February 26, 2019

Canaccord Genuity Inc (TSE:CF) Analyst on Aurora Cannabis (TSE:ACB) and Canopy Growth (TSE:WEED) Financials

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Midas Letter
Canaccord Genuity Inc (TSE:CF) Analyst on Aurora Cannabis (TSE:ACB) and Canopy Growth (TSE:WEED) Financials

Canaccord Genuity Group Inc (TSE:CF) (OTCMKTS:CCORF) (FRA:C6U) Analyst Matt Bottomley  breaks down recent financial reports released by Canopy Growth Corp (TSE:WEED) (NYSE:CGC) (FRA:11L1) and Aurora Cannabis Inc (TSE:ACB) (NYSE:ACB) (FRA:21P). Bottomley says the numbers should be a red flag to other industry players and potential investors, as Canopy and Aurora captured roughly 50 percent of the Canadian recreational space in an increasingly crowded market. Bottomley believes there’s room to grow in terms of sales volumes and thinks the ultimate demand of the Canadian market is 10 times what current sales suggest. He highlights lack of government resources and infrastructure as one reason for the bottleneck. Bottomley also notes that the Canadian recreational space is primarily an online model right now and lacks the product depth and classifications that will ultimately lift the market.


James West:   Matt, what are you looking at these days and what are you liking, what are you hating?

Matt Bottomley:    Well, it’s, there’s a lot going on, obviously, and you know, looking at the space, Q4, last time we talked, maybe a little after that, there’s a lot of the multi-state operators coming to market, and there’s been a few earnings since then. I saw in the preamble there, we have Acreage that’s going to be reporting; I think MedMen as well, towards the end of this month. So obviously keeping an eye on that.

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Last week was very busy, though. We had the two leaders in the Canadian space, being Canopy and Aurora, report their first full quarters of recreational contribution, so that’s something I’ve been digesting and taking a lot of investor calls on, just trying to glean if it’s within expectation, you know, given all the different variables in there. And I think the key takeaways I think gleaned from the information is, the pricing is a lot higher than I thought it would be.

Now, I wouldn’t get too excited about that, because if you look at all the expansion plans in the industry, there’s a potential glut of actual biomass or cannabis flower that’s going to be coming online throughout 2019 and into 2020, so I expect the wholesale pricing of the flower to come down. But certainly in the first three months, here, the Canopies and Auroras out of the gate got much higher pricing. We’re still waiting now on the profitability to finally make an appearance into the sector, which I do think is some quarters away.

James West:   Yeah. You know, on that issue of over-supply and when it’s going to happen, it’s not really a question of if, it’s just a matter of when; there’s one of the things that I noticed. So cannabis became legal on October 17th. People couldn’t really buy clones or seeds to grow at home, so there hasn’t really been that uptake in the opportunity to grow at home.

Now, me being me, I ordered a top-of-the-line, four-pod hydroponic system, which I just transplanted seedlings that I started back in January into on the weekend, and, you know, having four plants growing in your house, you sort of look at this and think, okay, if I get 400 grams a plant, you know, I’ve got basically a lifetime supply of cannabis for somebody like me; I don’t smoke it that much.

So I’m just curious: have you taken that into consideration in your modelling of future revenues, that there might be a big sort of glut of demand that is not present in the marketplace, because people are taking advantage of the ability to grow their own?

Matt Bottomley:    I think it’s included in my model as much as someone that covers Constellation Brands probably considers home-brew in their model, so I would say it’s very low. And joking aside, not at all. I do think that it is going to, you know, cut into the market at some immaterial amount.

Right now when you look at particularly what’s going on in the US and you look at what a mature market looks like, if you’re a casual user, someone that might smoke on the weekends or vape or use an edible, it’s not a very expensive habit relative to alcohol. I mean, you can buy a gram of marijuana; if you’re not a heavy user, that can, you know, be enough for you and your friends for the weekend, you can buy it for $7 or $8. So it’s not something that I think is going to make people have to go and, hopefully it’s a labour of love on your part, but at the end of the day, it is something that I think people are going to do, but I think it’s more of a hobby as anything. I don’t think it’s going to be with respect to trying to get cheaper marijuana.

Certainly you’re not going to get high-potency products, you’re not going to get all the different cannabinoid profiles you’re going to get, you’re not really going to make home edibles, though I suppose you could, which would be a whole other step. So I’m not really worried about it; I don’t really think much about it. I think it’s interesting, but I don’t think it really comes into play when you’re looking at the macro picture.

James West:   Sure. Okay, and what is your takeaway on the reported earnings of Aurora and Canopy in that last segment?

