Melius Research launched its coverage of the cannabis industry on Monday, with a neutral view of the overall industry and recommending a cautious entry into the space.
Analysts Rob Wertheimer and Marissa Schlueter named Aurora Cannabis Inc. (ACB) as their top pick with an Overweight rating and a neutral rating on Canopy Growth Corp. (CGC) , but with a possible upside to their target. Melius likes Aurora and Canopy both for their scale and because both companies are aggressively working to build that scale. The analysts also rated Cronos Group Inc. (CRON) as Neutral and Tilray Inc. (TLRY) received an Underweight rating.
The analysts seem to be straddling the fence with regards to the industry. On the one hand, they say cannabis will be a multi-hundred-billion-dollar market that will disrupt alcohol, beverages, over-the-counter medicines and branded pharmaceuticals. Then they counter that by saying that the stocks are priced for positives that "only may come true."
The report cited three key points about the industry:
1. Cannabis will disrupt the beverage industry. Analysts wrote: "In fact, most millennials and younger users reported reducing alcohol consumption, and marijuana users report quitting or consuming less tobacco, as well. This is particularly true for younger generations, and a concern for beverage investors as legalization broadens out usage."
The report, though, claims that cannabis beverages don't exist yet. "There indeed are cannabis beverages in existence and a plethora of new ones slated to come to market over the next few months," countered Cynthia Salarizadeh, President and Founder of House of Saka, an infused wine company. "Saka Infusions, Mood33, Dixie Elixirs, Two Roots Brewing Company, Sprig, etc... these are just a few that already have been in the market.
The report accurately notes that there are issues with combining cannabis oil and water-based beverages, but many companies have already solved that problem. "There will be more talk about nano emulsification," said Geoff Doran, Founder and CEO of Van Doran Brands, which is launching infused mixers and beers in July. "As nano emulsification becomes more main stream and competitive, we will begin to see a lot more players in this space," he added. "The beverage wars will heat up in the next 6 months."
2. Cannabis has the potential to disrupt over-the-counter drugs and prescription medicines. Analysts suggested that CBD remedies, ranging from appetite to pain relief, sleep, anxiety and depression would impact current products. The analysts also noted that with the FDA approval of GW Pharmaceuticals' (GWPH) plant-based cannabis drug, Epidiolex, synthetic cannabis drugs could be replaced. Marinol is the most famous of the approved synthetic cannabis drugs. While it gained a lot of attention early on as being a cannabis drug, the adoption by patients has not been very strong, so there has always been an opportunity to push these drugs aside.
3. Investments in cannabis stocks is highly speculative. Analysts cited issues with the industry, including regulatory restrictions, innovation and strong branding. The analysts also pointed out that some early market share Canadian companies could end up losing out to U.S. companies or from the global staples industry.
Melius gives Aurora a C$17 target price as its top pick and mostly cited the company's numerous acquisitions as an attempt to grab an early market share. "The tactic is bold: as the rush to supply a new and underserved market gathers steam, there will likely be a period of overcapacity coming for the Canadian market. Aurora is playing a large part in that, aiming to get production costs down and capacity in the field to capture market share and to try to hold margin though lower cost." The analysts believe that early scale will matter.
They also see substantial upside for Aurora as a result of it strategic alliances, better footholds into Europe than many others, and for turning some of its massive capacity into sales. Aurora says it is the largest importer, exporter, and authorized distributor of medical cannabis in the EU.
Melius notes that speed and early scale are important -- and Canopy, like Aurora, fits that bill. While the analysts are neutral, they suggest that there could be 20%-30% upside to their target, which sits at C$80. They also pointed out that Canopy currently trades at 65x 2019 estimated revenue, but wrote, "valuation has very little to do with current sales or margins." Compare that to beverage companies that trade at 0.5x revenue and up to 6x for dominant share leaders, or food companies that trade at around 2.5x.
The analysts prefer to compare the cannabis companies to food companies, by this measure. "So, investors in Canopy with a current market cap of $15 billion could see 100% upside if the margins approach global leaders in food; if the market rises 10x, as expected; if they capture 10% share of that market; and if the shares do all that without further dilution. That's a lot to assume, though."
The report highlighted the relationship with Constellation Brands (STZ) and said that the company intends to launch its beverages in October this year. It is expected to be calorie free, transparent with a fast onset. The product will have a long shelf life with scalable production.
Of course, Canopy has more going for it than just the relationship with Constellation. The company has medical and adult-use cannabis production, intellectual property development and distribution relationships. In addition to its regular cannabis, the company also has a hemp business and just signed an agreement with Martha Stewart through Sequential Brands for pet products.
Melius gives Cronos a Neutral rating and suggests there is a slight downside to its target price of C$27. Altria's recent investment in December of C$2.4 billion helped shore up the company's cash position. Cronos isn't engaging in the type of capacity race that Aurora and Canopy are, but instead is aiming to provide pure cannabinoid extracts -- including rare ones. The analysts think that Cronos' joint venture with Gingko Bioworks is very strategic, with great potential.
The report said, "Its Gingko Bioworks partnership will use a yeast-based production to biosynthesize cannabinoids, including rare ones, for what the company says is a fraction of the cost of current greenhouse production." Cronos' medical brand is Peace Naturals and its adult-use brands are OGBC, Cove and Spinach.
The analysts rate Tilray as Underweight with a $48 price target. The report immediately dove into the company's dual-class share and ownership structure. "Privateer owns all of the class 1 voting shares, with 10x the voting power of class 2 shares and about 76% of the class 2 shares," read the report. The Manitoba Harvest acquisition and the recent convertible notes used the class 2 shares, causing dilution. If the class 1 shares fall below 10%, then everything converts to class 2.
"There remains a differential incentive, however," the analysts pointed out. "As Tilray needs capital, the total share count can be diluted by 70%-80% or so, while leaving Privateer with the still-valuable control premium." Also, Tilray pays a licensing fee for some of the intellectual property owned by Privateer. That figure could increase at any time.
Tilray has an alcohol relationship with AB InBev and a pharmaceutical relationship with Sandoz. There is an Authentic Brands deal for hemp-based products and numerous adult brands like Marley Naturals. Yet, for all these deals, the analysts remained concerned with the Privateer ownership.