As cannabis companies with strong balance sheets look for inorganic growth and vertical integration, targets will likely be both domestic and foreign
SmallCapPower | May 25, 2018: We predict the M&A landscape for cannabis-related companies in Canada will be active this year as the cannabis legislation progresses and if company valuations remain high. As cannabis companies with strong balance sheets look for inorganic growth and vertical integration, targets will likely be both domestic and foreign, especially with a focus on U.S.-based companies with lower valuation multiples. The proverbial “big fish eating smaller fishes” already played out this year with Aurora Cannabis Inc. (TSX:ACB, OTCPK:ACBF.F) acquiring or investing in more than 10 companies in the past year, including Aurora’s announced acquisition of MedReleaf Corp. (TSX:LEAF, OTCPK:MEDF.F) for $2.9 billion in May and completed acquisition of CanniMed Therapeutics Inc. in January for more $1.1 billion. In this report, we outline Canadian cannabis stocks that we believe are potential M&A targets: CannTrust Holdings Inc. (TSX:TRST, OTCMKTS:CNTTF), Cronos Group Inc. (TSX:CRON, NASDAQ:CRON), Hydropothecary Corporation (TSXV:THCX, OTC:HYYDF), Village Farms International, Inc. (TSX:VFF, OTCMKTS:VFFIF) and Organigram Holdings Inc. (TSXV:OGI, OTCMKTS:OGRMF).
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CannTrust Holdings Inc. (TSX:TRST, OTCMKTS:CNTTF)
Licensing
CannTrust is a licensed producer of medical marijuana under the Access to Cannabis for Medical Purposes Regulations (ACMPR). The Company currently operates two facilities: (1) 40,000 sq. ft. Vaughan facility, licensed in June 2014, has a production capacity of 3,600 kg/year; (2) Niagara facility, licensed in October 2017, has a total of 430,000 sq. ft. of greenhouse space, 250,000 sq. ft. of which is currently operational, with a production capacity of 20,000 kg/year. The remaining space in the Niagara facility is expected to become production-ready in mid-2018, alongside a number of facility improvements. After completion, the facility is expected to produce 50,000 kg/year. The Company has a 10MW co-generation agreement with Envest Corp. to reduce costs. In Q1/2018, CannTrust’s active patient count increased 14% Q/Q and 194% Y/Y to ~42,000 patients.
International Distribution
The Company holds several agreements for distribution of its products overseas. In November 2017, the Company received Health Canada approval to ship to countries where medical marijuana is legal. Shipping to Australia began immediately. In March 2018, the Company launched a joint venture with Stenocare, receiving a 25% equity stake in the Danish marijuana developer. Stenocare plans to distribute CannTrust’s product and create its own production centre. Canntrust expects to begin shipping to Germany, Mexico, and Brazil in the future. The Company also holds a joint venture with Apotex, Canada’s largest generic pharmaceutical manufacturer.
Unique Products
In Q1/2018, 60% of the Company’s revenue was sourced from its cannabis extracts sales, which had increased 5.1x its total FY2017 sales quantities. CannTrust offers six varieties of capsules and oils, and 10 varieties of dried cannabis products, with a same-day delivery service in the Greater Toronto Area (GTA). In April 2018, the Company announced a partnership with Grey Wolf Animal Health for the creation of medicinal cannabis products for pets.
CannTrust Holdings Company Products
Source: CannTrust Holdings Company Website
Balance Sheet
As of May 15, 2018, the Company had $20.8M in cash and short-term assets, and total liabilities of $19.2M. The Company holds a $9.5M mortgage on its Niagara greenhouse.
CannTrust trades at 13.5x 2019 EV/EBITDA, as compared to its peers, which trade at an average of 19.5x. The Company has few long-term plans that are capital intensive. Strong production levels and supply to niche markets both domestically and internationally could prove valuable for prospective acquirers. The Company has an average price target of $14.78, representing a 67% upside. The Company has 8 Buy ratings.
Cronos Group Inc. (TSX:CRON, NASDAQ:CRON)
Licensing
Cronos Group is a licensed producer of medical marijuana under the ACMPR. The Company produces marijuana primarily out of its Peace Naturals facilities, which have a production capacity of 6,650 kg/year and 69,500 sq. ft. of production space. Cronos Group expects to complete the construction of a 286,000 sq. ft. facility with a production capacity of 33,500 kg/year by the summer of 2018. The Company also owns Original BC, which currently operates a 2,500 sq. ft. facility in Armstrong, B.C.
North American Retail
The Company distributes its product primarily through its two brands, Peace Naturals and Original BC. On March 23, 2018, the Company formed a joint venture with MedMen Enterprises, a U.S. cannabis retailer and, recently, announced a joint venture with Canadian First Nations for production and distribution with Indigenous Roots. MedMen Canada focuses on Canadian retail, licensing the brand for sale in Canada. Indigenous Roots plans to construct a 30,000 sq. ft. facility at the Original BC site and serve indigenous communities, who will own 50.1% of the venture.
