Cannabis in America: Investment Opportunities in the World’s Largest Cannabis Market Matthew Pallotta, Analyst [email protected] 647-253-1194 Andrew Semple, Associate [email protected] 416-687-6656 August 12, 2019 SPECIAL SITUATIONS AUGUST 12 2019 CANNABIS IN AMERICA INVESTMENT OPPORUNITIES IN THE WORLD’S LARGEST CANNABIS MARKET Executive Summary Our thematic provides an analysis of the investment opportunity presented by the US cannabis industry and builds a case for its attractiveness both in absolute terms and relative to other cannabis investment opportunities in Canadian and international markets. We examine the legal cannabis industry in the US and assess the landscape from the perspective of the competitive environment, financial and valuation metrics, regulatory and legislative backdrop, merger and acquisition activity, and lay out our key investment criteria for assessing operators in the sector. Our analysis also has a specific focus on the group of businesses referred to as Multi-State Operators (“MSOs”), which we feel present the most attractive means for investors to gain exposure to the US cannabis opportunity, due to a number of advantages over their smaller, single-state or regional peers, in terms of the scale of the business, access to capital, and exposure to key markets across the country, amongst others. The $60B Opportunity: US Presents the Largest Addressable Cannabis Market in the World We estimate the long-term potential of the legal US cannabis market to be ~$60B annually, using our estimates for average spending per user and usage rates, and under the assumption that recreational cannabis is eventually made legal across all 50 states. We believe the current regular user base for both legal and illicit cannabis in America is approximately 24M, with the potential to rise to nearly 30M as population and user rates increase in the coming years. Our research suggests that on a per user basis, annual spending on cannabis exceeds that of both tobacco and alcohol. The current legal medical-only markets across the US are home to some 128M residents, while the 11 states with legal adult-use cannabis laws are home to over 92M people, in all comprising roughly two-thirds of all residents in the country. Independent market forecasts place the legal US cannabis market at $30.1B in annual spending by 2024, compared to $5.2B in Canada, and $5.4B internationally. In our view, the scale of the addressable market alone makes the US, by far, the most attractive market for cannabis investment in the world. We believe the cannabis opportunity will emerge as a major consumer goods category over the coming years, and will have an impact on spending, product development, and strategy in related consumer categories such as alcohol, tobacco, wellness and nutraceuticals, pharmaceuticals, beverages, and packaged foods. We note that one of the most unique and attractive aspects of the burgeoning cannabis category, relative to other high-growth consumer segments, is that significant demand for the products already exists. While education will no doubt play an important role in shaping consumer demand for the products, the majority of growth in the sector in the next several years will come as a result of migrating existing illicit users to the legal channels. Regulatory and Legal Environment Continues to Steadily Shift in Favour of Legalization The US has a long and storied history of cannabis prohibition throughout the 20th century at the federal level. Today, laws allowing for legal cannabis in 33 states (22 medical and 11 adult-use) stand in direct contrast to the federal prohibition, and its classification as a Schedule I substance by the US Drug Enforcement Agency (“DEA”). Matthew Pallotta, CPA, CA, MBA | 647.253.1194 | [email protected] Andrew Semple | 416.687.6656 | [email protected] Page 1 of 100 US Cannabis Industry | August 12 2019 As the states continue to push forward with both medical and adult-use legislation, the cannabis industry has found new allies in the federal government in recent years, with members of Congress, and even Presidential candidates having voiced their support for reforming cannabis laws. Proposed legislation such as the SAFE Act (banking reform) and the STATES Act (assertion of state’s rights over legalization) have observers more encouraged than at any time in recent memory of pending changes to the federal government’s stance on the plant. Large Cap MSOs are Attractive on an Absolute and Relative Valuation Basis Compared to Canadian Peers As a group, large cap MSOs are discounted on a relative basis compared to their large cap Canadian peers on all metrics, including forward consensus sales, run rate sales, and forward consensus EBITDA. We acknowledge