#Cannabis Majors to Spark M&A Bonanza, Who Will They Acquire?

#Cannabis Sector Overvalued, but Strong Takeout Candidates Could Soar

{Please see disclosures at bottom of page}

[Updated for October 12th stock prices and company valuations]  

Most of the top 50 #cannabis (#weed / #hemp / #marijuana)– related stocks are overvalued, some wildly so.  I’m tracking 230 Canadian & U.S.-listed companies.   As of {updated} October 12th {updated}, the top 16 had a combined Enterprise Value (“EV”) [market cap + debt – cash] of C$73.6 billion, or C$4.6 B per company! 

Make no mistake, there’s a bubble in this sector.  Look no further than Tilray, Inc. (NYSE: TLRY).  Shares closed at US$148.30, (after briefly touching US$300 on Sept. 19th!).  Its EV is C$18 B.  That’s C$18 B for a company that had quarterly sales of ~C$12.6 M (~C$50 M annualized).  It’s trading at a run-rate EV/Sales ratio of 358x and a trailing 12-month EV/Sales ratio of 498x!  

Readers should note, it’s not just Tilray that’s overvalued.   There are 13 others in the top 50 trading at > 100x EV/Sales.  Among the 13 companies (the ones with sales as of June 30th) in the top 16, the average EV / trailing 12-months sales multiple = 146x.     

The bull argument for the cannabis / hemp sector is that since sales have barely begun flowing, one needs to look towards 2019 or 2020 operations to assess a company’s investment merits.  Eeven if revenues soar for the Majors, forward EV/Sales multiples would remain quite stretched.  For Tilray — if sales were to jump from the current annual run-rate of ~C$50 M to C$902 M (+1,700%), the EV would still be ~20x prospective sales.  

At what EV/sales multiples do global world-class Food & Beverage, Retail, Technology & Pharmaceutical companies trade at?  About 5x.  I believe that cannabis Majors will likely end up trading at 5x-10x sales in the next 2 or 3 years.    

A Massive Wave of M&A is Coming

Clearly, internal sales expansion alone will not propel Tilray to an attractive EV/Sales ratio.  Only a massive wave of M&A will save the top players from remaining massively overvalued.  As a thought experiment, consider Tilray’s valuation if it were to acquire the 10 companies in the top 50 with the lowest trailing EV/Sales ratios.  In that scenario, its EV/Sales multiple of 358x would fall to ~26x.  From a pro forma 26x multiple, a more realistic case could then be made for internal growth leading to a EV/Sales ratio under 10x

I argue that an aggressive, industry-wide, M&A strategy will be deployed by all overvalued cannabis companies.  That means there could be an appetite by the Majors to acquire many dozens of smaller peers.  The Majors, not just the top 10, but at least the top 20-30, have ample access to cash and banks offering them lines of credit.  Canopy Growth alone will have C$5 billion in cash after it receives an investment from Constellation Brands.  

But the problem is there are not dozens of companies with solid growth prospects and reasonable risk profiles to choose from!  Of the 230 names I’m monitoring, many have been riding the cannabis wave for a few years, but are now suffering from stalled revenue growth and/or weak or nonexistent profitability.  Others have blown out their capital structures (15 of the top 50 have > 250 M shares outstanding)

I believe that there are probably 20 or 30 highly desirable small cap names that the most overvalued players will be desperate to grab.  There will be bidding wars for the best of the bunch.  

Valuations to Fall While Top Takeout Candidate Share Prices Soar?

Readers should be looking for the companies most likely to be acquired in the next 6-12 months– those trading at low forward EV/Sales multiples, with clean balance sheets, attractive capital structures, strong growth prospects and reasonable risk profiles.  These select names could enjoy very substantial share price appreciation, even in the face of declining valuations among the Majors.

That’s why I’m focused on company #130 on my list of 230 names.  A company that has substantial blue-sky potential, albeit an investment opportunity that’s high risk (see risk factors below).  The Company’s name is Crop Infrastructure Corp. (“CROP”[CSE: CROP] / [OTC: CRXPF].  CROP operates like a REIT, investing, constructing, owning (typically 30% to 49% Interests) and leasing greenhouse projects by providing turnkey real estate solutions for hemp & cannabis producers & processors.  