Peace Naturals expansion
Source: Cronos Group Company Presentation
International Distribution
The Company holds a distribution agreement in Germany with Pohl-Boskamp, a pharmaceutical manufacturer. Cronos Australia, created in partnership with NewSouthern Capital, aims to complete a 20,000 sq. ft. facility with 20,000 kg/year of production capacity by H2/2019, and distribute Canada-produced cannabis within the country. Cronos Israel, a JV with Kibbutz Gan Shmuel, plans to construct a 45,000 sq. ft., 5,000 kg/year production facility and a 17,000 sq. ft. manufacturing and research facility. Should medical cannabis become legal in Israel, the Company will distribute there as well.
Research and Development
The Company has created 150 unique plant varieties, using unique CO2 extraction, mapping systems, and environmental controls to improve quality and yields. The Company operates a 1,200 sq. ft. lab at its Peace Naturals facility.
Balance Sheet
The Company holds $32.4M in cash and $8.9M in total debt. $5.4M of that debt is from a construction loan.
The Company trades at a hefty premium compared to its peers, at 27.5x EV/EBITDA FY2019, larger than any of its peers save Canopy Growth Corp. (TSX:WEED). Although Cronos Group is currently the fifth-largest cannabis company, its Market Cap is less than half of Aphria’s, (TSX:APH), which will be the next largest company following MedReleaf’s (TSX:LEAF) acquisition. In turn, it is ~50% larger than the next smallest company. If Canopy Growth, Aurora Cannabis (TSX:ACB), or Aphria are interested in significantly expanding their production with one acquisition, Cronos is the best target available. The Company has an average price target of $9.00, representing a 16% upside. The Company has 3 Buy ratings, 2 Hold ratings, and 1 Sell rating.
Hydropothecary Corporation (TSXV:THCX, OTC:HYYDF)
Hydropothecary Corporation is a Canadian cannabis producer operating a 50,000 sq. ft. growing facility in Gatineau, Québec. The Company differentiates itself through its commitment to natural growth techniques and a focus on customer service. The Company’s stock has returned 15% YTD and 232% since May 16, 2017, outperforming the Horizons Marijuana Index, which fell 9% and returned 85% over the same period.
Current operations in Québec produce 3,600 kg of cannabis per year. In October 2017, construction began on a 250,000 sq. ft. expansion at its current facility, anticipated to be operational by summer 2018. At the current facility, a second greenhouse construction project is expected to add an additional 1M sq. ft., scheduled for completion by December 2018. With both new greenhouses operational, the company expects to be able produce 108,000 kg of cannabis per year.
Licensing:
Hydropothecary has both a cultivation and sale license for cannabis and cannabis oils. Importantly, the Company is also the only producer in Quebec that is licensed for sale. The licensing process lasts one to two years from receipt of a initial cultivation license. Consequently, Hydropothecary’s complete set of licenses make it an attractive takeout target for a larger player who wants to expand operations into Quebec.
Supply Agreements:
On April 11, due to the Company’s Québec presence it became the preferred supplier to the Québec recreational market, expecting to supply approximately 200,000 kg over a five-year period, with the option to expand the contract by an additional year. Hydropothecary is expected to supply Québec with 20,000 kg of cannabis in 2018, making it the market share leader in Québec (35% of the market share). This is the largest forward supply contract in the history of the cannabis industry. This long-term contract brings business certainty and clear path to profitability through its stable continuous revenues.
In Q2 2018, Hydropothecary reported sales of $1.2M, a 7% increase Q/Q and an average cash cost per gram sold of $0.97, a 9% decline Q/Q.
Hydropothecary’s facility is in Gatineau because Québec has an abundant supply of renewable electricity, which benefits the Company with competitive rates, relative to Ontario-based producers. Québec also has lower construction capital costs and labour costs than Ontario-based producers. These favourable conditions position Hydropothecary as one of the lowest cost per gram producers in Canada.
Balance Sheet:
As of January 31, 2018, Hydropothecary held $265M in cash and short-term investments with no debt. The Company also has potential proceeds of $158M from the exercise of all the issued and outstanding warrants.
As of May 23, Hydropothecary’s Market Cap is over $980M with an Enterprise Value of over $720M. The average target price of 6 analysts is $7.42, implying 45% in upside. The Company’s 2019E and 2020E EV/EBITDA are 10.7x and 4.6x, respectively, compared to the peer mean of 19.5x and 9.9x. Hydropothecary’s relatively lower multiples indicate that it could be undervalued.
Branding:
Hydropothecary has 22 branded products consisting of sublingual sprats, edible powders, dried flowers and premium dried flowers. The Company produced the first and exclusive line of cannabis peppermint oil sublingual mists and it was the finalist for “Top High THC Oil” and “Best New Cannabis Product.” Hydropothecary is also the first licensed producer to offer activated marijuana powder made for oral consumption and it won the “Best New Cannabis Product” award.
Village Farms International, Inc. (TSX:VFF, OTCMKTS:VFFIF)
Village Farms International Inc., strategically located in North America, is a leading large-scale and low-cost greenhouse grower of agricultural products. The recent formation of the 50/50 joint venture, “Pure Sunfarms,” with Emerald Health Therapeutics, Inc. (TSXV:EMH, OTCPK:EMHT.F) has transformed the company into a low-cost, licensed cannabis producer with a capacity of 4.8M sq. ft. (potential yield of 300,000 kg).
