The first quarter of 2021 may have taken a few cannabis investors by surprise as the stocks that generated the highest returns on average were the Canadian-domiciled licensed producers (“LPs”) rather than the U.S.-based multi-state operators (“MSOs”), despite much of the fervour driving the stocks coming from the prospect of increased U.S. legalization.
Part of the reason for this is that the equity market, even as it relates to cannabis stocks, is still a predictive pricing mechanism, and through most of 2020, U.S. MSOs rallied on the prospect of U.S. legalization while Canadian LPs more or less languished. The U.S. presidential win by Joe Biden and his administration’s clear signal that they would support some sort of federal legalization legislation —something that is also supported by the Senate and Congressional majority Democrats — may pave the way for the well-capitalized Canadian LPs to enter the U.S. market.
Without federal legalization, most of the LPs have little to no access to U.S. market expansion, which in 2020, surpassed $17.5 billion in annual sales, according to BDSA Research. With legalization, the LPs could rapidly see revenue growth by engaging in aggressive U.S. expansion, through mergers and/or acquisitions, financed by their ability to tap into capital markets.
The ability for LPs to get U.S. exchange listings has been a key driver behind their rise in valuations, in our opinion, since a lot of the investor growth in the sector has come from U.S. retail investors who typically get their exposure through U.S.-listed stocks or ETFs. We can see, for example, that the U.S.-listed ETFs, which predominantly hold LPs in their underlying portfolios, accounted for nearly US$1.8 billion inflows during the first quarter of 2021 (Source: ETF.com as at March 31, 2021). This is a lot of money for a sector that has an average market capitalization that skews relatively low versus the broader equity sector.
This has created a large divide between the valuations on Canadian marijuana stocks vs. U.S. marijuana stocks. Canadian sales were strong in 2020, exceeding most industry estimates and topping $2.6 billion in sales for the 2020 calendar year, according to Statistics Canada. However, this pales in comparison to the aforementioned $17.5 billion in sales generated through state revenues in the U.S., where a state like California, for example, accounted for more than $4 billion in recreational sales alone, according to Marijuana Business Daily (“MJBiz Daily”).
Source: MJ Biz Daily as at December 31, 2020.
According to CIBC Capital Markets, the Canadian LPs are trading at an average enterprise value to sales (“EV/Sales”) of 14.3 times sales versus the MSOs at 6.3 times sales. This valuation difference is staggering, given the top 10 MSOs are expected to generate more than $10 billion in revenue in 2021 versus $4 billion in revenue for the top 10 LPs.
This divergence hasn’t gone unnoticed, with the potential for downward revisions on the LPs potentially likely to occur, particularly since it appears the pace of Canadian cannabis sales may not grow at the same torrid pace as 2020 when cannabis sales were buoyed by lockdowns and pent-up demand during the COVID-19 pandemic. Even if sales growth stays relatively flat, the LPs continue to be priced for expansion in a market that appears to be potentially tapped out for now, apart from the potential for U.S. expansion.
For now, it would appear unlikely that, barring a clear path to U.S. legalization, these stocks probably have limited upside in the near term, particularly relative to the U.S. MSOs. A lot of good news is priced in that has yet to manifest itself.
New York, New York
While LP investors bank on legalization to open up the U.S. market, the growth of the state-led markets continues at a strong pace. Fifteen U.S. states have now fully legalized recreational or adult-use marijuana, the 4th most populous state in the U.S., New York, as at April 1, 2021. Marijuana Business Daily projects that sales in New York alone could reach $2.3 billion a year by the program’s fourth year and nearly $2.5 billion by year five. There is a sense that legalization in New York could spur more advocates from Wall Street to get regulatory reforms allowing for more financial support of marijuana cultivators and distributors in the U.S.
It’s not just New York that will add revenue to the growing state-led revenues. Arizona and New Jersey are now fully legal markets, and other major state markets such as Pennsylvania and Maryland could potentially legalize in 2021.
The key here is that, even without federal legalization, the U.S. marijuana market will continue to see strong growth, which should favour the MSOs.
Source: MJBiz Daily as at November 19, 2020.
Valuations
One key driver of growth for the Canadian LPs remains consolidation and ongoing investment. On March 11, 2021, Organigram Holdings received a C$221 million (US$176.6 million) investment from a unit of British American Tobacco PLC to purchase 19.9% of the company. The two companies will enter into a strategic partnership initially focused on CBD product development. Keep in mind CBD is a legal product in the U.S., which again underscores that international interest in the LPs remains fully fixed on growing their footprint outside of Canada.
Looking beyond Canada was also the key driver behind the merger of Aphria and Tilray, which is slated for completion at the end of April 2021. The proposed merger would create the largest marijuana cultivator and distributor in the world, with revenue that could exceed US$1.2 billion, according to CIBC World Markets.
The main goal of this merger is global expansion, with a heavy emphasis on European and eventually U.S. expansion. Aphria will de-list from the Canadian stock market and only maintain a U.S. listing for the newly merged entity upon completion of the merger. Aphria is currently the largest holding in the Horizons Marijuana Life Sciences Index ETF (HMMJ).
HMMJ’s portfolio constituents have an average sales growth of 50.74%. Below are the price-to-book, sales, and price-to-sales metrics for the ETF and its top 10 holdings.
Here are the same metrics for the Horizons US Marijuana Index ETF (HMUS). You can see that while the overall sales totals are a little smaller than the biggest LPs, the MSOs are generating a higher rate of sales growth at lower valuations relative to many of the LPs.
HMUS is the only ETF listed in Canada that is exclusively focused on exposure to the US market sector that can provide diversified exposure across all of these names. Similar to the broader story, there will be winners and losers in the U.S. sector, but as the sector grows in aggregate, HMUS could potentially gain meaningful growth from that overall market development.
While the growth in the U.S. market would likely be reflected more acutely in HMUS, HMMJ could also benefit from further legalization in the U.S. for a couple of reasons:
- HMMJ can add U.S. MSOs that partake in cannabis cultivation and production (which are currently included in its underlying index but not within HMMJ’s holdings) if/when federal legalization is allowed
- Large holdings in HMMJ, such as Canopy Growth, have potential exposure to the U.S. marketplace. For example, Canopy would be able to fully acquire Acreage Holdings, a large MSO, upon any announcement of U.S. federal legalization, based on existing agreements.
In either case, as we’ve seen over the last quarter, diversified exposure to the sector has been key, with HMMJ significantly outperforming HMUS on a quarterly basis, underscoring the need to potentially improve diversification by having some exposure to both ETFs.
The views/opinions expressed herein may not necessarily be the views of Horizons ETFs Management (Canada) Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.
HMUS is expected to invest in the Marijuana industry in certain U.S. states that have legalized marijuana for therapeutic or adult-use, which is currently illegal under U.S. federal law. HMUS will passively invest in companies involved in the marijuana industry in the U.S. where local state law regulates and permits such activities, as well as in companies involved in the Canadian legal Marijuana industry. Neither HMMJ nor HMUS will be directly engaged in the manufacture, importation, possession, use, sale or distribution of marijuana in either Canada or the U.S. Please read the full risk disclosure in the respective prospectus before investing.
HMMJ will not knowingly invest in any constituent issuers that have exposure to the medical or recreational marijuana market in the United States, unless or until it becomes legal. HMMJ will not be directly engaged in the manufacture, possession, use, sale or distribution of marijuana in either Canada or the U.S. Please read the full risk disclosure in the prospectus before investing.