Canada Leads the Global Cannabis Paradigm Shift Initiating Aphria and Canopy at Outperform May 2018 Tamy Chen, CFA Peter Sklar, CPA, CA Cannabis Analyst Retailing/Consumer Analyst BMO Nesbitt Burns Inc. BMO Nesbitt Burns Inc. (416) 359-5501 (416) 359-5188 [email protected] [email protected] This report is intended for Canadian & EU distribution only. Unauthorized reproduction, transmission or publication without the prior written consent of BMO Capital Markets is strictly prohibited. This report was prepared by an analyst(s) employed by BMO Nesbitt Burns Inc., and who is (are) not registered as a research analyst(s) under FINRA rules. For disclosure statements, including Analyst’s Certification, please refer to pages 50 to 53. 16:00 ET~ Table of Contents Initiating BMO Cannabis Coverage ................................................................................................................... 2 Executive Summary .......................................................................................................................................... 4 Legal Environment Favours Canadian LPs ........................................................................................................ 6 Initial Recreational Market Outlook ................................................................................................................. 7 Current Medical Market in Canada: Opaque .................................................................................................. 13 Near-Term International Medical Opportunity: Germany ............................................................................. 15 Long-Term Industry Outlook ........................................................................................................................... 16 Company Snapshot: Our Current Coverage Universe ..................................................................................... 24 Company Coverage: Aphria ............................................................................................................................ 25 Company Coverage: Canopy ........................................................................................................................... 35 Comparable Companies - Cannabis ................................................................................................................ 46 Comparable Companies – Alcohol & Tobacco ................................................................................................ 47 Glossary ........................................................................................................................................................... 48 This report is intended for Canadian & EU distribution only. Unauthorized reproduction, transmission or publication without the prior written consent of BMO Capital Markets strictly prohibited. Cannabis | Page 1 May 28, 2018 Initiating BMO Cannabis Coverage Aphria: We are initiating coverage of Aphria (APH-TSX) with an Outperform rating. First Mover Advantage: We believe Aphria will be one of the few licensed producers (LPs) with sufficient product to supply the initial recreational demand and we believe such a “first mover” advantage should enable the company to quickly capture significant share and generate attractive unit economics in an undersupplied market. Leading Low-Cost Producer: We believe Aphria could emerge as a leading low-cost cannabis producer given the significant commercial-scale greenhouse cultivation expertise held by the management team, and the infrastructure and greenhouse culture that is inherent in the Leamington, Ontario community. Scale Is Critical to Long-Term Growth: We believe Aphria’s scale will facilitate meaningful investment in long-term growth opportunities such as brand development, value-add format manufacturing, the gradual legalization of international medical markets, and advanced pharmaceutical applications. Valuation: Our target price of $17 is based on a projected enterprise value that is about 17x our Base Case fiscal 2020 EBITDA estimate. We note that our Base Case fiscal 2020 EBITDA estimate assumes that Aphria’s facility expansions are only at 65% of full ramp potential versus management’s expectation that the facilities will be close to 100% ramp by that time. If these facilities were to reach full ramp by fiscal 2020 and Aphria experiences firmer selling prices, our implied target multiple would be in the high-single-digit range. See Aphria company section for details. Canopy: We are initiating coverage of Canopy (WEED-TSX) with an Outperform rating. First Mover Advantage: We believe Canopy will be one of the few LPs with sufficient product to supply the initial recreational demand and we believe such a “first mover” advantage should enable the company to quickly capture significant share and generate attractive unit economics in an undersupplied market. Head Start in International: We consider the company’s current international operations to be more advanced versus most other players, and Canopy appears to be laying the groundwork in markets where medical is not yet legalized, but may soon be. The approach to develop cultivation in “hub” regions like Denmark for export to Germany and eventually Australia for export to the Asia-Pacific region provides the company longer-term access to these markets. Long-Term Global Branded Leader: Canopy could emerge as a leader over the long term given that the company’s scale will facilitate meaningful investment in long-term growth opportunities such as brand development, value-add format manufacturing, the gradual legalization of international medical markets, and advanced pharmaceutical applications. We believe Canopy’s strategic alliance with Constellation Brands (STZ-NYSE; US$216.81; Outperform rated by Amit Sharma, BMO Capital Markets Corp.) could prove to be a significant advantage as the industry evolves into value-add formats, and particularly, into cannabis-infused beverages. Valuation: Our target price of $45 is based on a projected enterprise value that is about 20x our Base Case fiscal 2020 EBITDA estimate. Our target multiple reflects our view that Canopy has a relative head start in brand development and international expansion, and could emerge as a leading global-branded company in the long term. We note that our Base Case fiscal 2020 EBITDA estimate assumes that Canopy’s facility expansions are only at 65% of full ramp potential versus management’s expectation that the facilities will be close to 100% ramp by that time. If these facilities were to reach full ramp by fiscal 2020 and Canopy experiences firmer selling prices, our implied target multiple would be 11x. See Canopy company section for details. This report is intended for Canadian & EU distribution only. Unauthorized reproduction, transmission or publication without the prior written consent of BMO Capital Markets strictly prohibited. Cannabis | Page 2 May 28, 2018 Relative Positioning Canopy Growth Aphria • Could emerge as a large, • Could emerge as a leading low- cost contract cultivator branded player • Potential to gain “first • Strategic alliance with mover” advantage in • Continues to establish strategic Constellation Brands could prove initial recreational relationships in international to be a significant advantage as market markets, but appears slightly behind compared to Canopy the industry evolves into value- • Scale should facilitate add formats meaningful investment • Supply agreement with • Current international operations in long-term Shoppers Drug Mart broadens appear more advanced versus opportunities medical distribution reach other LPs; strategy to develop • Pressure on the stock following cultivation hubs abroad for controversy with Nuuvera international export could acquisition, resulting in lower provide longer-term market valuation vs. other LPs and access provides better return opportunity Source: BMO Capital Markets. This report is intended for Canadian & EU distribution only. Unauthorized reproduction, transmission or publication without the prior written consent of BMO Capital Markets strictly prohibited. Cannabis | Page 3 May 28, 2018 Executive Summary Near-Term Outlook First Mover Advantage for Larger LPs: Initially, demand/supply dynamics will favour the larger LPs. Anticipated demand from the initial recreational market in Canada is expected to considerably exceed industry production as only a handful of the larger LPs will have sufficient cannabis output at that time to meaningfully fill the distribution channels. As a result, this “first mover” advantage should enable the larger LPs to benefit from the favourable pricing dynamics expected in an initially undersupplied market. See Exhibit 3. In addition, this “first mover” advantage should enable the larger LPs to initially dominate retail shelf space in the recreational market, which would provide a head start for brand development. Value-Add Formats Will Mitigate Dried Flower Price Compression: We anticipate in year two of our forecast that supply will begin to catch up to demand, which will result in some pricing pressure on dried flower. However, our Base Case projections anticipate that in year two, federal regulators will begin legalizing value-add product formats, which should carry much higher pricing on a grams-equivalent basis and mitigate the pricing pressure that arises in dried flower (see Exhibits 3 and 4). Our Base Case forecast assumes that the industry growth rate for medical patient acquisition slows when