The recent pullback could represent an opportunity to take a position in stocks such as Aphria Inc. (TSE:APH), Canopy Growth Corp. (TSE:WEED), and Aurora Cannabis Inc. (CVE:ACB)
David Bar | April 25, 2017 | SmallCapPower: It has happened! The long-awaited tabling of legislation to legalize the recreational consumption of marijuana has arrived. However, it appears that the markets and investors haven’t been as fond of the news as one would have thought. So why is that? Yes, the legislation leaves a lot in the air, like how each province will regulate and distribute, or more importantly how the product is going to be taxed. More so, it doesn’t look good when company executives cash in large sums of their holdings, as has happened with Aurora Cannabis Inc. (TSXV: ACB) and Canopy Growth Corp. (TSX: WEED).
That being said I think that this recent pull back is unjustified and represents a buying opportunity for those who have been looking for an in. I will justify this stance by presenting supporting justification from a recent DCF I conducted with a colleague of mine, Nicholas Somos, at the beginning of April for Aphria Inc. (TSX: APH).
When the exercise was conducted, we tried to be conservative to provide confidence in the valuation that was reached. A list of those assumptions are:
- Aphria will only be able to reach 90% of its expected capacity
- Marijuana recreational sales will not start until 2019
- Retail and wholesale prices are $7/gram and $3/gram, respectively
- Only included sales of dried cannabis (oil is a higher-margin product)
- Applied the full corporate tax rate of 38% to all earnings to account for unknown tax regiment. For a sanity check, net corporate tax rate in Canada is an average of 15% according to the CRA, and large beer breweries in Ontario are taxed approximately 20%, which is one of the most taxed provinces in Canada
- Used a discount rate of 12.04% using a build-up approach, compared to a discount rate of 8.37% which is what is reached upon using CAPM (rfree=2.34%, mpremium=5.69% and a ß of 1.06 taken from Eikon)
- Only valued its Canadian operations; Aphria recently announced a $25mm investment in Florida
First and foremost, Health Canada’s projections for the number of patients registered for its medicinal marijuana system has been severely underestimated. In 2013, Health Canada only projected approximately 68,000 registered users, but recent reports put that number at over 130,000 as of December 31st, 2016. It is believed that these projections, as well as those made by others, have been severely underestimated.
Due to this, we forecasted a continued 30% growth for Q1 and Q2 of 2017 (government fiscal year), then falling off steadily until the end of 2018, where it steadies at a 0.5% increase quarter over quarter. This provides us with a medicinal user base of 522,000 at 0.8 grams per day (less than Health Canada’s numbers) consuming approximately 150,000 kilograms.
For our projection of the recreational market, we used two surveys conducted by Deloitte as well as Forum Research, who put the participation rate of the population between 31% and 39% (including those who currently use and those that would use once legal). We adjusted this range for those who will grow at their home, those in the medical system, and those that will remain buying from the black market… It can be hard to teach an old dog new tricks! This provides an adjusted base rate between 26.50% and 35.40%, so a 28% participation rate was used. That being said, once legalization occurs, the rate starts at 12% and works its way up to a mature 28% by 2022, as people become accustom to the new regime, which was felt to be conservative.
Using an average weighted gram per user per quarter of 34.11 grams (calculation in Figure 1 below), with numbers taken from a study presented to the Colorado revenue department, a long-term population growth rate of 0.7%, and a 28% participation rate produced a market demand of 1.46mm kilograms of dried marijuana, 1.61mm including medicinal by the end of 2023. This demand is well above the current production capacity of licensed producers, as well as their planned production capacity.
Figure 1: Cannabis User Profile Analysis
Using the parameters above, along with a phased approach for bringing new capacity online (including a four-month inspection, and four months for first crop rotation) from its planned expansion projects helped to keep in check revenue numbers as they were forecasted over quarters. Finally, income statement numbers were pegged to revenue and balance sheet to assets (like presented in my last article, here) to show how its cost and capital structure would develop over time.
Altogether, at that time, an enterprise value range was calculated, from which, only $7.55mm was deducted, and $134.3mm in cash (balance sheet and financing activity) and redundant assets were added back. This provided an equity value of $1,044.95mm, equal to a share price with an implied upside of approximately 20% from its trading price on close of Wednesday, April 19th. A summary of how the conclusion was arrived can be seen below accompanied by a sensitivity analysis.
Figure 2: Aphria Inc. share price range estimation
Still many risks to consider
Remember that this number is before the potential of the new venture in the state of Florida. That being said, you will want to conduct your own research on whether or not that should be included because from what I’ve read, it hasn’t been a smooth start to legislation creation, and it could be a while before a clear path forward materializes.
Additionally, one of the biggest issues facing the medical marijuana market right now is the safety of the products that they produce. With the recent recalls that producers have had to complete the public perception of the industry has certainly taken a hit. It also questions Health Canada’s ability to police the industry efficiently as if they can’t oversee the 42 licensed producers for the medical regime, how will they fare with a recreational market?
Overall, with more than a year to go before the legislation is made into law, it is going to be a road with many highs and lows for producers, and their investors. Stock prices are most likely to jump up or down as final decisions regarding packaging, distribution, etc. are released over the next year and a half. But as I stated in my last article, Aphria Inc. is, in my eyes, one of the safest bets in the space as they are profitable, cash-flow positive, and their expansions are phased so construction and Capex can be adjusted to meet changes in legislative timelines, reducing the potential for a large loss.
Figure 3: Forecasted Income Statement
Figure 4: Free Cash Flow Calculation
Figure 5: Discounted Cash Flow Calculation and Sensitivity Analysis
Disclaimer: The author has not been paid by Aphria for this content, nor does he own any shares of Aphria. He does, however, have holdings in other marijuana companies (Aurora Cannabis, Cannabix Technologies, Supreme Pharmaceuticals, Maple Leaf Green World).
Neither any of the principals at Small Cap Power, nor their family members, own shares in any of the companies mentioned above.
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