marijuana in Canada, Canopy Growth may have to reduce prices in order to maintain its market share and this could potentially cut its margins.

Research and studies against the benefits of usage and consumption of cannabis in the medical and recreation spheres could also inflame market sentiment on cannabis. Furthermore, stricter and restrictive legislations domestically in Canada and internationally could further impair Canopy Growth’s potential to prosper in the cannabis markets.

Aphria’s profitability built on non-cash items

Toronto-listed Aphria is the first public licensed cannabis producer to report positive earnings in consecutive quarters. Revenue doubled y-o-y to C$13.29 million, and net profit rose 54% y-o-y to C$21.17 million for its 1QFY2019 ended Aug 31. Net profit included an unrealised change in the fair value of long-term investments. Still, the company possesses a strong balance sheet, with approximately 1.5 times more deployable assets and working capital against total liabilities. Our DCF projections suggest a fair price of C$16 for this stock, while a margin of safety analysis based on the quality of assets indicate a price of C$10.82 per share. Aphria closed at C$12.70 on Nov 14.

With a presence in more than 10 countries and the entire cannabis value chain, Aphria has managed to secure sales agreements in every province in Canada. The company’s cannabis production capacity is estimated to rise to 255,000kg early next year from 35,000kg last month. Its recent strategic partnership with Southern Glazer’s Wine & Spirits, North America’s largest wine and spirits distributor, boosts Aphria’s market distribution and coverage, especially to the retail sector on the continent.

Key risks include negative consumer perception and scientific research on the usage of marijuana. Aphria is also reliant on state reimbursement policies for the usage of medical cannabis, such as the reimbursement for retired Canadian Armed Forces veterans by the Veteran Affairs Canada department of the Canadian government. Veteran sales have been on a declining trend, and if this trend persists, VAC might amend or revoke its reimbursement policy, which can materially and adversely affect the company. Also, Aphria relies heavily on a single production facility located in Ontario. Any adverse impact to this facility will significantly damage the company’s ability to produce and market its products.

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