Matt Bottomley:    Yeah, so I think there’s sort of three keys that I would look at. So one we talked about was pricing; the second one would be the actual market share. So it was very surprising: the Government of Canada actually has released monthly numbers for the first three months of Canadian rec sales, both between dried bud and oil products. And when you take the quantities that were sold, I believe it was about 30,000 kilograms if you include what was in inventory at year-end, as well as 30,000 litres of oil, and if you try and back into what Canopy and Aurora reported for their sales for the quarter, it seems like those two companies combined had about a 50 percent combined market share, which is, I think, a bit of a red flag when you’re looking at the industry as a whole, considering how many cannabis players there are.

Now, that’s great for Canopy, great for Aurora. I think when you include Aphria and Tilray and maybe CannTrust, I mean, those companies will probably make up, at least to start, you know, 80 percent of the market, which leaves a very small portion for the other 20 or 30. And you know better than anyone out there how many cannabis names are actually out there, certainly listed on all the different exchanges.

So I think it’s a bit of a red flag for investors that might have investors in a breadth of, you know, 20 or 30 of these Canadian LPs, because I think it’s becoming apparent that it’s only going to take a handful of these guys to get the market over the goal line, and that’s who the Constellations and Altrias and everyone are going to invest in. And I think that having those two companies come out so strongly is an indicator of that.

So, yeah, all in all, I thought it was, you know, pretty impressive earnings. The third point being profitability. So we had negative EBITDA in the amounts of about negative 75 for Canopy and negative 40 or so for Aurora, so still a long ways away. Canopy obviously has, you know, 4 billion-plus sitting on its balance sheets, with warrants to bring in another 4 billion, so I don’t think they’re too worried about the burn, but at some point, investors are going to want to see an inflection into positive EBITDA so that a reasonable assumption could be made as to what EBITDA multiples should be applied.

Right now, as you know, with the valuations, it’s very hard to decipher how investors look at it.

James West:   Yeah, you bet. So in terms of the volume of sales in the first full quarter of legal cannabis in Canada recreationally, do you think that’s a number that’s going to grow over time, or do you think that’s pretty much the volume we can expect to see in terms of consumption by Canadians going forward?

Matt Bottomley:    Yeah, so I don’t, obviously it’s going to be higher. I don’t have the, you know, the crystal ball as to what the number would be, but my back of the envelope calculation that I think I put it in a note the other day is that I think the ultimate demand is about 10 times higher than what was sold.

Now again, it’s a relatively low base; I think there was probably between recreational/medical, about 250 to 300 million of revenue sold in the quarter, which is great for a start, but really you have to look at where the bottlenecks are in this space, and there’s a little bit when it comes to what the producers are producing. But the biggest bottleneck by far in this state has nothing to do with producers. It’s the government and retail infrastructure, and being able to put cannabis in the hands of consumers.

So right now it’s predominantly an online model, even in states, or provinces rather, that have private sector that has been working on this for some time. There’s not many stores opened. I took a glance into one of them in Vancouver a couple of weeks ago, and it’s basically empty compared to all of the other illegal ones running around, and that’s because, the second point being, you don’t have product breadth.

So you don’t have infrastructure to get these into the hands of the consumers, and then you’re not providing what a recreational user is going to demand. So if you go to California or some of these other states, we don’t have edibles in Canada, we don’t have vape pens. We don’t have all these product classifications that really lift the market up. So your incremental user, someone that doesn’t smoke cannabis, someone that doesn’t think about cannabis, if you ask them today, Are you a cannabis user? They’re not going to have the ability to even potentially participate into this market until it looks a little more CPG-friendly, it’s in stores, it’s beside, you know, or in Shoppers, it’s beside where they go grocery shopping. You know, you’re not going to really get it from, in my view, overpriced cannabis just on an online platform.

James West:   Sure. Do you think that the Government of Canada is going to get that point, that they’re kind of keeping the market down by being so restrictive and so conservative with the rules? I mean, even alcohol manufacturers have a lot more liberal policy towards them in terms of how they can advertise, what kind of events they can sponsor. Do you think it’s just a matter of time till the Government of Canada eases up and says, Okay, this isn’t going to turn into the Reefer Madness show we thought it was; we can pull back on some of these rules and let these companies make a little more money?

Matt Bottomley:    I’m certain they’re aware of it. I don’t think there’s a lot of incentive to run before you can walk, rather. We’d all like to see that; certainly LPs would like to see it, but coming into an election year, the last thing you want is having every colour gummi bear and gummi worm out on the market and some minor gets their hands on it and you have a PR nightmare. So that’s just one small factor, but I think the real, you know, reason why we are here today in terms of being a little behind the 8-ball with the rollout, is just a function of when you go back in time and it was all medical, my understanding, at least when I started looking at this market in early 2016, there might have been 30 people at Health Canada working in this cannabis group; and they’ve slowly been growing and growing and growing.

