Big tobacco has finally taken the plunge and is now actively looking to enter the medical and recreational marijuana markets.

Yesterday, Imperial Brands (LON: IMB), A UK-based tobacco giant, bought a stake in Oxford Cannabinoid Technologies. Oxford is licensed by the UK Home Office to conduct research and development of cannabis-based therapies.

Of the major tobacco companies, Imperial is the first to take an equity stake in a marijuana company. Competitors Phillip Morris (NYSE: PM), Altria (NYSE: MO), and British American Tobacco (NYSE: BTI) will likely follow suit.

 

Smaller Players Entered First, But the Majors Will Definitely Follow

Imperial Brands is not the first tobacco company to buy into marijuana. That honour falls to Alliance One (NYSE: AOI), a midsize tobacco company in North Carolina who bought a stake in Goldleaf Pharm Inc. in January.

The larger players have been somewhat late to the game as they’re likely waiting until legalization is a done deal and marijuana use becomes more respectable in the eyes of the general population.

With the legalization date set in Canada and restrictions against marijuana loosening quickly in the US and Europe, tobacco management teams may be sharpening their pencils to decide which is the right company to buy.

 

Big Tobacco Has More Than Enough Firepower to Enter the Marijuana Market in Size

To put the size of big tobacco in perspective, the top four players sport a market capitalization of $341 billion compared to the entire marijuana industry in Canada at $28 billion.

The top four tobacco companies have enough cash ($15 billion) to buy 50% of the marijuana market in Canada if they chose.

Big Tobacco vs Marijuana Market Capitalization

Source: SEDAR, SEC.gov

Big Tobacco Values Medical Research

Taking a contrarian view, we think the tobacco companies only value medical research not intellectual property related to growing.

Taking a contrarian view, we think the tobacco companies only value medical research not intellectual property related to growing.

They know marijuana is a commodity and the only real sustainable advantage will come from pharmaceutical patents, not from unique growing techniques.

Imperial Brands demonstrated this point by investing in a marijuana research firm first, not a grower.

Tobacco players have significant research and development departments already creating similar products to the licensed producers such as vape pens and other smokeless methods to ingest tobacco.

Moving into medical products with an actual health benefit makes a lot of sense for tobacco companies from a brand perspective after years of being vilified by the media and consumers.

 

Licensed Producers May Present an Opportunity to Buy Cheap Growing Capacity

We think tobacco companies will use legal marijuana producers as a way to purchase fully constructed and operating growing capacity so they don’t need to build it themselves. They already have sophisticated distribution assets so the raw material is all that will matter.

In this scenario the most important metric is the stock price per gram of long-term capacity.

Organigram (OGRMF) looks to be the top pick if big tobacco wants to buy capacity on the cheap.

For a reasonable premium, Aphria (TSE: APH) also looks very attractive with more than twice the future capacity of Organigram.

Cronos Group (NASDAQ: CRON), Aurora Cannabis (TSE: ACB), and Canopy Growth (TSE: WEED) are too expensive to be purchased only for their growing capacity. Keep in mind that a new 1,000,000 sq. ft. greenhouse is being built for less than $2 per gram of capacity in Canada.

Stock Price per Gram of Long-term Capacity

Dollar Paid per Gram of Production

Source: Grizzle Estimates

Grizzle - horizontal rule

Long-term Capacity

Production Capacity

Source: Grizzle Estimates

We don’t doubt that big tobacco will make a splash in the Canadian and US marijuana markets at some point, but the question is when.

Another big unknown is whether they buy or build their own capacity.

If tobacco management teams are really sophisticated they will wait until late 2019 to see if they can buy into the industry for a bargain as the coming oversupply drags down retail and stock prices.

Regardless of your beliefs, don’t expect big tobacco to sit on the sidelines forever.