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The Matrix or the Metrics

Updated: Mar 13, 2019

Will the Cannabis Fantasy Eventually Yield to Financial Reality?

To begin this thought exercise we call a commentary, I will borrow from the wonderful Laurence Fishburne in the Matrix: “You take the blue pill —the story ends, you wake up in your bed and believe whatever you want to believe. You take the red pill —you stay in Wonderland, and I show you how deep the rabbit hole goes. Remember: all I'm offering is the truth. Nothing more.”


If you love the public markets in Canada, specifically the large cap Canadian cultivators/operators there, you may want the blue pill and just nuke this and forget you ever saw it. If you want some context and insight into a value disconnect we see emerging in real time that could affect the way you perceive the cannabis market going forward, take the red pill and read on.


In any emerging market, information is going to be opaque and putting the spotty information into proper context is very difficult. This is why investors often end up interested in diversified, risk-mitigated portfolios built by professional investors or asset managers like Merida. The disconnect we are seeing revolves around the seemingly efficient capital engine in Canada, which is credited for having created the world’s first fully transparent capital market for cannabis companies, and the U.S. market, the world’s largest by a country mile, yet which lacks the imprimatur of regulators and the support of a large and growing financial infrastructure with an appetite for transactions such as exists in Canada.


We have been thinking about this disconnect for some time, but it really came to focus while listening to the earnings report of a publicly traded U.S. ancillary company and perusing the comments around their numbers. We wanted to see some horizontal comparables, figure out the TAM for their vertical based on other public company reports and observe how other companies were presenting their own projected operational/market milestones in this sector. And yes, we called our friends from New Frontier Data for some help on this as well. It took three of us nearly 20-man hours to reach some level of a comparable matrix to put the information into a context by which we could reasonably assess what we were hearing and analyze it in a way that we felt would be productive.


Compare that to the almost daily research reports we receive on Canadian companies or U.S.-based companies that trade in Canada, the majority of which are currently multi-state operators. A tiny province announces that it will sign 13 contracts for supplying cannabis to their province-owned dispensaries and 20 different companies in Canada will produce a quick detailed report on it and their view on the affected stocks within days. New York announces that its Department of Health recommends adult-use and…you get a two-paragraph email from one company in Canada - a good start but perfunctory in many ways. No views on the stocks exposed to this (3 of which trade publicly in Canada), no commentary, and no context. The fact that several Canadian-based companies trade on the Nasdaq or NYSE further bolsters the notion that federal legality in Canada adds a level of predictability and transparency to these companies. This is true if you remove the element that this predictability and transparency is driven by investment banks and research analysts…i.e. interested parties to the advance of stocks.


While this is part of the disconnect, it doesn’t strike to the heart of what we see as the macro-effect of this disconnect between the perception of U.S. and Canadian-based operators. Canadian companies have more research coverage, investment banking and yes, a highly efficient market mechanism and so have attracted a huge following for investors to express their belief in the cannabis industry. U.S.-based companies that are currently trading in Canada are somewhat riding this trend but in most cases Canadian research is not nearly as sophisticated (or comprehensive) on individual U.S. state markets or these companies and so they seem to trade far below the metrics established for their Canadian counterparts who have smaller revenue bases, or a less attractive operational dynamic in front of them.


Interestingly, while most U.S.-based Canadian pubcos are raising money to spend in the U.S., Canadian companies have largely focused on international markets, with one recently announcing something in Malta, another in Lesotho, and many pursuing European markets.


Why is this important? Because it’s driving the valuation disconnect that is extremely difficult to analyze even though more than a few people allude to it on Twitter or privately without a clearinghouse for people to actually discuss it openly. Hence the reason it continues apace. Consider a recent example pertaining to Canopy Growth (CGC) in a research note we received “…we note that the company currently trades at 31.9x our two-year forward EBITDA forecast, at the high end of larger peers averaging 23.1x EV/EBITDA (2-year forward).”


Investors in the U.S. have to virtually search through the Encyclopedia Brittanica to decipher earnings on OTC companies and make sense of any specific quarterly earnings, create our own metrics for normalizing that analysis, and then weaponize all of those man hours into an investment thesis.


This is one of the things that we at Merida feel we do as well as anyone (and there are other incredibly competent U.S. and CAN-based investors doing it well) but keep that in mind when contemplating that large financial institutions in Canada aren’t concerned about hundred million dollar positions in a company trading at 31.9X two-year forward EBITDA , as if that can even be accurately predicted in cannabis.


Trust us on this, estimates have not been missing on the low side in cannabis regardless of how “conservative” the source of the estimate. Yet fear seems to be missing from the Canadian landscape and, in our opinion, that is being driven by the federal legality which leads to a perception of transparency and an efficient market, even if the metrics driving that market are completely out of whack, which we may not know for some time. For instance, analysts actually try and equate value to the hundreds of millions of foreign investments made by Canadian LPs but it could be that the vast majority of these investments have little yield for many years and the dilution which allowed these investments is less than strategic.


The point isn’t to denigrate Canopy, or any LP, or analysts in Canada but to highlight this interesting phenomenon occurring before our eyes in real time and facts are the only way to do that. In fact, we think Canopy is an incredible company and their CEO, Bruce Linton, said one of the most astute things we’ve heard in the space: “Some of these deals that I’m seeing out there, it kind of proves that you can actually spend a dollar to buy a dime, and I’m not really in that game.” Now that is an interesting critique of Canadian LP investments.


