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analyst q&a

Marijuana plants are pictured on Jan. 21, 2016.Sean Kilpatrick/The Canadian Press

Legalization of recreational cannabis is potentially just three months away. As such, this is a market with robust long-term growth potential.

Matt Bottomley, the Alternative Pharmaceuticals research analyst at Canaccord Genuity, recently spoke with The Globe and shared his thoughts on the cannabis market and provided three stock recommendations in this sector.

What are your overall thoughts on the sector?

I think over the next four to six months, there's a lot of positive catalysts still to come. All the provincial governments are going to be rolling out their own retail distribution frameworks so once it's legalized by the federal government, the provinces are going to be responsible for that rollout. We have already seen a significant announcement from Québec, so we think that the Ontario announcement could be in the next six weeks or two months - we think that's a huge catalyst. We have the actual legalization from the federal government expected around June as well, and then other international developments. The German government might be announcing some of their initial domestic cultivators as well in the spring so a lot of positive catalysts.

Over the next six months, I think there's quite of bit of catalysts but once rubber hits the road and recreational sales actually begin, which now looks like this may begin in August or September, that's when investors could become more discerning and start taking a harder look at underlying fundamentals.

If investors become more discerning, what characteristics should they be looking for?

First mover advantage is key and a lot of the larger cap companies in the space are first movers. As well as having differentiation in your strategy, whether it is just in Canada or potentially inroads into international markets. What I am very cautious about is companies that are only focused on cultivation of cannabis domestically.

What I look for is differentiation, we want to see companies that have an oil license or are in the process of getting an oil license, that are starting to introduce different breadths of products. The second thing, which is becoming much more topical, is international exposure. There are many countries in Europe that are currently formulating their medical platforms including Germany, Italy, Spain, as well as Australia, and a lot of Canadian LPs [licensed producers] have either strategic investments in those types of companies or are looking at actually getting licenses directly in those companies as well.

By differentiation, I also mean strategic initiatives so partnering with companies that have extraction technologies, we've seen a number of licensed producers do that. We've even seen some co-branding strategies.

At the end of the day, we think the winners in this space many years down the road are going to be brands, it's not going to be who has the lowest cost of production per gram of cannabis.

We think we'll see an evolution in this space. We think that over time it will probably shake out closer to the alcohol industry where there is a little more leeway there with what you can do but it will take time.

Last year, Canadian LP Canopy Growth Corp. attracted Constellation Brands International Inc., which acquired a stake in the company. Will we see more of this investment activity?

We think that there is the potential for other consumer brands or tobacco or pharmaceutical companies to enter the space as time goes on. In my view, these companies are going to partner with companies that are large enough for it to make sense. There are five to seven companies that have valuations that are high enough to potentially attract capital. For a reference point, the big four in this space right now are companies that have between $2-billion to $6-billion market caps, have the highest revenue run rates, and they probably account more than 50 per cent of the industry over all.

Let's turn to your three stock picks.

There are two companies that are Canadian licensed producers and one company that is Canadian listed but a U.S. operator.

Let's begin with your official top pick, iAnthus Capital Holdings Inc. You have a target price of $5.25.

The reason why I like iAnthus is that it's capturing what I believe is a valuation arbitrage between what we are seeing in the Canadian market and the lack of liquidity that exists in the U.S. market. Canada has a very robust regulatory framework. In the U.S., cannabis is still a schedule one drug, a narcotic, and because of that every state has had to either elect through its state legislature or through ballot initiatives legalized medical cannabis programs. The first one to come on-line was Colorado back in 2014 and since then there's about eight or nine States that have legalized recreational cannabis and on top of that we have what will soon be over 30 states that have legalized medical cannabis. While the Canadian market is attractive with a population of 35 million, the U.S. is 10 times bigger and probably 50 to 60 per cent of it, although illegal at the federal level, has legalized it on a state-by-state level.

iAnthus is investing in what I would call blue-chip states, a lot of those are on the U.S. east coast and those are states that are a bit newer to the game that have regulations that have been put in over the last number of years. For example, iAnthus' key assets are in Massachusetts, Florida, and New York state. Recreational sales for Massachusetts are rolling out this year. The Florida medical market is very attractive in terms of its demographics, and New York, although it will only be for medical, could be one of the biggest cannabis markets in the U.S., outside of California, if recreational sales are eventually legalized down the road. The reason I mention all those states is because when you add it all up, iAnthus has exposure to almost 50 million residents and it's one of 10 or one of 15 players in the States, compared to Canada, which has 35 million residents but we have 90 competitors in the space.

