The month of August has been “hot, hot, hot” for a group of publicly traded Canadian-based Marijuana companies. Since August 1st, the share price of Aurora Cannabis (TSE: ACB.TO), Cronos Group (NASDAQ: CRON), Canopy Growth (NYSE: CGC), and Tilray (NASDAQ: TLRY) has returned an average of ~101%, based on the closing price through Wednesday, August 29th. Two catalysts have been driving the parabolic movement in share price: 1) The pending legalization of recreational cannabis in Canada, expected in late October, and 2) Constellation Brands (NYSE: STZ) $4B investment in Canopy Growth (NYSE: CGC), raising its stake to 38%, along with warrants which will allow Constellation to acquire a controlling interest in the company, has sparked investor speculation that other liquor companies may look to a similar strategy and diversify by investing in marijuana companies. Some liquor-based companies, such as Molson Coors Brewing (NYSE: TAP), have already announced partnerships, selecting to work with Hydropothecary Corporation (TSE: HEXO.TO) through the company’s Canadian business unit, and recent rumors have suggested that Diageo PLC (NYSE: DEO) is now looking for a partner. Speculation of who may be next has added significant fuel to the recent run-up in publicly traded marijuana companies during August.
What is the Market Opportunity for Legal Marijuana?
According to research from ArcView Group/BDS Analytics (1), a leading research firm in the marijuana industry estimated global revenues for legal marijuana in 2022 could potentially equal $32 billion. This compares to estimated 2017 legal marijuana revenues of $9.5 billion in 2017. ArcView Group’s estimate for 2022 includes both recreational and medical based marijuana. Medical marijuana accounted for 71% of worldwide spending in 2017, but with further legalization in U.S. markets, is projected to decline towards 41% in 2018.
In its research, ArcView Group suggests that the U.S. states which have already legalized marijuana will likely be the vast majority of the 2022 market, with expectations of ~$23 billion in revenue. In 2017, the U.S. market grew 31% year-over-year to $8.5 billion. If 2022 estimates for the U.S. market are achieved, it would suggest a 22% five year compounded annual growth rate (CAGR). Today, the U.S. market represents ~90% of the 2017 world market, and potentially 85% of the 2018 world market, but this share is projected to shrink towards ~73% in 2022, per the ArcView Group. The remaining estimated revenue in 2022 is likely to come primarily from the Canadian market as it legalizes recreational marijuana usage in 2018. According to the ArcView Group estimates, Canada and California will likely represent 41% of the legal marijuana market by 2022 or $13.2 billion in revenues.
Based on ArcView Group/BDS Analytics’ estimated market size for Canadian legal marijuana in 2022, we have tried to project what percentage of Canadians would need to use legal marijuana, how many grams per year each user would need to consume, and the price per gram companies would need to charge consumers. Per Tilray’s recent quarterly earnings report, today’s market for a gram of marijuana is roughly ~$6/gram. We believe given the significant competition for share of the Canadian legal marijuana market, with dozens of companies competing today and new companies coming online in future periods, using $5/gram will be the more likely scenario a year from now, and perhaps less than this figure by 2022.
To achieve the estimated ~$5 billion in annual legal marijuana revenues for the Canadian market in 2022, at similar usage rates to California (1 in 4 use legal marijuana), we project the total market will require each user consume 3-4 ounces annually, or at double the California market rate, 2 ounces per user annually, assuming current market rates per gram (~$6). At only $1/gram less (~$5), these same usage rates would require 4-5 ounces annually per user, or at the higher uptake rate, 2 ounces per user. At similar usage rates with California, coupled with lower market prices, every user would need to consume 2-3 grams to achieve the projected revenues. Given that heavy smokers may use much more than this, while others may consume less, the average of this number is not unrealistic. But given the risk of ASP erosion due to limited barriers to market entry, we believe the consumption and usage rates would need to significantly increase to maintain or increase the market size in years beyond 2022.
Estimated Consumption Needed to Achieve ArcView Research/BDS Analytics 2022 Canadian Legal Marijuana Market Estimates
Current Valuations May Price-In Future Market Opportunity
With the significant increase in share price during August 2018, current valuations for the four companies we discussed previously, Aurora Cannabis (TSE: ACB.TO), Canopy Growth (NYSE: CGC), Cronos Group (NASDAQ: CRON) and Tilray (NASDAQ: TLRY) may not support the potential market opportunity in 2022. The current total market capitalization of the four companies as of August 29th equaled ~$25 billion, with an average of ~$6.4 billion. Based on trailing year revenues, this equaled a price-to-sales (P/S) multiple of ~283.5x. The average trailing P/S multiple for specialty retailers was ~0.8x. Thus, based on current revenues, the companies mentioned are significantly overvalued by comparable metrics, but investors in the legal marijuana market will point to future growth opportunities driven by the legalization of the Canadian market.
If investors assume these four companies will achieve ~40% market share combined in 2022, the current valuation would represent a much more reasonable P/S multiple of ~2X (40% combined market share) or ~1.3x with ~60% combined market share. Under our best-case scenario, which would see these four companies gain combined global market share of ~80%, the P/S multiple would equal ~1x, which would be much more in-line with specialty retail comps. Given the growth opportunity in the legal marijuana market, none of these P/S multiples would be unreasonable in our opinion. However, given the significant competition that already exists for the legal marijuana market in Canada, with multiple companies seeing awards from provincial government agencies (example: 14 companies supplying Nova Scotia with population of ~945k), we are hesitant to suggest market share for these four companies could exceed our mid-level assumptions of ~40% combined global share.
