Canadian Cannabis Scorecard (Spring 2019)

What is the Cannabis Scorecard?

The Cannabis Scorecard is a comprehensive tool for investors to judge which Canadian companies are best and worst positioned for the newly legalized recreational market.

A scorecard for the quickly expanding list of U.S. operators is also available.

The scorecard is full of important charts and metrics, providing you with a quick way to judge which companies may be worth an investment and which are better left alone or shorted.

(Update April 12, 2019)

Thanks for sending in your questions on our Canadian Cannabis Scorecard. We’ve selected some questions and added in this video Q&A. Enjoy!

Revenue

Revenue per gram may seem straightforward, but look a little closer and it can give us some useful information about the pricing strategy of each company.

Does management want to be the premium product in the market, the value brand or something in between?

When supply and demand are balanced a company’s market share often determines what pricing they can get away with. The higher the market share, the higher the price.

We would not put too much stock in current pricing as the market is so new; these company’s don’t yet know what consumers are willing to pay.

Companies basically made up prices and submitted them to the government distributor, but are just starting to adjust product pricing based on consumer behaviour.

At this early stage, Aurora, Canopy Growth, and Tilray look to be playing for the premium segment while Cronos, HEXO, and CannTrust are trying to offer more value to drive higher sales.

Selling Price per Gram Equivalent

Source: Grizzle Estimates, SEDAR

Growing Costs

The next piece of the puzzle is growing costs.

Producers are all ramping up capacity to bring down their growing costs to ensure they generate attractive profits even when the government is paying less than producers were used to with their medical clients.

In general, the lower your growing costs the more cash you generate at the end of the day.

These companies are still scaling and have promised sub $1/gram growing costs so expect production costs to continue falling in coming quarters.

Aphria, in particular, should see much lower production costs once its first 1 million square foot greenhouse comes online this summer.

Canopy will also see much lower costs once a few large facilities reach full production, but the company has a long way to go to be competitive with peers.

Growing Costs per Gram Equivalent

Source: Grizzle Estimates, SEDAR

Gross Margin

A wrinkle in our statement that lower costs equal higher profits is the fact that more profitable products like cannabis oils and pills are also more expensive to produce.

Just because a company is high up on the cost scale doesn’t necessarily mean they are less profitable than peers.

That is why gross margin is the only number we care about.

Gross margin is a true comparison of which grower runs the most profitable greenhouses. It takes into account the price, product mix, and cost of what a grower sells.

Canopy Growth makes $2.30 more per gram than Organigram, but because Canopy has much higher growing costs, Organigram actually generates 130% more margin per gram than Canopy.

This is the power of low production costs. Aphria, Aurora, and Organigram have the flexibility to undercut competitors to win over more customers while still generating a similar level of profitability.

Gross Margin Per Gram

Source: Grizzle Estimates, SEDAR

Cash and When Will These Companies Break-Even?

Investors often forget the importance of cash when they are investing in a high growth industry.

Even though licensed producers are seeing rapid revenue growth, they are not yet profitable and still need to spend millions to expand capacity to meet demand. Cash is king.

The chart below looks at each company’s cash balance in the latest quarter and their cash burn from operations plus their spending on construction of new greenhouses.

We exclude cash spent on investments because these can be cut back if the company faces a cash crunch.

Years of Cash Left at This Quarter’s Spending Rate

Source: Grizzle Estimates, SEDAR

At the end of the day, we want to know which company can turn a profit before their cash runs out.

Even the most profitable business model is worthless if the company runs out of cash before they can get up and running.

The most attractive cannabis stock is the one with more than enough cash to carry the company to profitability.

Unfortunately, there are not many cannabis stocks that fit the bill.

For example, Organigram was profitable last quarter selling 8,300 kg annually and no longer has to worry about running out of cash.

Contrast Organigram with Tilray, which is effectively a biotech company. At Tilray’s current production growth rate it will be 28 years until the company can cover its operating costs, far longer than the 2 years of cash the company has left.

Companies without enough cash to carry them to profitability will at the very least have to issue more shares, which would pressure the stock price and at worst could run into liquidity issues during a market downturn that would crater the stock.

This next chart below makes it clear that investors in Cronos, Tilray, and potentially Canopy Growth are buying what are effectively biotech companies that are years away from profitability, instead of soon to be profitable cannabis growers.

To see more details on how we calculated the years to breakeven go to the bottom of the report.

Years Until Break-Even vs Years of Cash Left

Source: Grizzle Estimates, SEDAR

Sensitivity Analysis

To help investors put numbers behind the upside and downside for each licensed producer we have provided target stock prices under two different scenarios.

These are two simple starting points and are not inclusive of all possible future scenarios.

If your favourite stock screens as overvalued it means the market is expecting extra sources of revenue beyond the company’s current growing capacity, or they expect much higher selling prices and profitability from the legal market.

All these expectations could come true, but beware that by owning stocks like Canopy Growth, Cronos, or Tilray you are making a bet that the future will be even brighter than the market currently expects.

Scenario 1

Licensed producers reach fully funded capacity and sell their products for $5.50 per gram, which is the expected average wholesale price paid by government distributors. They generate a 30% EBITDA margin on sales. The market is willing to pay a 10x EBITDA multiple, in line with major beer companies like Miller Coors and Budweiser.

Prices as of 4/4/2019. * TLRY price converted from USD to CAD.

Scenario 2

Licensed producers reach fully funded capacity and sell their products for $8.00 per gram due to the release of higher margin infused drinks, edibles, beauty products, and higher priced exports to other countries. They generate a 30% EBITDA margin on sales. The market is willing to pay a 15x EBITDA multiple, in line with major wine and spirits companies like Diageo and Constellation Brands.

Prices as of 4/4/2019. * TLRY price converted from USD to CAD.

Years to Break-even Calculation

First, we looked at each company’s total overhead costs (salaries, R&D, marketing) and divided by their gross margin (profit after direct operating costs) to arrive at volume needed to break even.

Next, we looked at production growth last quarter, the first quarter of legal sales, and annualized it by multiplying by four.

Lastly, we took the difference between current sales and breakeven sales and divided by the volume growth rate in grams to figure out how many years until each company turns a profit.

Example:

Tilray has a gross margin of $1.98/gram and total operating costs of $114 million, implying it needs to sell 57,463 kg a year to turn a profit.

Tilray sold 8,212 kg on an annual basis last quarter and grew sales by 1,760 kg annualized.

57,463 – 8,212 = 49,251 / 1,760 = 28 years to break even

About Author

Scott Willis

Scott has over 15 years of institutional investment management experience analyzing both debt and equity securities. He has held senior investment research roles at Credit Suisse, and TD Asset Management. His core areas of investment coverage at Grizzle include marijuana, energy and technology. Scott is a CFA charterholder and has been featured on Bloomberg, CBC, CNBC and Macleans.

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The opinions provided in this article are those of the author and do not constitute investment advice. Readers should assume that the author and/or employees of Grizzle hold positions in the company or companies mentioned in the article. For more information, please see our Content Disclaimer.