Growing for the Future Initiating Coverage on Aphria Inc
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INITIATING COVERAGE October 2018 Growing for the Future Initiating Coverage on Aphria Inc. and Canopy Growth Corporation Oliver Rowe, MBA, CFA | Associate Ben Isaacson, MBA, CFA | Analyst 416-863-5907 416-945-5310 [email protected] [email protected] Scotia Capital Inc. – Canada Scotia Capital Inc. – Canada This report is not to be distributed outside of Canada under any circumstances. For Reg AC Certification and important disclosures see Appendix A of this report. Analysts employed by non-U.S. affiliates are not registered/qualified as research analysts with FINRA in the U.S. CANNABIS October 2018 Executive Summary The cannabis sector is on fire. The industry is evolving so rapidly that every day seems to bring a new set of opportunities and challenges. What is important to investors one week seems irrelevant the next. Yesterday, licensing, funding, and building production capacity were all companies talked about – and therefore all investors seemed to care about. Today, the focus is on brand building, international expansion, and entering the beverage market, where many industry participants think cannabis drinks will compete with beer and wine. Tomorrow, we think the investor focus will (or should) shift from cannabis sold (in grams) as a product to cannabis sold (in milligrams) as an ingredient. Think about the chocolate industry. Few care about which companies produce chocolate in Ivory Coast. Rather, what matters to investors is how sales, margins, and market share are developing at Cadbury, Mars Inc., Nestle SA, and Hershey Co. Exhibit 1.1: What Matters to Investors? Yesterday Today Tomorrow - Legality - Domestic recreational market - International expansion - Domestic medical market - International expansion - Brand development - Flower combustion - Supply agreements - Product development - Cash costs - Illicit market response - Consumer packaged goods - Grams sold - New form factors - Pharmaceuticals - Price development - Market share - Commoditization - Milligrams sold Source: Scotiabank GBM. At some point soon, we think investors will have to focus on fundamentals and common-sense valuations. If not, history will almost certainly repeat itself, with the speculative bubble popping. We have seen it before, beginning with the tulip craze in 1634 and moving through the U.K. railway mania in the 1840s, the U.S. stock market bubble in the 1920s, the commodities hype between 2002 and 2008 (particularly for uranium and rhodium), numerous property bubbles worldwide, and, most recently, the cryptocurrency craze. While prudent investors will have to be selective in picking not just the survivors but the industry champions, let’s be clear: the cannabis industry is real, it is here to stay, and we believe there is money to be made. There is a good reason why fundamentals don’t seem to matter to some. Simply put, nobody knows what cannabis fundamentals are: not us, and not the CEOs of any of the cannabis majors. Forget about prices, costs, and margins for the moment, and even forget about the size of the Canadian recreational market, for now. What is even a reasonable ballpark figure for the size of the cannabis beverage industry? What about the pharmaceutical potential? Our report discusses where we see the industry heading, which companies are likely to succeed, and, of course, our best investment ideas. Similar to any rapidly emerging sector, historical company financials will be almost useless for forecasting, and consensus likely won’t matter much over the medium term as estimates will vary widely and shift often. For us, what will matter is quality of management, funding – not just to build production capacity, but for R&D, too – and strategic relationships, both vertically and horizontally. We have initiated coverage on Aphria Inc. (Sector Outperform) and Canopy Growth Corporation (Canopy; Sector Perform), which, in our view, are trailblazers ahead of the curve. We intend to initiate coverage on several other cannabis majors over the coming months. The days of cannabis being a taboo subject are gone. While the pre-legalization Wild West trade is behind us and some companies are bound to fail, the industry is not going anywhere. Rather, the opportunity for strategic and financial investors (both individual and corporate) is set to grow… like a weed. This report is not to be distributed outside of Canada under any circumstances. 1 GROWING FOR THE FUTURE October 2018 Table of Contents Executive Summary 1 Investment Highlights 3 Growing for the Future 3 Birth of an Industry 5 Why Is/Was Cannabis Illegal Anyway? 6 Why Are Some Countries Decriminalizing or Legalizing Cannabis? 