The company has a $225-million market capitalization roughly, much lower than some of their Canadian listed industry peers that have market capitalizations over $2-billion. Is this discount justified?

One of the reasons for that is because liquidity isn't as large because the TMX Group [the exchange operator for the Toronto Stock Exchange] does not allow for any Canadian listed companies to have U.S. cannabis exposure, they are very clear that they do not want to have any of their listed companies to be breaking any U.S. Federal laws, no matter what regions they operate in. So because of that, a lot of these U.S. operators that are Canadian listed have elected to trade on an exchange called the Canadian Securities Exchange.

This allows these companies to have access to capital in Canada and deploy that into the U.S. market, which because the federal government is very restrictive on banking rules, which has essentially stifled growth south of the border because these companies have to stay within their states. You can't be a large player where you can ship product state to state, every region has its own rules and regulations to follow. Because of that, a lot of the valuations in the States, privately where you can pick these assets up, are much lower than what we are seeing in Canada so you are getting a public company multiple when you raise your capital and you are able to deploy it in the States at a much lower valuation and that creates instant accretion, in my opinion. It's set a foundation for iAnthus to have a lot of assets in what I call blue-chip states. Right now, it is trading at market cap of approximately US$250-million, which I think will eventually re-rate as the stigma continues to dissipate. I think there is a longer path to maturity in the United States but I think that provides the opportunity today to get in on the ground floor where the valuations are incredibly lower than what we are seeing in Canada.

iAthus has a high-quality basket of assets that its buying up right now at relatively cheap valuations. It's just waiting for the stigma to continue to dissipate, and then there will be a valuation re-rating, while at the same time waiting for its fundamentals to grow and that will be a function of the Florida market continuing to register medical patients, New York state continuing to do the same, and then the Massachusetts recreational market to start later this year. I think we are going to see a double whammy if you will with their actual earnings going up significantly over the next number of years and the potential for a valuation re-rating.

How do you arrive at your $5.25 target price?

The way that we get to our valuation for iAnthus is actually similar to how we do it for all our names in our coverage list. We do 10-year DCF's [a discounted cash flow model].

Let's move to your other stock recommendations - two Canadian licensed producers.

The Canadian market is becoming saturated with what I would call "planned capacity." Companies that I have a more favourable view on are ones that have a first mover advantage secured already. Aphria and MedReleaf are both companies that have been operating for a number of years now that have solid relationships with Health Canada, have leading market shares, and have the balance sheets and the capacity built to-date and expansion plans that are currently under way today to be able to facilitate a large purchase order.

You are forecasting an attractive double-digit return for MedReleaf with your price target at $31. Why the bullish expectations?

MedReleaf is a company that today has maybe the number two or number three spot in terms of market share. It has a fully ramped facility [operating] at capacity where they have been able to show a low cost of production in an indoor facility in Ontario. The reason why that's important is if you are an indoor grower, the most expensive place to do it is Ontario because of the hydro rates and there have been a lot of companies that have struggled to get their production costs down. MedReleaf was, if not the first company, one of the first companies to actually ramp up a fairly large facility at over 5,000 kilograms of capacity, which is larger than most companies today. It has one of the largest revenue run rates today in the industry. It also has an international angle to it. Currently, it has boots on the ground in seven countries internationally. They are one of four companies where Shoppers Drug Mart has announced that if they get a license they are going to be a supplier to Shoppers Drug Mart. They are the first company to officially announce their recreational brand, which is a partnership with Amsterdam Brewery. They are putting their logo on a can of beer. A year before recreational rolls out, the logo will already have been in the eyes of some potential cannabis users down the road. It may be something they recognize. That brand is called San Rafael '71 and it's already available.

What does the company's production profile look like?

MedReleaf currently is doing about $10-million a quarter. That is expected to grow quarter-over-quarter going forward because we are expecting recreational demand to come online.