The Company’s portfolio of projects includes cultivation properties in California, Washington State, Nevada, Italy & Jamaica and a JV on 2 California dispensary applications.  CROP has an active near-term revenue generating portfolio, including the development of Cannadrink, a cannabis-infused functional beverage, plus U.S. & Italian distribution rights to over 55 cannabis topical products and a portfolio of 16 cannabis brands.

Why do I like CROP?  

  1. Enterprise Value = C$56 M vs. an average EV of C$942 M of the top 100 names on my watchlist
  2. Multiple, diversified business segments, structured like a REIT, 100% non-Canadian operations (most opportunities in the U.S.) – California, Washington & Nevada are 3 of the best markets in the world
  3. Meaningful commercial sales to begin soon (4th qtr. 2018)
  4. Proprietary growing technologies & sophisticated methods will be used by CROP’s partners, leading to consistent, high-quality products produced at attractive and sustainable low cost  
  5. Trading at less than a 5x EV/2019 Sales ratio   
  6. Risk sharing business model entails working with multiple, diversified industry players
  7. Substantial exposure to the U.S. hemp market, a market poised to go crazy if the Hemp Farming Act of 2018 is passed (as part of a larger Bill) as soon as this month…. Management believes that CROP is #1 in  cannabis/hemp in the State of Nevada. 
  8. CROP has NOT already returned 500%+ to investors this year [20 of top 100 are up at least 500%
  9. Moderate # of shares:  117 M outstanding, vs. an average of ~232 M shares in my list of 230 peers
  10. Exposure to International markets: (Italy & Jamaica so far)

Due to the above mentioned attributes, CROP is a very attractive takeover candidate.  

Let me flesh out some of the above mentioned reasons why I like CROP.  First, the market cap.  This is important because there’s a lot more room for a C$56 M EV to double or triple than for a C$400 M+ company (the top 30 companies have EVs > C$400 M) to soar.  And, since a takeout is my stated endgame, there are many, many more suitors with the financial wherewithal to take out a C$56 M company than a much larger one. 

CROP’s commercial sales are expected to commence next quarter, while a large number of peers are still 2, 3 or 4 quarters from meaningful sales.  Overvalued companies, wildly outperforming the market, without any sales…. a recipe for disaster.  At the very least, one should fear material equity dilution in those cases.  

Hemp Could be the Biggest Winner of 2019, CROP Well Positioned

Industry pundits, most notably Chris Parry and his team at Equity.Guru are very bullish on hemp.  In fact, Equity.Guru is also bullish on CROP and on M&A picking up in the sector.  Blockbuster uses of hemp are coming from human & pet consumption in an ever growing list of medical and wellness applications.  

After nearly 50 years as a Schedule I federally controlled substance in the U.S., hemp is set to become a legal crop.  If passed, the 2018 omnibus farm bill (which includes the Hemp Farming Act of 2018) would allow cannabidiol (CBD) products to be legally sold in all 50 states.  If readers remember nothing else, remember this, it’s a BIG DEAL… Management believes that CROP has a #1 position cannabis / hemp in the State of Nevada. 

Crop Infrastructure Likely Trading at Under 5x 2019 Sales

Based only on existing business opportunities in California, Washington & Nevada, I believe that sales in CY 2019 could be well into the tens of millions of C$, (compared to an EV of C$56 M).  This suggests (my opinion only) that CROP is trading at < 5x next year’s sales.  Importantly, the sales figure for 2019 could be quite large, perhaps larger than the EV of the Company — but it depends on management execution and the timing of a number of corporate initiatives, especially CROP’s hemp opportunities in Nevada.  

What makes me so optimistic about Nevada?  Simple math.  Based on the number of controlled acres, typical yield/acre and current hemp flower pricing for high-quality CBD strands, (CBD content 10% to 18%) the upper range of sales possibilities gets really crazy.  While not a sure thing, this type of blue-sky upside should not be taken for granted, not every cannabis / hemp play has it. 