Looking at current valuations from a different perspective, we try to establish potential EBITDA generated by the four combined companies in 2022, based on assumed market share, and then assign a multiple to this EBITDA value. With current market valuations already at a combined level of ~$25 billion, only eight scenarios out of 16 could justify current valuations or even higher potential valuations, based on current estimates for the legal marijuana market in 2022. For the share price of the four companies to continue higher, investors would have to assume that the market share is at least ~40% combined, EBITDA valuation multiples will equal ~12.5-15x, which is closer to technology/software company multiples, or at lower multiples of ~10-15x if combined share is equal to or greater than 60%, which would include our best-case scenario of combined global market share ~80%. Our valuation analysis also assumes EBITDA margins equal to or greater than 20% at ~40% combined share, or 15-25% at combined market share levels of 60-80%. Given we believe the companies will require significant operating expenses to support such high levels of future revenue growth, we see the likelihood of achieving EBITDA margins in excess of 20% as a lower probability. If investors assume 40% combined global market share in 2022 for the four companies mentioned with 15% EBITDA margins, and a 10x EBITDA multiple, which is inline with specialty retail comps, the current valuation would suggest that the market may be overvaluing these four companies by as much as 30%. What eventual share, EBITDA margins, and potential multiples may be in 2022 is anybody’s guess, but we believe at current valuations these four companies could already be suggesting a very positive outcome.
Upcoming Rebalance in Marijuana ETFs Could Create Near-term Volatility
We believe the upcoming rebalancing in two publicly traded marijuana ETFs could create volatility within publicly traded marijuana companies, and specifically in some of the four companies we have highlighted. Each quarter both the Horizons Marijuana Life Sciences Index ETF (Ticker: HMMJ) and the ETFMG Alternative Harvest ETF (Ticker: MJ) rebalance their holdings. The quarterly rebalance for both funds will occur over the coming weeks. The Horizons Marijuana Life Sciences Index ETF has an investment mandate which states any holdings above 10% most be sold and reinvested in other companies during the quarterly rebalance. As of August 29th, three companies in this ETF exceeded the threshold of 10%, Aurora Cannabis (TSE: ACB.TO) (~17.7%), Canopy Growth (NYSE: CGC) (~14.3%) and Aphria Inc. (TSE: APH) (~10.1%). We believe a similar rebalance will likely occur within the ETFMG Life Sciences Index with two companies exceeding 10%, Cronos Group (NASDAQ: CRON) (~11.2%) and Canopy Growth (NYSE: CGC) (~10.6%). We believe the upcoming rebalance in these two ETFs could create new selling pressure in the companies who’s shares now represent greater than 10% of the funds’ assets, which could negatively impact the companies being sold, but could be positive for shares of smaller companies who may see investment dollars reallocated.
Tilray May Want to Raise Capital in Near-Term
Shares of Tilray (NASDAQ: TLRY) have skyrocketed during August 2018. We see the potential risk that the company may choose to raise additional capital at current lofty valuations. As of June 30, 2018, Tilray (NASDAQ: TLRY) had ~$25 million in cash and cash equivalents. Year-to-date, in 2018, the company has spent ~$28 million ($14 million per quarter) in capital expenditures (CAPEX). We believe investments in operating expenses will also continue, as year-to-date spending was up 110% to $17.1 million. The company's recent IPO will add additional funds after the use of proceeds to pay down debt. However, given the substantial run-up in shares, management may choose to use the increased valuation to raise capital to fund the company’s future growth in the coming years. Depending on the valuation assessed to Tilray (NASDAQ: TLRY), along with the addition of more shares to the float from the capital raise, we believe shares could potentially come under pressure given the recent meteoric rise in valuation.
Announced Partnerships Could Provide Additional Fuel to the Fire
While our analysis is looking at what future values for the four publicly traded marijuana companies we have chosen to highlight may be, we also recognize that an announced deal for any of the companies mentioned excluding Canopy (NYSE: CGC), given its partnership with Constellation Brands (NYSE: STZ), could have a significant positive near-term impact on share price and potentially change investor perceptions about what future value may lie ahead in 2022 and beyond.
The growth opportunity in the legal marijuana sector is unquestioned, and could become even larger if, over time, the U.S. were to move to a fully federal legalized system. We believe investors should look to gain exposure to the legal marijuana sector, but instead of trying to pick individual winners in a very broad field, utilize an ETF, such as the ETFMG Alternative Harvest ETF (Ticker: MJ). However, we believe investors looking to gain exposure to this rapidly growing market may be better off waiting for the sector to pullback from the parabolic rise in market valuations witnessed during the month of August 2018.
Disclosure: As of time of publishing, Grinder Capital is short shares of Canopy Growth (NYSE: CGC) and Tilray (NASDAQ: TLRY). Mr. Schreiner also owns put options for Tilray (NASDAQ: TLRY) in his personal accounts. Grinder Capital and Mr. Schreiner are long shares of Organigram (OTC: OGRMF), Emerald Health (OTC: EMHTF), and Green Organic Dutchman (OTC: TGDOF). On August 30th Grinder Capital closed our short position in Cronos (NASDAQ: CRON), and Mr. Schreiner closed out Cronos (NASDAQ: CRON) put options in his personal account.
Reference to any public marijuana company or publicly traded ETF is not a recommendation to buy or sell any security. Investing in emerging markets has inherent risks and investors should do their own due diligence before committing capital to any investment.
(1) ArcView Group Research, The State of Legal Marijuana Markets, Sixth Edition (SOLMM6). Oakland, California.