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5 pot stocks join Morningstar coverage list

Kristoffer Inton  |  11 Jul 2019Text size  Decrease  Increase  |  
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We have initiated coverage of cannabis, an industry we forecast to grow by nine times through 2030 amid widening legalisation and increased participation for the US, Canadian, and international markets.

For the United States, recreational cannabis and medicinal cannabis have penetrated just 8 per cent and 21 per cent of their estimated markets, leading to our expectation for 25 per cent and 15 per cent compound annual growth rates through 2030, respectively. We expect six more states to legalise recreational cannabis and three states to expand commercial distribution. Furthermore, we expect the federal government will recognise states’ rights to decide legality.

For Canada, despite recent recreational legalisation, cannabis has penetrated just 12 per cent of our estimated market, setting the stage for a 20 per cent CAGR through 2030. However, increasing competition from other countries could limit the opportunity for Canadian producers to US$20 billion.

For the international market (which excludes Canada and the United States), we forecast market potential of nearly US$43 billion and a 23 per cent CAGR through 2030 as more countries recognise the benefits of medical cannabis.

Of the five cannabis companies we now cover--  Aurora Cannabis (XNYS: ACB),  Canopy Growth (XNYS: CGC)/(XTSE: WEED),  Cronos (XNAS: CRON),  Curaleaf (PINX: CURLF)/(XCNQ: CURA), and  Tilray (XNAS: TLRY)--we think Aurora, Canopy, and Curaleaf offer investors attractive risk-adjusted upside at current prices.

We assign all companies a no-moat rating and stable moat trend rating, as they will struggle to earn economic profit as they spend on growth in this early-stage industry.

Aurora Cannabis

Ticker ACB

Last close US$7.39

Fair value US$10

Value 27 per cent discount

Moat None

Data as of July 11, 2019

Aurora Cannabis cultivates and sells cannabis in Canada and exports medical cannabis internationally. Our fair value estimates are US$10 and C$13 per share. Our valuation is based on a 10-year explicit forecast that assumes a roughly 41 per cent volume CAGR, about a 2 per cent price CAGR, and a 2028 operating margin before plant adjustments of 35 per cent.

Aurora is focused on becoming a large-scale, low-cost producer by expanding and optimising its cultivation operations. Unlike its Canadian peers, Aurora has yet to enter a strategic partnership with a major alcohol, tobacco, or pharmaceutical company. It also does not offer investors any US exposure.

Canopy Growth

Ticker CGC

Last close US$38.60

Fair value US$54

Value 28 per cent discount

Moat None

Data as of July 11, 2019

Canopy Growth grows and sells cannabis in Canada and, to a lesser extent, global markets. Our fair value estimates are US$54 and C$71 per share. Our valuation is based on a 10-year explicit forecast that assumes a 30 per cent volume CAGR, a 4 per cent price CAGR, and a 2029 operating margin before plant adjustments of 37 per cent.

Canopy offers two unique advantages. First, it will acquire US-based Acreage Holdings, a cannabis company with vertically-integrated operations in 20 states, for US$3.4 billion immediately upon a change to federal law, giving it entry into the largest and most attractive cannabis market. Second, a strategic investment from Constellation Brands can help Canopy develop cannabis-infused consumer products.

Cronos Group

Ticker CRON

Last close US$15.29

Fair value US$11

Value 41 per cent premium

Moat None

Data as of July 11, 2019

Cronos Group cultivates and sells cannabis predominantly in Canada and, to a lesser extent, global markets.

Our fair value estimates are US$11 and C$14.50 per share. Our model uses a 10-year explicit forecast that assumes a roughly 31 per cent volume CAGR, a 3 per cent price CAGR, and a 2028 operating margin before plant adjustments of 35 per cent.

Cronos is expanding its capacity with plans to cultivate in Israel, Colombia, and Australia through joint ventures. Cronos also has limited US exposure through a research and development partnership with Ginkgo Bioworks to produce cultured cannabinoids.

In addition, Altria Group’s investment provides Cronos with an experienced partner to navigate strict regulatory environments.

Curaleaf Holdings

Ticker TLRY

Last close US$6.86

Fair value US$10.50

Value 35 per cent discount

Moat None

Data as of July 11, 2019

Curaleaf Holdings cultivates and sells cannabis in the US with a presence in 15 states. Our fair value estimates are US$10.50 and C$14 per share. Our valuation is based on a 10-year explicit forecast that assumes a roughly 36 per cent revenue CAGR, a 3 per cent price CAGR, and a 2028 operating margin before plant adjustments of 32 per cent.

Curaleaf offers the advantage of pure-play exposure to the US through a vertically integrated operation that includes cultivation, processing, and dispensary operations on the East and West Coasts. Unlike its Canadian peers, Curaleaf does not operate internationally, which is a disadvantage since the global market looks lucrative.

Tilray cultivates

Ticker TLRY

Last close US$45.93

Fair value US$40

Value fairly valued

Moat None

Data as of July 11, 2019

Tilray cultivates and sells cannabis in Canada and exports to 13 countries. Our fair value estimate is US$40 per share. Our valuation is based on a 10-year explicit forecast that assumes a roughly 24 per cent volume CAGR, a roughly 4 per cent price CAGR, and a 2028 operating margin before plant adjustments of 30 per cent.

Tilray has pursued options to improve its international and recreational competitiveness. It has expanded cultivation facilities to Portugal to supply European demand with cheaper production. A partnership with Anheuser-Busch InBev can help it create cannabis-infused drinks, while a partnership with Authentic Brands Group will help it market CBD products in the US.