So there just hasn’t been the resources there in order to facilitate a fast-growing market. Where I think there’s been pretty big missteps that could have been avoided is on the retail rollout. I have no idea why, obviously Ontario had a provincial election and the leadership change and okay, the model got pivoted; but out in Alberta, why is there, you know, whatever the number is now, 10 stores, and BC, five stores? You know, two years after, this was sort of known to be in the mix?

So that’s a little bit surprising. So you know, there’s incentive for the government to roll this market out given all the tax money that’s at stake, but given that it’s the government, I don’t think, you know, don’t expect this to happen in the next couple of quarters.

James West:   Yeah. Do you think the private model is better than the government model in states, or rather, provinces where it’s more privatized, like Alberta, as opposed to where it’s more restrictive, like Quebec?

Matt Bottomley:    Well, I think, you know, if I could design it from the ground up, yeah. I think that, you know, when you put the private sector into it, it’ll probably be done a little bit more efficiently, because, you know, they need a return on their investment for putting it into the different retail locations.

I personally don’t hate the LCBO, I think it’s a pretty run store, but that’s, you know, decades in the making. So in terms of rolling out this market, I think a private sector’s probably a better model; but more so, I think you should be leveraging off of people in parallel industries like traditional retail, or even the LPs themselves, like helping to do that with…what Ontario did by putting this in a lottery where the criteria was, you have to have a credit card and access to internet, I mean, it’s a little silly.

I mean, no disrespect to the 25 people that got it, but it doesn’t make sense to me that that’s how you would roll the market out. So that, I don’t really understand either.

James West:   Mm-hmm. So, we’ve got a situation now where, let’s say we have a mature cannabis market in terms of the large-cap cannabis companies in Canada; we’ve still got a never-ending bouquet and sort of rain of small companies that are coming to market, and the range of business models is growing wider, but there’s been a few real significant ones emerge. Like the biosynthetics, I’ve now got seven Power Points on my desk from seven different biosynthetic companies. Obviously, biosynthesized cannabis is a threat to the large producers in some respects, because if it can be produced at a much lower cost of input, then obviously there’s a risk there.

Do you think – like, which of these sectors, like at this point in, halfway through Q1, or I guess, almost exactly halfway through Q1 – at this point, which of these other sectors, like large caps, small caps coming to market, multi-state operators in the US, biosynthetics, we just had Raj Grover here from High Tide, which specializes in equipment and paraphernalia – which of these sectors do you get most excited about?

Matt Bottomley:    Well, there’s a lot of them. So the one that I like the most, though it’s not on the Canadian theme, is the multi-state operator. When you add up the, and I think we’ve talked about this before: the market capitalization in Canada is 100 billion or whatever it is this hour; if you cut that in half or by 60 or 70 percent and say this is how much I think the Canadian sector is overvalued – assuming you think that – that’s still well higher than the macro market cap of all these multi-state operators, where I think the combined value is about 15 billion right now.

So these are companies that have access to hundreds of millions of potential customers, are vertically integrated where they’re not dealing with the government at all for their retail stores, and there’s less of them to digest. I mean, there’s probably going to be an increasing profile, but there’s sort of six or seven that are really out of the gate as the leaders. So that’s what I’m looking at. In the Canadian space, I think, you know, the biosynthetics is obviously something that’s interesting. I actually don’t have the view that it would necessarily be a competitor with the large caps should it go that direction, because at the end of the day, what’s going to happen here is, the market is going to transition to CPG.

So whoever gets the leading market share right now in Canada, you know, as the quarters turn into years, that’s going to turn into a brand. There’s going to be brand equity there, and then someone like Bruce Linton at Canopy, and there’s been others as well, they’re just looking for the lowest cost input or the most efficient cost input. So whether that’s growing it yourself in Year 1 to buying it wholesale in Year 2, to having some lab concoct it for you in Year 3, I don’t think the – I think the runway is too long for those types of companies for them to actually come in to compete with them.

So that’s not one that I think is necessarily a bad investment opportunity, because I think there’s a tremendous amount of IP and R&D that needs to go into the space given the historical illicit nature of it, but it’s going to take some time. I don’t see one of those companies de-throning one of the leaders in the LP space.

James West:   Mm-hmm. Matt Bottomley, great perspective as usual. We’re going to have you back sooner rather than later; again, thanks for joining me today.

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