Smoking up on valuations

Canadian Cannabis Stocks

Canada is due to fully legalize marijuana in the second half of 2018, the first G7 country to do so on a national basis. In anticipation of this, many Canadian companies are investing in order to fulfill the demand. Many unknowns remain. For example, the provincial regulations that will govern marijuana distribution will differ across provinces, with some provinces proposing distribution only through government-owned stores, while others are expected to allow distribution through privately operated retail outlets. However, the marijuana market in Canada will ultimately behave like every other commodity, with supply, demand, and pricing all having an impact.

The number of publicly-traded Canadian companies associated with marijuana production has grown dramatically and early investors experienced outsized returns, leading to potential new investors clamoring to buy before legalization. This begs the question, does investment in this segment still make sense?

Size of the Marijuana Industry

Statistics Canada¹ estimated retail prices between $7.14 and $8.84 per gram, and most estimates mention prices no higher than $10 per gram, inclusive of both recreational and medical grade marijuana. Therefore we anticipate average retail prices including taxes to not exceed $10 per gram.

Statistics Canada also estimated Canadian usage of 700 tonnes per year in a 2015 report, which at $10 per gram equals $7 billion of annual sales.

The state of Colorado, having legalized marijuana several years ago, is a source of reasonable estimates. The Colorado Department of Revenue² reported recreational and medical cannabis sales of approximately $1.5 billion US in 2017. Adjusted for some marijuana tourism, this translates into roughly $270 US per person. At $340 Canadian per person at current exchange rates, and applied across a population of 35 million Canadians, this equals to about $12 billion of total annual Canadian sales. For comparison, per person annual alcohol consumption³ in Canada was about $740 in 2015-2016 and annual tobacco expenditure⁴ was roughly $670.

Our total industry revenue estimates of $7-12 billion include retail/distribution markups and taxes. Canadian cannabis producers would likely capture half of that, to arrive at total revenue estimates of $3.5-6 billion. Another way to look at this, is if marijuana sells at $10 per gram, producers receive $5 per gram, and the other $5 per gram goes to retail markups and taxes.

Market Value of Cannabis

The common shares of the 20 largest Canadian marijuana-specific stocks, as held within the Horizons Marijuana Life Sciences exchange-traded fund⁵, had an aggregate stock market value of $25 billion Canadian at the end of January. Because these companies carried virtually no debt, their “enterprise value” was essentially the same. If we divide this amount by their estimated annual revenue of $3.5-6 billion, the resulting ratio indicates that investors currently value this sector’s stocks at between 4.2 and 7.1 times every dollar of revenue. How does this compare with valuations of other similar industries?

The stocks of large tobacco⁶ companies are currently valued an average 4.8 times their annual revenues (“4.8X”), pharmaceutical6 companies average about 4X, and alcohol6 companies average about 3X. Tobacco companies are generally thought to have the highest valuation because their profit margins are higher than those of pharmaceutical companies, which in turn are higher than those of alcohol distillers. Because cannabis producers are essentially more agricultural than industrial or technological in nature, and because the industry’s barriers to entry are very minimal (i.e. no more difficult than establishing a greenhouse), their profit margins will likely lie closer to the lower end of this spectrum.

Canadian cannabis producer valuations of 4.2-7.1X are already higher than the 3-4.8X range of similar industries. Along with lower expected profitability, this strongly suggests that the Canadian cannabis producer market is already somewhat overvalued.

Other impacts to consider

Since legalization has not yet occurred, many unknown factors can further affect this market. To list just a few:

• Legal age - a higher legal age will reduce demand because primary users are younger
• Minimum pricing - if government sets a minimum price higher than the illicit market, commercial demand will be reduced
• Self-supply - if individuals can legally grow their supply at home, this will reduce demand for commercially-produced cannabis

One factor often mentioned to support current valuations is the first-mover advantage Canadian producers might have, should other countries eventually legalize. However, the minimal barriers to establishing marijuana production in Canada are no different elsewhere, and we see no reason other countries will be beholden to Canadian-produced marijuana.

Closing thoughts - it's too early to tell...

Only hindsight is 20/20, and nobody knows with certainty what the marijuana market will look like in ten years. Perhaps some Canadian producers will fend off new entrants in Canada and elsewhere, and capture a meaningful slice of the global market. Looking at only Canadian demand, however, current stock valuations make the Canadian marijuana industry seem somewhat overpriced and risky for new investors.

Source:¹Statistics Canada - Economic Insights - Experimental Estimates of Cannabis Consumption in Canada, 1960 to 2015

²Colorado Department of Revenue - Marijuana sales report

³Statistics Canada - Alcohol consumption

⁴Statistics Canada - Tobacco usage

⁵Horizon Exchange Traded Funds - Horizons Marijuana Life Sciences Index ETF

⁶Bloomberg