Some advantages, but not enough for a moat

We don’t believe any of the cannabis companies we cover have an economic moat. Although there appear to be potential sources of competitive advantage through intangible assets and cost advantage, several barriers prevent the companies from earning a moat in the medium term.

Regulation intangible assets

We believe the most likely moat source would come from intangibles stemming from regulation. Cultivators and dispensaries require government licenses to operate in every market where recreational or medical cannabis is legal. As a result, companies with licenses could be protected from outside competition, helping establish pricing power. This could prove particularly true if holding an existing license provides an advantage for when new licenses are issued. History suggests this could be possible, as Illinois’ early plans for recreational legalisation would hand an advantage to companies with medical cultivation and dispensary licenses. However, even if this were the case, we see sustained positive economic profits for cannabis companies as unlikely over the next 10 years.

Challenges to economic profit

Because the cannabis industry remains in the growth stage, we think that years of significant investment will be necessary. An extended capital expansion cycle through the next several years means that companies are unlikely to generate returns on invested capital in excess of their costs of capital.

Also, we see both governments and the black market squeezing cannabis cultivators and dispensaries and preventing economic profit generation. With national, state, and local governments reeling from budget problems, the emergence of cannabis as a legal product has come to be viewed as a funding panacea. For example, Washington state has implemented a 37 per cent tax rate on recreational cannabis - early evidence that governments, with full control over licensing, will attempt to maximise their economics.

All else equal, on the other end of the value chain, consumers would probably bear any government tax increase, as in the cigarette market. However, a large and accessible black market effectively serves as a price ceiling that consumers are willing to pay. When California legalised recreational cannabis with a relatively high tax, the legal market shrank as consumers moved back into the black market.

Companies that are involved in the cultivation and sale of cannabis have the least leverage against the government and consumers. Although there could be years of economic profit generation when supply has been slow to respond with expansions, we do not have confidence that cannabis companies could consistently earn economic profits over the next decade.

Brand intangible assets

Potentially offsetting the challenge of generating economic profit from regulation intangibles, we think that the creation of brand intangibles would help cannabis companies pass increased costs to consumers, thus protecting their own economic profit. Alcohol and cigarettes are typically highly taxed, but producers have established strong enough differentiation and brand intangibles that consumers are willing to pay premiums.

Although the cannabis companies are attempting to strengthen their brands, we see the creation of a brand intangible within the next decade as unlikely. Canadian regulation restricts packaging to be bare and unexciting and bars direct contact between the company and dispensary workers who provide expert advice and help consumers select their cannabis. Advertising is possible in venues in which only adults will be present, but we think limitations create meaningful barriers to brand creation. We believe that the selection process in Canada will be more like selecting wine than liquor, in which the choice is made on qualities rather than brand.

Restrictions are laxer in the US, where there are fewer limitations on packaging and direct contact with dispensaries is allowed. While brand power may strengthen eventually, we think it is highly unlikely that any brand will be strong enough in the next 10 years to command pricing power, and there are a few reasons for this:

  1. Because we anticipate that federal legalisation will take a few years, cultivation and selling is limited to intrastate. This limits any brand creation to a local level for the next several years.
  2. Although a strong relationship with a dispensary worker could provide an advantage, we think these workers would be loyal to whichever company last paid them, requiring significant marketing expense to maintain relationships and eroding economic profit.
  3. While typical consumer product companies, and even tobacco companies earlier in their history, have built brand recognition through advertising campaigns, we expect cannabis will face the same if not stricter limitations as tobacco in advertising in the US. We believe this makes it even harder for cannabis companies to build a recognisable brand, as opportunities to address the consumer will be limited.

Under the Family Smoking Prevention and Tobacco Control Act, tobacco product advertising faces restrictions on outdoor advertising near schools and playgrounds, sports and entertainment brand sponsorships, and point-of-sale advertising, among others. Advertising on television and radio has been banned since 1971 by the Federal Communications Commission. Although tobacco companies spend roughly US$10 billion in marketing in the US, roughly two thirds is spent on price discounts to reduce the cost of cigarettes to consumers. While this may help tobacco companies protect brand intangibles with its customers, we don’t think the same strategy could build a new brand intangible in cannabis.

As cannabis shifts from its traditional smoking form to infused drinks and food products, there may be potential for the creation of brand intangibles. However, we think the development and widespread distribution of regulator-approved infused products will take too long for a brand intangible to drive excess returns within the next decade.

Cost advantage

We think it is unlikely that the cannabis companies we cover will be able to establish a cost advantage. Because of the climate, most cannabis in Canada is grown either in greenhouses or indoors. Although this allows for higher-quality cannabis to be grown, these methods are also much higher cost because of the required lighting and climate control. Additionally, advantages in greenhouse and indoors can be much more easily imitated than geographic advantages that may be present in outdoor cultivation.

Cannabis grown in the Western US in states like Oregon is grown outdoors. Without the need for as much equipment, costs are significantly lower, partially offset by fewer harvests and lower quality. However, labour is the single-largest cost of production for any growing method. Thus, countries with cheaper labour that have expressed a desire to establish a medical cannabis industry are likely to produce at a lower cost than any US or Canadian cultivator.

Kristoffer Inton does not own shares in any of the securities mentioned above.

A version of this article first appeared on Morningstar.com. It has been edited for an Australian audience. 

 

is an Equity Analyst for Morningstar

Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

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