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While marijuana stocks may be considered a contentious sector to invest in to some investors, this is a sector that could be quite profitable for long-term investors. If recreational cannabis is soon legalized, many marijuana companies are positioned to potentially experience explosive earnings growth in the years ahead.

Three marijuana stocks are now included in the S&P/TSX Composite Index, and that number may continue to grow.

Given the growing presence and leadership of these stocks, I recently spoke with Vahan Ajamian, an analyst who currently covers eight marijuana equities at Beacon Securities Ltd. Here are excerpts from our conversation, with an expanded version available online at tgam.ca/inside-the-market.

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With the pullback in the marijuana sector in recent months, should investors be investing now or is there further downside?

I think people should start positioning themselves now for the remainder of the year. Sometimes, you have to separate what’s going on in the industry and what’s going on in the stock market. The industry in both Canada and the U.S., in my opinion, is clearly moving forward. Now, the stocks are not moving in parallel with what’s happening in the industry. I think sometimes the market, given the emerging nature of the industry, sometimes, things get carried away on the upside and then pulled back too much on the downside.

I think we will get another round of enthusiasm and a run in the Canadian stocks heading into legalization so you probably want to be long late-summer. Then, we will have to see what happens when recreational sales actually start. Maybe early next year, we are going to start to see financial results from recreational sales and we will see who is actually making money and who is not.

Where do you deviate from consensus in term of your outlook for the marijuana sector?

The one place we are outliers at Beacon is that we are very bullish on the U.S. marijuana sector. We’re believers in the Canadian story and believe them to be global champions but we’ve seen a lot of outsized returns in the last two to two and a half years in the Canadian stocks. If you see what’s happening in the United States, that’s probably the next source of outsized returns for investors.

In Canada, you are getting a lot of high valuations because companies can go public fairly easily and access capital. In the U.S., you can’t go public because it’s not federally legal so valuations are a lot lower. In Canada, all we have is (dried cannabis) flower and oil really. In the U.S., in the established markets like California, Oregon, Washington, Nevada, you have the whole plethora of pills, tinctures, edibles, drinks - the market is much more developed.

I think over the next 12 months, you will have a few things going on. The four points I would like to point to are : One, the halo of legalization in Canada is eventually going to fade. Two, in the U.S., John Boehner, former U.S. speaker, joined the board of Acreage Holdings, which is a U.S. cannabis company and then President Trump said he was going to work with Congress to entrench States’ abilities to legalized marijuana. The third point is more and more States are coming online. The fourth and potentially most important thing is you will have more and more companies coming public that are U.S. operators that actually have meaningful revenue and EBITDA [earnings before interest, taxes, depreciation and amortization]. They can go public on the CSE (Canadian Securities Exchange). They can’t go public in the U.S., but they can go public in Canada.

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We still like the Canadian story, but if you are looking for the next outsized returns, the real home runs that we saw in Canada, we think it’s more likely to be in U.S. over the next two to three years.

Why did you choose not to highlight any U.S. stocks?

The companies that I cover do not have much in terms of revenue right now.

Let’s discuss Canopy Growth Corp. (WEED-T), the largest marijuana stock in the S&P/TSX Composite Index. You have a price target of $37 and recently upgraded your recommendation to a “buy”.

With Canopy, we think they are doing a great job in terms of getting ready for legalization. I think they have the financial resources, the team/talent and expertise, the regulatory know how, and the intent, the will to move much faster than anyone else.

I’ve been to their facilities out in British Columbia and saw how quickly they have transferred that 3-million square foot greenhouse from growing tomatoes or peppers to cannabis. They are moving much faster than any of their peers. I went through my numbers and realized my numbers are too low so I raised them. I went from a “hold” to a ‘buy’ recommendation.

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They should have about 220,000 kilos available in the first year of recreational marijuana sales. They already have the most patients on the medical side, they will have the most outlets in terms of provincial distribution, the widest variety of brands and they are also able to sell other people’s brands. For their partners, they can provide distribution. They have about 30 per cent of the medical market today, they are aiming to get maybe as high as 40 per cent of the recreational market. As things progress, they have a partnership with Constellation Brands. Who’s going to dominate the drinks markets when that comes out? They probably have the best chance.

Then you have the global play. Right now, they are in several provinces and they have distributions signed up with most of them so their approach of being local everywhere is working. Now, they are [also] in numerous countries, you can see how they can replicate this model. Management has said that their goal two years from now is to have more revenue outside Canada medically than inside Canada recreational. Canada will be their first leg of growth and then it will be the global market opportunity.

On so many levels, they are so far ahead of everyone else that I think they have the best chance of being the global champion.

Do you see any potential roadblocks for Canopy that could hinder their growth?

The biggest risk is execution. If you look at their track record, they’re doing it better than anyone else.

The next stock you want to highlight is Hydropothecary Corp. You have a price target of $9.50, the highest on the Street. Why the bullish expectations?

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If you look at the company’s average revenue per gram, last quarter it was around $9, higher than the Big 5 (Canopy, Aurora, MedReleaf, Aphria and CannTrust). Last quarter, cost per gram was much lower than the Big 5.

Last quarter, cost per gram was much lower than the Big 5. They have the ability to get unique products though the regulatory standard. For example, they are the only one to have a sublingual spray, and a second product they have is a powder which you can use to make your own capsules. They have these innovative products so they were able to get higher prices that helps you on the revenue side. They have lower costs because they only have greenhouses. They have structural cost advantages of being in Quebec. Quebec has the lowest power prices in the country. Quebec has a minimum wage of $12 per hour. The final thing that they have is what I would call a stranglehold on the Quebec market because they were the only ones licensed in Quebec up until five or six months ago.

In April, the company announced a five-year agreement with the Société des alcools du Québec (SAQ), a transformational agreement.

The company said they expect over the five years to have sold the SAQ 200,000 kilos of marijuana, which is by far the biggest contract from a government agency that any company has. This company has higher revenue per gram than almost anyone else, lower costs per gram than almost anyone else, a balance sheet that’s fully-funded for their expansion in Gatineau, and a five-year deal with one province so distribution has been taken care of.

The company is ramping up their production capacity.

Right now, they have a 50,000 square foot greenhouse. They are building a 250,000 square foot greenhouse which should be done (in May or June). That will get them up to 25,000 kilos of which they sold 20,000 to Quebec for the first year. They are also building 1-million-square-feet greenhouse facility, which should be finished by the end of this year. They are estimating capacity will increase to 108,000 kilos a year by December 2018.

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What type of discount does Hydropothecary trade at compared to Canopy Growth?

It trades at about three or four times 2020 EBITDA [enterprise value-to-EBITDA]. Canopy Growth trades at eight or nine times. Hydropothecary is smaller, it’s less well-known. Last quarter, revenue was just over $1-million whereas it was $21.7-million for Canopy. But once they start proving that they basically pre-sold $1-billion worth of marijuana and they finish their greenhouses and have one or two quarters [of production] under their belt, I think valuation improves significantly. All the building blocks are there, they just have to show that everything they’ve told us they’d do that they’ve done.

What key milestones will improve investors’ convictions and potentially expand the company’s multiple?

Finishing the first expansion, getting the first shipment or two to the SAQ and showing it as revenue, I think those are very important milestones.

The sector has been consolidating with active merger and acquisition announcements.

If you are looking at a company that may be taken out, I think Hydropothecary is a real possibility. If somebody wants to get a foothold in the Quebec market, improve their own cost per gram and revenue per gram, and if they can buy Hydropothecary for a fraction of their market cap, I think if somebody’s looking for a takeout candidate, Hydropothecary has got to be one of the better ones out there.

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