With the inauguration of the Joe Biden Administration and a so-called “blue wave” taking over three levels of the U.S. government — Congress, the Senate and the Presidency — there is a general optimism that cannabis may see its status as a Schedule 1 narcotic repealed. Should this happen, it may create an opportunity for North American exchange-listed cannabis companies to potentially expand their revenue.
The promising regulatory prospects for cannabis growth in the U.S. has resulted in a significant rally in the cannabis sector issuers since the November 7, 2020 presidential election. While this excitement may be reminiscent of the fever we saw in Canadian cannabis sector issuers in late 2017 after federal legalization was announced, it may be driven by some real growth potential opportunities for the sector.
The MORE Act – A U.S. Policy that Benefits Canadian Producers?
On November 29, 2020, Democratic House Majority Leader Steny Hoyer announced that the U.S. House of Representatives will vote on the Marijuana Opportunity Reinvestment and Expungement (“MORE”) Act.
The MORE Act is far more progressive than the previously contemplated Strengthening the Tenth Amendment Through Entrusting States (“STATES”) Act. MORE proposes to legalize cannabis nationwide, removing it from the U.S. Controlled Substances Act. The Bill was passed by Congress on December 4, 2020. It awaits Senate and Presidential approval in 2021.
Of the utmost importance to the cannabis sector investors, the MORE Act would allow Canadian firms to buy and build assets in the U.S. It would also feature record expungement and the implementation of a federal sales tax.
In our last update, we highlighted how the biggest challenge for Canadian licensed producers (“LPs”) was that they were “trapped in Canada.” These companies have the ability to tap into larger investor bases since they typically have listings on larger stock exchanges or even dual listings in the U.S. and Canada. However, the majority of their revenue currently comes from the Canadian market. The Canadian market generally exceeded growth expectations in 2020; COVID 19 and the work-from-home environment helped drive significant growth in the use of cannabis-related products. Still the size of Canadian market, is paltry compared to the revenues being generated in the United States.
Adult-use Cannabis Sales by month in Canada
Source: MjBiz and Statistics Canada as at October 30, 2020.
*Adult use cannabis sales began October 17, 2018
At this rate, Canadian recreational cannabis sales are projected to surpass C$2 billion in 2020, which is an impressive feat considering that key markets, such as Ontario, continue to have distribution challenges. Canada is not where global growth is going to come from for the larger LPs; sales are expected to be primarily driven by the U.S. Over the longer term, BDSA, a leading marijuana analytics provider, predicts global cannabis sales will reach US$47.2 billion by 2025, a compounded annual growth rate (“CAGR”) of 22%, with the bulk of this growth coming from the U.S. market, which they expect to reach US$34.5 billion by 2025, a CAGR of 18%.
Canadian LPs have access to equity markets and investment from large financial institutions, including some of the large Canadian banks, but what they cannot do is take their capital reserves and go directly into the U.S. to invest.
Instead, multi-state operators (“MSOs”) have generated strong earnings growth by building a patchwork network of seed-to-sale operations in leading states where adult-use marijuana is legal at the state level, including key populous states such as California, Colorado, Nevada, and most recently, Arizona and New Jersey in 2021. Altogether, this has created aggregated diversified sales from the U.S. market that is probably somewhere between US$15 billion and $18 billion, according to estimates by MJ Biz Daily, even without federal legalization in place.
The valuations of the MSOs vs. the Canadian LPs are quite stark, with CIBC World Markets highlighting in their 2021 Equity Outlook that the MSOs are generating positive EBIDITA vs. negative EBIDITA for Canadian producers. In fact, CIBC estimates the MSOs will generate nearly $9 billion in sales alone in 2021 versus an estimated $3.6 billion in sales for Canadian LPs, and will trade at a much lower 4.4x enterprise value (“EV”) to sales versus 7.7x for the LPs.
Why the high relative valuations for the LPs? In a nutshell, it is investor access; these are the issuers that retail investors can easily purchase. Now an additional path to profitability exists; if these LPs can get access to the U.S. market during the rollout of legalization, they could start to generate sales potential in line with their valuations. This underscores why the Horizons Marijuana Life Sciences Index ETF (“HMMJ”), which currently doesn’t have any exposure to U.S. MSOs, was up 42.05% during the month of January 2020.
Scaling Up: Preparing for U.S. Entry
In mid-December, the merger of Aphria and Tilray was announced. 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. In fact, 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.
The two charts below provide some context on what Aphria and Tilray are trying to achieve. If you look at the average sales growth of the holdings of HMUS, which is primarily comprised of U.S. MSOs, you can see the average is much higher, with an average sales growth achieved by the top underlying holdings of about 124% as at the end of December 31, 2020, versus about 93% sales growth for holdings of HMMJ. Look at companies like Aphria, which had about 60% sales growth, and Tilray, which had about 48% growth. While on their own these are strong sales growth numbers, the price to sales of the stocks are lower than U.S. counterparts; if there’s a way to access the U.S. market or at least highlight the potential of growing U.S. sales, it provides a lot more momentum for the Canadian issues.
Source: Bloomberg, as at December 31, 2020.
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 could 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 and 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 implementation of U.S. federal legalization, based on existing agreements.
Either way, we could see a lot of convergence between the two regional sectors in 2021 in what might end up being a huge milestone for the global cannabis industry.
Source: Bloomberg as at December 31, 2020. *Performance since ETF inception of HMMJ on April 04, 2017, and HMUS as at April 17, 2019 for the period ending December 31, 2020.
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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.
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