Current state of the cannabis industry

As the first of the G20 countries to fully legalize cannabis for non-medical adult consumption, an unprecedented opportunity exists for Canada to be the global leader in the cannabis space, to shape the regulatory framework for cannabis around the world, and to spur innovation and economic productivity.

Ramping up

All levels of government and industry stakeholders in Canada are ramping up cultivation and processing capacity to address the anticipated demand for cannabis flower and oil.

A bulk of cannabis oil is exclusively for the CBD market, where product lines including CBD vape pens and starter kits are in high demand. Reviews of a lot of these products can be seen on blaze4days, including articles on cannabis health benefits and dry herb vaporizers.

The first months and years post legalization will bring a flurry of activity and turmoil, such as the race for market share.

Winners and losers will result.

Which provinces, cities and companies will win the race to commercial prominence and sustainable success?

Outlooks and opinions will be plentiful over the early years when the industry is changing rapidly.

It will be important to look at the quality of the analysis underlying these predictions.

Provinces and Territories have adopted different retail and distribution models, which ultimately may limit the ability for cannabis companies to be fully vertically integrated.

A by-product of federal legislation will be the critical focus on collecting and analyzing data (including social and economic impacts).

How much of an advantage do the incumbent public companies have?

Approximately half of all licensed entities who have received production and sales licenses from Health Canada are either public companies, or have parent companies that are public companies.

These licenses from Health Canada are under the Access to Cannabis for Medical Purposes Regulations (ACMPR) regime (predecessor to the Cannabis Act), which allow companies to cultivate, process, or sell cannabis for medical purposes.

A time for powerful valuation analysis

Businesses and investors will need to revisit valuation fundamentals to avoid overpaying for assets.

Entrepreneurs who are founding members of cannabis businesses will need to do the same to avoid leaving money on the table (selling interests for proceeds below fair market value).

So far, it’s bleak on the earnings front.Nearly all of the public companies have reported negative earnings (e.g., EBITDA) in the 12 months leading up to 30 September 2018 (see the last column in the preceding table).

This is not unexpected.

Revenue to date is only for the medical market, while operating expenses have been impacted by significant investments in operating structures (people, production facilities, marketing, distribution networks, research and technologies) to get these entities ready to do business in the legalized recreational market.

It’s been a hot market, with lots of deals in 2017 and 2018, many at very pricey deal metrics.

During the twelve months leading up to 30 September 2018, the cannabis industry has experienced a high volume of high profile M&A activity. Calculating typical valuation multiples of completed transactions (such as EV/Revenue, EV/EBITDA, Price/Book ) shows a wide range of multiples, some of which appear incredibly high.

In the press releases for these deals, some factors regularly discussed as having impacts on transaction pricing are listed below.

It’s important to analyze the relative importance of these factors, along with the inputs and assumptions used.

It’s also important to consider the motivations of the buyers and sellers,and the impacts of so-called ‘special purchasers’.

► Licenses

► Revenue generating availability of tangible assets for cultivation and processing (land,facilities, technologies, machinery and equipment)

► Skilled personnel

► Stage and nature of the distribution chains

► Market penetration

► International exposure, and

► Growth expectations for market share in Canada and globally.

Legalizing the recreational use of cannabis changes everything. The medical use of cannabis is not new, but the (legal) recreational use is transformational.

Because the competitive landscape and cannabis companies are rapidly transforming, prior history of the industry for 2018 and earlier is not predictive.

If the valuation looks absurdly high in light of the historical results, it may be (in part) because the historical results reflect only the medical use cannabis, but the future forecasts reflect anticipated future revenues from recreation use and the global medical market.

A key valuation principle is that value is based on future cash flows (historical ones may be useful as a guide).

The future for a cannabis business is likely going to be dramatically different from its past.

This cannabis ramp-up isn’t without some precedents worth examining.

When the Internet stocks that are stalwarts today were in their infancy, the valuation multiples being paid then may have appeared absurdly high on first blush.

Analyst outsiders back then struggled to find creative ways to look at those early Internet stock valuations — using site metrics, even though there was much noise in the data in those early years.

Valuations in an industry poised for explosive growth and disruption of other competitive alternatives may look absurd on the surface in comparison to other industries.

However, the expected future cash flow (the growth story) is the key to rational analysis.