that several fundamental factors are the cause of this discount, including, amongst others, i) higher cost of capital and lesser liquidity in shares due to being barred from listing on major exchanges; ii) excessive tax burdens borne by US operators due to the application of Section 280E; and iii) greater risk and uncertainty from a regulatory perspective. We also present support for our position that MSOs justify, and will continue to command, valuation premiums relative to smaller, single-state and regional operators. The Catalysts for Revaluation of US Operators Lie Ahead We believe the fundamental factors contributing to the discount on US MSOs relative to their Canadian peers will eventually be resolved with the passage of legislation such as the STATES Act. While we make no forecast on the precise timing of such events, we believe that the removal of these issues constitutes a prospective catalyst for a fundamental upward revaluation of US cannabis businesses. By contrast, the most significant regulatory catalysts for the Canadian cannabis market, including the expectation of international medical cannabis sales, appear to have been priced into those issuers. We believe that once appropriate legislative reform removes these encumbrances, capital rotation will quite possibly see US MSOs trade at a valuation premium to their Canadian and international peers. Strategic Investors and Institutional Capital have yet to Enter this Market in a Major Way We believe that a meaningful portion of the cash currently on the balance sheets of Canadian Operators, raised from institutional investors, strategic partners and debt from Schedule I banks, is earmarked for investment into the US market. There is simply no other consumer cannabis market large enough to absorb this type of capital investment, particularly given that billions have already been invested in Canada over the past several years. As regulations allow for it, we see this capital making its way south, and quickly. The prices for US cannabis assets are only likely to become more expensive in the coming years relative to Canadian cannabis assets, which we believe was the impetus behind Canopy Growth’s (WEED-TSX, NR) move to lock in the option to purchase Acreage Holdings (ACRG.U-CA, NR) once US laws and regulations allow for it. We also consider the possibility, which in our view is often overlooked, that the next global alcohol, tobacco or beverage company to replicate the landmark multi-billion-dollar investments by Altria (MO-US, NR) into Cronos (CRON-TSX, NR) and Constellation Brands (STZ-US, NR) into Canopy, may very well be waiting on the sidelines for federal laws to allow for their investment into a US cannabis business. Passage of the 2018 Farm Bill Opens up Opportunity in Hemp-Derived CBD, but THC Market Remains the Better Bet The passage of the Farm Bill in December 2018 has opened up an opportunity for the estimated $15B hemp-derived CBD market. While hemp and its derivatives have been removed from the list of Schedule I substances, regulations for both the production of hemp (governed by the USDA) and its uses in food and supplement products (governed by the US FDA) have yet to be finalized. Matthew Pallotta, CPA, CA, MBA | 647.253.1194 | [email protected] Andrew Semple | 416.687.6656 | [email protected] Page 2 of 100 US Cannabis Industry | August 12 2019 While the potential for the category is no doubt significant, we are not as bullish for the prospects of upstart cannabis firms, including the largest US MSOs, competing in this category against global Consumer Packaged Goods (“CPG”) firms, and in retail channels dominated by large national pharmacy and grocery retail chains. We continue to strongly favour companies with a core focus on the THC category, which is insulated from competition by both global CPG businesses and well-capitalized Canadian cannabis firms. Over the long term, we believe the THC category will allow for more defensible margins, and greater returns on capital. Continued M&A Activity to Reshape the Landscape of the US Cannabis Market M&A activity is likely to continue to play a major role in shaping the US cannabis industry, with consolidation and roll ups of smaller operators by MSOs resulting in fewer, larger credible players with advantages in access to capital, scale, and national reach. We also note the recent proliferation of cannabis-focused Special Purpose Acquisition Corporations (“SPACs”) which have collectively raised ~$2B, the majority of which has been invested, or is earmarked for investment in, the US cannabis industry. This supports our view that a significant sum of capital is looking for investment opportunities in the US cannabis industry. The deployment of this capital