Right now, they are producing on a trailing basis about $10-million a quarter and that's predominately out of their Markham facility, which has 7,000 kilograms of capacity [annually]. Their Bradford expansion is supposed to get them four times that level and they're expected to finish that by the end of the summer. They are expected to have enough infrastructure built to be at 35,000 kilograms of capacity.

On top of that, management recently announced a large acquisition in Exeter, Ont.

So that has a greenhouse and the strategy there is they get the benefits of a lower cost of production by growing in a greenhouse. The greenhouses that they bought exist today, they just need to be retrofitted. Once that's done, it's supposed to add another 105,000 kilograms of forward capacity. I think it's an important term to distinguish, it's the infrastructure built to support a potential 105,000. If you add up the existing facility and their expansion plans, they are supposed to have the infrastructure built by the end of 2018 to support 140,000 kilograms of production, which is one of the largest expansion plans announced in the industry.

Do they have the balance sheet capacity to fund this growth?

They do. They recently did a large raise and the reason why it's funded is because they are not building these greenhouses from the ground up. They are existing greenhouses that they are going to retrofit.

Let's delve into Aphria Inc. You have a target price of $26.50. What's your investment thesis for this stock?

I think they have a very strong management team. Vic Neufeld was the former CEO of Jamieson [Laboratories] so he has experience getting products on shelves and growing a business. Aphria does have a supply agreement with Shoppers Drug Mart if they get a license. They are a company that I think has done an excellent job in this industry of telegraphing exactly what they are going to do and they are very conservative with how long things are going to take and when they're going to reach certain achievements and so far I think they have executed flawlessly. On top of all that, they are very similar to MedReleaf, where they have one of the largest built capacities in the industry today. They have one of the largest publicly disclosed expansion plans in the industry today at 240,000 kilograms. They have 100,000 kilograms at their main facility, they have another 130,000 kilograms at a recently acquired facility called Double Diamond, and they have another acquisition they did of a company called Broken Coast, which is out of B.C., that has the potential to do 10,000 kilograms at its current facility and their timing for that is the early part of 2019, they expect all of it to be built but it will then take further time to get up to full production run. They are if not the lowest cost producer in the industry, they are one of the lowest cost producers. Finally, they acquired Nuuvera about a month ago, which gives them the leading international strategy in the Canadian market today. Nuuvera has relationships in 11 international countries. This transaction gives them a potential cultivation license in Germany, they now own one of only seven import licenses in Italy, and they are also involved now in the export market in Spain and that's all through this company Nuuvera.

And all of these expansion plans are fully funded?

All of its capacity expansions are fully funded. The funding required for international opportunities will need to be determined on a case by case basis.

What is your target price?

My target price is $26.50.

Is all of their production greenhouse?

It is.

Aphria trades on the Toronto Stock Exchange. You mentioned earlier that the TMX Group does not want any of their listed companies having operations that breaks U.S. Federal laws. Aphria does have U.S. exposure though.

They had two assets, a Arizona company that was sold weeks ago. The other asset they have started to divest.

Any other closing comments?

I think one thing that's important [to note] is how much of a leader the Canadian market is from a regulatory standpoint. If Canada legalized cannabis in the June time-frame, there will only be two countries in the world that have legalized both medical and recreational cannabis at the Federal level and that's Canada and Uruguay.

As fast as the Canadian market seems to be moving, things are starting to move pretty quickly internationally as well. Now, it's not going to start with recreational cannabis, it's going to start with medical programs. There are a dozen countries out there that I think in the next year or two are going to be turning on the switches for medical cultivation and I think that a lot of different stakeholders and players in the Canadian market could potentially have meaningful investment internationally or at least provide a meaningful role in the rollout of [legalized] cannabis worldwide, so I think that this sector in Canada is definitely something to be proud of.

I can't think of any other example where you have an opportunity this large that's happening on a global scale where the U.S. is not a competitor. The U.S. is not a competitor because every place has to do it state by state so there is no large consolidation happening down in the U.S. yet, and because of that, it's put the U.S. on the sidelines and its opening up the opportunity for a lot of other countries, and Canada is currently the leader.

Ahead of marijuana legalization, traditional crops are being traded in for cannabis plants at Canadian greenhouses. The COO of legal pot producer Newstrike says crop turnover in the greenhouse industry is common.

The Canadian Press

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