June 20, 2018

BIV on THC

I recently attended an investment conference whose focus was cannabis. As many institutional investment firms will not allow client money in marijuana stocks, the space represents somewhat uncharted waters. Weed stock valuations appear incredibly high, so I wanted to get a lay of the land and a sense for whether there may be attractively valued opportunities. My takeaways follow.

Clear Therapeutic Benefits. Evidence abounds regarding the medical benefits of cannabis. Chronic pain relief, mood enhancement, reduced agitation for Alzheimer’s patients and improved sleep are just some of the positives, while there is little conclusive data implying a causational link between marijuana use and long-term negative health consequences. The biggest opponents to legalization include the pharmaceutical industry and big alcohol, as marijuana’s effects are disruptive to both, since it is both therapeutic and similar to alcohol but without the hangover. While the act of smoking has a negative stigma, there is no evidence that smoking marijuana causes lung cancer (unlike tobacco), and there is significant innovation occurring around ingestion methods. Today, only half the market is dried raw flower, while 30% comes from concentrates that are inhaled but not combusted, and the remaining 20% comes from “other” products like edibles and pre-rolls. Still, there remains a negative stigma from government policy over the past century, as the New York Stock Exchange would not allow Canopy Growth Corp (WEED CN) to use the same ticker here (they are using “CGC” for now until NYSE chills out).

Massive Addressable Market versus Tiny Market Cap. The companies estimated a total addressable global medical marijuana market of $180B. Estimates of the recreational market vary, but the black market in Canada is estimated to be almost the same size as the beer market there. If we extrapolate that relationship to the rest of the world, there could eventually be hundreds of billions of dollars of market cap tied to marijuana, versus a $25B publicly traded market cap today. I think the clear assumption in the extrapolation is that the increased volumes from greater adoption via legalization would offset the price declines legalization would cause. While valuations on a name-by-name basis seem high at first glance, we are at a tipping point for exponential growth in the addressable market. Today, 29 countries have legalized marijuana versus just 5 four years ago, and more are considering it every day in light of the data.

Commodity, Consumer Packaged Good or Both? The key question will be how much prices fall with legalization. In Washington state, prices have dropped by 80% in four years since legalization. The companies most focused on building large brands at scale — Canopy Growth and Aurora — contend that the key will be customer experience. They point out that one company sells 1/4 of all the retail coffee in America. Aphria and Hydropothecary agree that brands will matter to an extent, but they are laser-focused on being the low-cost producers, noting that an oversupply situation will occur at some point, and the low-cost producer will win.

HEXO (HEXO CN) Most Interesting for Investment. While all the names appear inexpensive on an addressable-market basis, HEXO also looks inexpensive relative to its own prospects. It goes tit-for-tat with Aphria as the low-cost producer and has been focused on automated greenhouses since the beginning. The CEO has a track record of exceeding expectations, and they recently secured the largest supply contract in cannabis history. They scored a take-or-pay (aka “guaranteed”) deal with the Canadian government at a pre-contracted rate, so the revenue estimates have less risk of price compression than peers. Despite the revenue visibility (which theoretically should deserve a premium valuation versus peers), massive growth and high margins, the company trades at 7.7x EBITDA and 3.0x sales (both ’20). To put this in perspective, Philip Morris (PM), whose products kill you and have a shrinking addressable market, trades at 10x EBITDA and 4.4x sales (’20). HEXO also has a great chart.


Any views expressed are subject to change at any time, and Miller Value Partners disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results, and there is no guarantee dividends will be paid or continued.

©2018 Miller Value Partners, LLC

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