We Believe The Odds Favor Another Canadian Cannabis Rally Before Legalization
With the second great sector bull coming to an abrupt halt recently, investors are starting to sort through the body count. The time to start buying shares of select companies may be premature, but the carnage is making for some interesting options. If there’s an upcoming third bull leg, the time to start thinking about positioning is now.
The next bull cycle — which I posit could reignite anytime between the next few weeks leading up to July 1st, 2018 or late summer legalization period — may provide one more excellent investment opportunity before the inevitable sell-the-news event arrives. After all, once the sector goes live, market euphoria will subside. Wild speculative fervor will be replaced by the sterile reality of MoM retail sales comps, quarterly earnings reports and an assortment of credible business anecdotes. Data is a wonderful thing, but it leaves no room for the imagination to run wild.
And that’s a positive thing. It’s the natural transition of a maturing sector putting on its ‘big boy’ pants and going corporate. While the halcyon days of 400% YoY moves (as seen in the sector in both 2016 and 2017) provided amazingly quick returns, we suspect most will appreciate a more balanced risk profile. That will eventually include such benefits as dividends and better sharpe ratios.
Let’s face it: the bubble was in serious need of a short-term pin. At a valuation apex of about $31 billion (as judged by the Canadian Marijuana Index), Big Cannabis was worth more than Telus Corporation (TSX:TO), a cashflow generating behemoth with $13 billion is annual revenues, $5 billion in annual profits, and 7-10% semi-annual dividend increases through the end of 2019.
By comparison, the Canadian cannabis market will be much smaller; at least initially. For example, the California market is expected to reach US$3.7 billion in 2018 and about US$5.1 billion in 2019 according to research firm BDS Analytics. With a population of 39.25 million and similar consumer/regulatory dynamics, the Golden State compares favorably to the Canadian market.
The fact that Canadian cannabis valuations are on par with Telus highlights the frothiness of underlying equities. Sure, select winners will have much higher growth rates for the foreseeable future. But it’s unlikely the cashflow/profit gap will close by the time cannabis growth rates start coming back to earth. This is a highly regulated industry after all. As it often does, the market is pricing-in the Goldilox scenario, even if it doesn’t compute from a analytical perspective. It’s the reason why bubbles keep materializing, despite investors knowing better.
As such, we present our best cannabis stock plays for our anticipated third bull cycle. The focus here is on underestimated laggards with compelling stories. Should that third upleg occur, I believe it will be driven by mid-market which maintain lower ascribed valuations. These companies could be attractive acquisition targets. There’s still business/supply chain/compliance gaps the leaders need covering, and they’re up against the clock.
Therefore, expect sector consolidation to be the next big market driver. January’s Aurora Cannabis-CannaMed merger was just 2018’s opening salvo. If our thesis is correct, more activity on the takeover front is expected in the coming months.
Cannabis Stocks We’re Watching Right Now
With our investment thesis firmly in place, here are two interesting value propositions right now. I believe both companies could be undervalued relative to their growth potential and strategic positioning within their relative markets. This isn’t an all-encompassing analysis of each stock, rather, a general topline synopsis on why we like their story.
Delta 9 Cannabis NINE (CVE)
Delta 9 is Manitoba-based outfit growing small batch, hand trimmed, high quality medical cannabis strains in proprietary Grow Pod systems. The company is financed to build out 600 of these grow pods, which at capacity can yield 31.5 kilograms of medical cannabis each at an aggregate market value of $170 million per annum.
They do this on 80,000 square foot production facility in East Winnipeg, with an expansion capacity to 835,000 sq/ft in existing onsite buildings as needed. The company was one of Canada’s first ACMPR licensed companies and has a strategic foothold in the Winnipeg market, Canada’s 7th most populous city (2011 Census).
Recently, the company expanded its footprint into Alberta with the acquisition of Westleaf Cannabis Inc. This gives Delta 9 a fifty percent equity interest in a large-scale 4,000 kg cannabis production facility located in Southern Alberta. The company anticipates designating the Project as an expansion facility under its existing ACMPR license, with product moving sometime in 3Q 2018.
Despite an expanding production capacity, existing licensing and distribution agreement, the company’s stock has languished relative to its peers. Perhaps an ascribed market cap of $155M for a company with sub 7-digits revenues is scaring investors off. They have minimal presence in Canada’s “Big 3” urban markets, and have been born from decidedly “mom & pops” roots. In college football parlance, it would be akin to Alabama playing Western Kentucky.
But Delta 9 Cannabis Inc. has notable operations and reach between the eastern Rockies and Steinbach. One wonders whether Kenora and Thunder Bay are within their market range also. For a Tier-1 looking to expand supply chain production in the Mid-Canada market, Delta 9 might be worth a second look. Pure speculation on our part, but one that doesn’t take much imagination to see unfold.
Harvest One Cannabis HVT (CVE)
Harvest One is a global cannabis company servicing both the recreational and medical markets. The company serves as the umbrella company over its two main subsidiaries United Greeneries and Satipharm.
The former’s flagship property – the Duncan Facility – rests on a 1.2 acre property previously used as cold storage for a large commercial greenhouse growing operation located adjacent to a 40-acre land package on Vancouver Island. On October 13, 2017, Health Canada issued the amendment to allow sale of dried marijuana to registered patients.
The Duncan Facility has approximately 10,000 square feet of cultivation area and high compliance items such as a Level 8 Narcotics Vault and an in-house biochemical laboratory. Total production capacity is about 1,000 kg of cannabis per annum
Harvest One’s big prize is their Lucky Lake, Saskatchewan property. It’s currently in the late-stage application phase to operate a 62,000 square foot agricultural facility 100 km south of Saskatoon. If approved, cultivation capacity could be upwards of 11,700 kg of cannabis annually.
Furthermore, United Greeneries has addition plans to retrofit an industrial lumber kiln in Chemainus, British Columbia. Total annual capacity is anticipated at approximately 8,000 kg and can be fully funded with current cash reserves. This is an early-stage project at this point.
On the pharmaceutical front, Harvest One’s Satipharm subsidiary already has a fast-growing product on the market. Its Gelpell® Microgel Capsules are a CBD-only medicinal solution which uses micro-emulsion to substantially enhances the oral bioavailability of the cannabinoid.
But here’s the money part: Sales of Satipharm’s Gelpell-CBD capsules in the first quarter, while very modest, were $174,544, a 76.8% increase over fiscal 2017 sales. That’s only poised to increase because in November 2017, Satipharm commences distribution Gelpell-CBD capsules to approved patients in Australia.
That isn’t all. In January 2018, Satipharm AG received an initial import license to sell in the Canadian market. Once initialized, Satipharm’s Gelpell capsules will be added to United Greeneries’ ACMPR retail distribution. The company estimates the product will start distribution sometime during Q2 2018.
Although there’s some projection required (the revenues aren’t there yet and Lucky Lake still hasn’t been approved), I believe Harvest One could be an attractive target. They have existing (albeit modest) west coast production, fledgling larger production nearing approval, and a fast-growing medicinal product already on the market. With subsidiaries on four continents, they offer potential suitors higher yields and quick access to Australian/European and soon-to-be Canadian medicinal markets.
Disclosure: Neither Midas Letter Publishing Group nor the author own any financial interests in the profiled companies.
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