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  1. RBC initiates coverage of Canopy, Aurora, Hexo, Organigram and CannTrust
  2. The three smaller firms offer more compelling valuations than Canopy and Aurora, according to the analysts   
  3. The analysts predict most companies “will be unable to weather the storm that emerges as we enter the second phase of Canadian Cannabis”

Royal Bank of Canada launched analyst coverage of five Canadian cannabis companies on Monday, assigning three “Outperform” (Buy) ratings and two “Sector Perform” (Hold) ratings, in a report that took a mostly cautious view of the industry.

RBC analysts Douglas Miehm and Savneet Uppal gave Canopy Growth Corp. and Aurora Cannabis Inc. Sector Perform ratings, noting both firms’ early dominance in the space, while suggesting their future growth potential “is largely priced in at current levels.”

Hexo Corp., Organigram Holdings Inc., and CannTrust Holdings Inc. were rated Outperform. “From a value perspective, we believe small to mid-sized operators present a more compelling option,” wrote Mr. Miehm and Mr. Uppal. All three Outperform ratings were qualified with a “Speculative Risk” rating to account for execution risk in the rapidly changing industry.

Notably absent from the report were Tilray Inc., Cronos Group Inc. and Aphria Inc., the third, fourth and fifth largest cannabis companies by market capitalization. RBC did not comment on why it chose to focus on Hexo, Organigram and CannTrust, over these larger firms.

RBC began cannabis coverage in December with a report that looked at the industry broadly. Monday’s research report is the next step for Canada’s largest bank, which has trailed Bank of Montreal and the Canadian Imperial Bank of Commerce in cautiously embracing the cannabis industry. Both BMO and CIBC have co-led equity and debt financing for cannabis companies. RBC has yet to announce any direct involvement in cannabis financing.

“RBC will evaluate business relationships with the cannabis sector through a similar due diligence process that we use with clients in other sectors, with the key difference being ensuring there is no connection to the U.S.,” said an RBC spokesperson in an e-mail, in response to a question about the company’s current involvement in the space.

Mr. Miehm and Mr. Uppal’s report offers a sober take on the new legal industry, which under-performed in its opening months, and may soon “weed out firms lacking brand strength, strategic partners, international distribution, intellectual property, and financial flexibility.”

In December, the analysts predicted fourth-quarter recreational sales volumes of around 26,000 kilograms, a relatively conservative estimate compared with other analyst expectations. The actual legal rec sales volumes in October, November and December were around 16,000 kilograms. “It now appears that execution and undersupply have been even more challenging than we (and the Street) were expecting, especially at the retail level,” wrote Mr. Miehm and Mr. Uppal.

More important than a sluggish start to the legal rec market, is a transition the analysts expect to happen over the next two or three years, from a market focused on agriculture to one focused on brands and higher-margin consumer products.

“In our framework, we identify a “pivot” between the plant and ingredient phases that ultimately results in a shakeout in the industry. As a result, we believe domestically focused firms today have a finite window to enjoy excess financial and market returns as most will be unable to weather the storm that emerges as we enter the second phase of Canadian Cannabis,” Mr. Miehm and Mr. Uppal wrote.

“Canopy is best equipped to navigate this dynamic shift,” the authors wrote, citing the company’s size, intellectual property, financial assets and backing by Constellation Brands Inc.

“Although the other [four] LPs are far more domestically driven, they must not be overlooked as the sector as a whole enters a period of significant revenue growth,” added Mr. Miehm and Mr. Uppal. “Even though these LPs are a step or two behind Canopy, we believe they are far better off than the 100+ licensed producers in Canada.”

Even if Canopy, and to a lesser extent Aurora, have a distinct advantage in the shift towards branded consumer products, it does not mean their current valuations offer a good entry point for investors.

“For WEED and ACB, even if share of global cannabis markets approaches revenues in Canada by 2022 as projected in our outlook, we do not find relative valuation compelling. As such, we believe the companies must deliver on such expectations, which may be easier said than done, to support current valuations. Having said this, if WEED or ACB share prices begin to weaken in the coming months given the historical volatility in the sector, we could see our views becoming more constructive on the names given the various attractive attributes of each company,” wrote Mr. Miehm and Mr. Uppal.

“Additionally, we believe Street estimates are factoring in international revenues far too quickly for most LPs. Although Canopy and Aurora are likely to grow their global businesses this year, we believe meaningful international medical sales for HEXO, CannTrust, and OrganiGram are at least a year or two away. Similarly, we believe the industry as a whole has benefitted from initial inventory stocking effects and remain cautious in using current sales as a run-rate figure going forward. As a result, we see room for downward revisions for consensus estimates through 2019,” the analysts added.

RBC Capital Markets forecasts

Share price$58.51$9.14$7.75$12.61$7.74
Fully diuted shares (MM)3971,068227108159
Market cap (MM)23,2399,7611,7581,3571,233
Enterprise value (MM)18,6079,8571,4741,2811,131
RBCCM forecasast
C2020’ revenue (MM)1,266970219201215
C2020’ gross margin42.8%55.6%52.7%56.0%60.8%
C2020’ EBITDA (MM)7164475690
C2020’ EBITDA margin0.6%16.9%21.3%28.0%42.0%
Target multiple (EV/sales)10.0x8.0x6.5x5.5x6.0x
Price target$65$10$10$15$11
Implied return11%9%29%19%42%

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