How is an average investor supposed to put all of these swirling facts into context and how is it that while fear and skepticism are fixtures in the U.S. investment landscape, they are almost wholly lacking in the Canadian view of LPs? There are more than 100 Canadian licensees coming online, and just about every LP has a massive facility that will require them to export most of their production simply to break even, yet it is hard to determine what the economics of export are over the long term since most local markets will be looking to create their own industries over time.

The anchoring of values at the billion CAD level and a lack of fear around those values seems like a meal of madness with a dash of FOMO sprinkled in. Most Canadian LPS are raising capital at levels that makes that capital virtually free. They have built some of the most incredible technologically advanced growing operations imaginable. The advancement and vision deserve the highest praise.

At a recent conference, every Canadian grower simply got up and talked about how many kilograms they can produce and the status of their cultivation buildouts. Analysts put an average price on it and – voila! - guaranteed earnings. How many analysts looked at Colorado and California and what happens when more operators enter into a market, giving consumers unlimited choices. How many Canadian analysts looked at the 100 or so Canadian LPs coming on line, or the fact that the new rec law allows unlimited licenses. How many have analyzed the effect of a liquor control model on margins or consumer behavior?


The Canadian market and cannabis in general have found a way to wrap all of the excess found in the internet boom and bust and put the volume on full blast so that very few people even understand the context in which they should be reviewing company performance, or valuation. Don’t believe it’s that simple? Look at the sheer volume of capital being raised by Canadian LPs and U.S. companies alike in Canada. It’s staggering and should scare any investor, yet we see more euphoria than caution (let alone fear).


We have a theory that perhaps people are pricing in a U.S.-based descheduling or legalization and these huge Canadian companies will just waltz in and buy things up. That again means that speculation is now an excuse to ignore what should cause real fear. If their results don’t meet expectation, it’s not going to be so easy to raise capital at anything close to current levels and the music will not only slow, it will stop playing and many of the market participants will find themselves without a chair.


The counterpoint to this is U.S.-based companies, and their largely modest valuations, and the fact that many investors focus on completely reasonable aspects of a company’s earnings when reviewing U.S. companies. Fear can have that effect. Many U.S. based companies are being evaluated in a thoughtful and sober manner and with that fear comes volatility and caution. This is ironic given the sheer speed and substance of the evolving U.S. market.


Look at the last two week’s news and the velocity of change is incredible. New York announced an emergency bill that allows any patient who receives a prescription for opioids to take that script to a dispensary and get a 90-day temporary card (subject to certain conditions). Illinois also has a similar law. New York followed that up by announcing that its Department of Health has recommended adult-use legalization. New York is about 65% the size of Canada. Hawaii announced it is looking to allow reciprocity for other state medical patients to get medicine. Puerto Rico already allows that. New Jersey (legislatively) and Michigan (ballot measure) are looking like a sure thing for adult-use passage. Massachusetts adult-use is finally launched.


Taken together, this small sampling of news from just recent weeks is massive as compared to Canada’s market. New York and New Jersey adult-use is likely bigger than the entire Canadian medical market and pretty close to their entire market due to the closeness of population figures.


Will ancillary companies like Kush, Waters Co., Scotts or GrowGeneration explode on this bucket of news? Will vertically integrated companies with exposure to New York? We think this is unlikely because the forces that drive this type of focused information are typically investment bankers and research analysts. With Canada having a virtual monopoly on these resources, their market simply has huge structural advantages. In many ways, the success of Canadian companies in bringing in investors is likely to be the very thing that forces the speculative future of Canadian valuations to meet the reality of performance and normalized price metrics. And that reality may not be so rosy for the highest valued companies until their performance merits it.


It’s human nature to overdo things and we are mostly herd animals and right now the herd is stampeding in Canada while the U.S. simply meanders forward in a much more reasonably valued way. If they both find reality, then it seems like U.S. stocks have a ton of room to roam and many Canadian stocks have solid headwinds coming their way.


One day the full force of the American institutional market will enter the cannabis space. When that happens, you better be long U.S. stocks or private companies focused on this market. If you expect the dinner triangle to ring a month before that occurs, then you have seen too many episodes of Little House on the Prairie. Right now, Canada is the only country open for business and that has pushed fear of missing out (FOMO) ahead of fear of losing money (FOLM). That is the disconnect separating the U.S. and Canada now. Long term, the challenges inherit to the U.S. market could benefit investors who have done the work to develop a refined sense of risk and reward throughout the fear. Before buying any stock, U.S. or Canadian, traded anywhere, focus on how a company’s valuation is justified and remove the fact that it’s a cannabis company from the equation. If it seems like the metrics being used are a stretch, then the valuation is almost definitely a stretch. Move on from FOMO to FOLM.


For those who have gotten this far, here is your blue pill: cannabis is equal to the early internet boom in the unlocking of entrepreneurship. Medically, it is helping people on a massive scale. Recreationally, it is a safer version of substances that people often rely on for unwinding. There are a ton of great companies who will succeed. Canopy is likely to be one of them.


Do not be deterred by short term stock volatility or fear that you missed the easy money. Invest with caution and do your homework or call us and let us do it for you the way Morpheus guided Neo in the Matrix.


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