Licensing
Village Farms International initially contributed 1.1M sq. ft. within their BC greenhouse assets called Delta 3, which is expected to produce 75,000 kg of quality cannabis per year by 2020. The Company was granted its Cultivation License in March 2018. Village Farms anticipates receiving its Sales License by July 1, 2018.
Low-Cost Producer
The Company forecasts industry-low cash costs of less than $1.00/gram, driven primarily by lower energy needs from its anticipated greenhouse. Together, with a combined 30 years of greenhouse operating experience, the partnership with Pure Sunfarms is expected to reach revenues of $300M-450M by 2020.
Balance Sheet
As of the last reported financial quarter (Q4/2017), Village Farms International has cash and debt of US$7,091,000 and US$61,298,000, respectively. The Company’s equity raise was US$11,212,000 in 2018, where the Company closed a US$9,769,000 financing at $3.91/share.
Valuation
Village Farms International currently trades at $5.91, up 16.3% MTD. Like the whole cannabis sector, the Company’s stock price has corrected from a peak of $9.03 in January, falling to a low of $4.60 in April. Village Farms has a Market Cap of $236.6M and the stock is down 22.6 % YTD, which underperformed relative to the Horizon Marijuana Index, which was down 7.4%.
Village Farms International has 2 analysts covering the stock with an average target of $12.50, representing 117% in upside. VFF trades at $5.65 as of May 17, 2018. It has a projected EV/EBITDA of 7.7x for 2019, trading at a discount to peers, which have a mean forward EV/EBITDA value of 24.0x for 2019.
Organigram Holdings Inc. (TSXV:OGI, OTCMKTS:OGRMF)
Organigram Holdings, via its subsidiary Organigram Inc., is a Canadian licensed producer of medical cannabis. It focuses on growing high-quality cannabis and developing unique strains. In November 2017, it won awards at the Canadian Cannabis Awards for top sativa flower, top blended/value variety, and top licensed producer with compassionate pricing. The Company’s stock has returned 14% YTD and 76% since May 16, 2017.
Organigram operates a growing facility in New Brunswick. According to the Company, it is up to 50% less expensive to locate in N.B. than in Ontario. Production at the end of 2017 was estimated at 22,000 kg/yr from its current 134,000 sq. ft production facility. However, Organigram plans to expand this facility to more than 500,000 sq. ft with a targeted production capacity of 113,000 kg/yr by 2020. A diagram of the expansion plan can be found in the image below.
Organigram has several ancillary revenue sources. It receives $770,000/yr in rent from leased areas of its facility. It also benefits from vertical integration with a network of cannabis clinics with 13,000 patients.
Licensing:
Organigram is a licensed medical marijuana producer under the ACMPR with 134,000 sq. ft. of growing space. As of May 15, 2018, OGI is also a “Licensed Dealer.” This additional license, issued by Health Canada, allows the Company to conduct activities not normally permitted under the ACMPR. For example, Organigram is now approved for testing, importing and exporting an extensive range of cannabis products, including oils and derivatives. Licensing and regulatory controls can act as a major barrier to entry or hurdle to expansion. Larger companies often choose to acquire a company with an existing license, rather than begin the process from scratch.
Supply Agreements:
Organigram is one of only a few companies to secure MOUs with provincial governments for the recreational market. In September 2017, Organigram signed a deal with the provincial government of New Brunswick to supply its recreational cannabis market. The deal secures a minimum of five million grams per year, which the company estimates has a retail value between $40M and $60M/yr. In January 2018, it signed a similar deal with Prince Edward Island for one million grams per year, estimated at $8M to $12M retail value. Long-term contracts create stable revenues that are not only attractive to strategic acquirers as income, but also make the company easier for them to value.
Low-Cost Producer:
As of February 2018, Organigram has an all-in cost of $1.47/gram , far below its peer average of $2.29. It has also increased its yield per plant to an average of 71 grams in the quarter ended February 2018. 
Source: Organigram company website
Balance Sheet
As of February 28, 2018, the Company had $178M in cash and short-term investments. Total debt amounted to $96M, of which $93M was unsecured convertible debentures. Each convertible has a coupon rate of 6% and matures on January 31, 2020. They can be converted into common shares until the maturity date at a price of $5.42/share. Organigram can force conversion of the aggregate principal outstanding, at the conversion price and with 30 days’ notice if the daily volume-weighted average trading price of the common shares are greater than $7.05 for 10 consecutive days. 
Organigram trades at a discount to its peers at 11.4x 2019E EV/EBITDA vs. its peer average of 19.5x.
Branding
Organigram has the exclusive Canadian branding, product development and distribution rights to “The Green Solution,” a Colorado retailer of recreational marijuana. A strategic acquirer could benefit from procuring an established brand name with an existing customer base. Though branding guidelines and private retailing will be limited in Canada, future opportunities in the U.S. market may develop.
Disclosure: Neither the author nor his family own shares in any of the companies mentioned above.
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