I will have a lot more to say next month as events unfold.  CROP has been active on the news front, press releases, (5 in September through Friday)….  I’m watching closely for ongoing corporate updates, but mostly I’m interested in management’s ability to generate revenue next quarter.  I never expect smooth sailing in the cannabis / hemp space, it’s a very volatile place, but if/when meaningful revenue starts flowing, I expect new investors (including institutions) might take a closer look at the Crop Infrastructure (“CROP”[CSE: CROP] / [OTC: CRXPFstory.  

Risk Factors

** CROP is thought to be on the cusp of significant commercial sales, (4th qtr. 2018), but the Company has no sales to date.  Delays in revenue generating activities is a substantial risk.  

** A large portion of revenues in 2019 are slated to come from hemp operations in the State of Nevada.  These operations are not yet up and running. 

** Numerous industry dynamics are undergoing seismic changes.  The situation in the U.S. is quite different than conditions in Canada.  A considerable amount of risk & uncertainty is beyond the control of even the best management teams. 

** In the U.S., growing/selling cannabis & hemp are illegal at the Federal level, but legal in select States like California, Nevada & Washington.  In some States it’s legal to use cannabis & hemp recreationally, in other States such use is only permitted for medical purposes.   

** Each State has its own set of laws, regulations, procedures, protocols to understand and comply with.  Failure to follow the rules could cause severe delays (or worse) in reaching meaningful commercial sales. 

** Entire indoor or outdoor crops (2-3 crop cycles per year) can be rendered worthless if they fail to pass stringent tests confirming high quality (no mold, low impurities). 

** There’s a great deal of debate about cannabis & hemp pricing going forward.  Risks are most likely to the downside.  

** There are hundreds of public & private cannabis & hemp-related companies, as well as illegal (black market) operations.  As such, it’s very difficult to analyze or truly understand potential new supply into the market.  If an unexpectedly large amount of cannabis or hemp comes online, pricing could more than just decline, it could collapse. 

** Cannabis & hemp related companies are highly speculative and the stocks are highly volatile.  For example, industry giant Tilray stock touched US$300/shr. in intraday trading on September 19th, but closed at US$148.30 on October 12th.  Bad news from one or more industry players could have a materially adverse impact on many other industry participants.  

Disclosures: The content of this article is for information only. Readers fully understand and agree that nothing contained herein, written by Peter Epstein of Epstein Research [ER](together, [ER]) about Crop Infrastructure Corp  including but not limited to, commentary, opinions, views, assumptions, reported facts, calculations, etc. is to be considered implicit or explicit investment advice. Nothing contained herein is a recommendation or solicitation to buy or sell any security. [ER] is not responsible under any circumstances for investment actions taken by the reader. [ER] has never been, and is not currently, a registered or licensed financial advisor or broker/dealer, investment advisor, stockbroker, trader, money manager, compliance or legal officer, and does not perform market making activities. [ER] is not directly employed by any company, group, organization, party or person. The shares of Crop Infrastructure Corp. are highly speculative, not suitable for all investors. Readers understand and agree that investments in small cap stocks can result in a 100% loss of invested funds. It is assumed and agreed upon by readers that they will consult with their own licensed or registered financial advisors before making any investment decisions.

At the time this interview was posted, Peter Epstein owned stock options in Crop Infrastructure Corp. and the Company was an advertiser on [ER]. Readers understand and agree that they must conduct their own due diligence above and beyond reading this article. While the author believes he’s diligent in screening out companies that, for any reasons whatsoever, are unattractive investment opportunities, he cannot guarantee that his efforts will (or have been) successful. [ER] is not responsible for any perceived, or actual, errors including, but not limited to, commentary, opinions, views, assumptions, reported facts & financial calculations, or for the completeness of this article or future content. [ER] is not expected or required to subsequently follow or cover events & news, or write about any particular company or topic. [ER] is not an expert in any company, industry sector or investment topic. [ER] may buy or sell shares in Crop Infrastructure Corp. and other advertising companies at any time.