6 Sizing Up Canadian Supply and Demand 7 A Brief History 7 A $5.5 Billion Market… 7 We Forecast Demand Could Rise ~20% in 2019 9 Converting Illicit Demand to Legal Demand Should Be Swift 12 We Expect Domestic Medical Demand Growth to Slow to 5% 14 Cannabis Beverages Could Drive the Next Big Wave of Demand Growth 15 Initial Shortage Followed by Oversupply 16 Mid-term Domestic Oversupply Seems Inevitable 17 Pricing Outlook 19 Government Projections Imply $9.50/g Retail Pricing 19 We Think Retail Prices Will Fall to $8/g and Wholesale Prices to $3.50/g 19 We Think the Wholesale Market Could Be Worth $20 Billion to $25 Billion 21 The Retail Opportunity 23 Retail Offers Additional Margin Capture for the LPs 23 Limited Packaging and Advertising Opportunities Will Make Product Reviews Critical for Brand Success 24 Online Government Sales Will Set a Price Ceiling for Retailers 24 Volume Commitments Will Be Key to Success 25 Looking Beyond Canada 27 A Background on the U.S. Regulatory Environment 27 The United States Is Worth Watching but Inaccessible, for Now 28 Big International Potential but Little Near-Term Earnings 29 Investment Catalysts 32 Investment Risks 33 Company Reports Aphria Inc. – Ticking All the Boxes (Sector Outperform; One-Year Target $25.00) 34 Canopy Growth Corporation – Superb Story and Outlook, Full Valuation (Sector Perform; One-Year Target $61.00) 59 Publication date October 17, 2018. Pricing as of October 11, 2018, unless otherwise stated. All currencies in Canadian dollars unless otherwise stated. Cover photo credit: www.istockphoto.com/ca/OpenRangeStock. This report is not to be distributed outside of Canada under any circumstances. 2 CANNABIS October 2018 Investment Highlights Growing for the Future Birth of an Industry We have initiated coverage on the cannabis industry with a positive outlook. October 17, 2018, marks the first day of legal recreational cannabis sales in Canada. As the first G20 country to fully legalize cannabis use (and the second country worldwide, behind Uruguay), Canada has positioned itself to be far more than just a tolerant and progressive society as it relates to cannabis. While there will always be pockets of Western culture that consider cannabis taboo (similar to alcohol), gone are the days of “reefer madness” and cannabis being tied to only hippies, “stoners,” and “burnouts.” Within a decade, we expect cannabis consumption to compete seriously with beer and wine consumption in Canada. We believe Canada’s first-mover advantage allows it to establish a thriving and highly profitable industry, with little organized international competition. This is why there are now more than 120 licensed producers (LPs) in Canada, each preparing to grab a piece of the current $6+ billion domestic cannabis market, which is set to soar when recreational use is legalized. As with any illicit activity, statistics on recreational cannabis demand are hard to come by. However, most agree estimates the size of the 2017 market in Canada was 775,000 kilograms (775 tonnes). We forecast a surge in demand in 2019 and 2020 to ~1,000 tonnes and ~1,130 tonnes, respectively, driven by new consumers coming to the market and higher daily intake once new product formats are introduced. We estimate 80% of illicit recreational demand will convert to legal demand by 2021. Beyond Canada, several countries are at different stages of partially or fully legalizing (or decriminalizing) various forms of cannabis use. Some, including Canopy, expect the global market to eventually reach $200 billion or more, with half of that coming from the United States. That said, while the opportunities for Canadian companies are set to grow, we do not expect a paradigm shift in international legalization of recreational use without a change to the classification of cannabis as a Schedule I and Schedule IV narcotic by the United Nations. Oversupply Seems Inevitable… We estimate $1 invested in production capacity generates $1 in annual EBITDA, assuming full utilization rates and commoditized margins. This exceptional return on capital and payback is why market observers estimate between 5x and 10x annual demand will be built as production capacity within the next 12 to 24 months. This capacity growth suggests to us industry consolidation is inevitable, as are failures by companies that don’t have sufficient funding or are simply too late out of the gate. With oversupply likely comes some price compression. As such, we expect the long-term recreational retail price for dried flowers to decline to $8/g, from initial pricing closer to $10/g. For the producer, we expect netbacks to fall toward $3.50/g (excluding the excise tax), from about $5/g today. As many of the large-scale producers expect their cash costs to also fall (improve) to well below $1/g, margin contraction shouldn’t reflect the magnitude of decline that headline prices will likely experience. … but the Future Is Bright As the wholesale cannabis business matures quickly, we expect well-funded producers to diversify into many different business lines. Opportunities range from establishing international operations and export markets and opening up retail stores to developing cannabis products to be used as an ingredient in food and beverages, topical sprays and creams, pharmaceutical products, and medical applications. In our minds and if regulations permit, the U.S.