Introduction and Background:
The cannabis industry has arguably been one of the most talked about, but turbulent and testing markets in recent times.
Despite a scattering of activity throughout the rest of the world, particularly in Germany and Uruguay — Canada and the U.S. are where the bulk of the business buzz has been centered.
Cannabis in Current United States:
Divided opinions, politics and unknown health and societal implications have created much debate as to whether the drug should remain classified as a Schedule I Controlled Substance.
According to Business Insider, as of June 2019, just 11 states and Washington, D.C. have legalized cannabis for recreational use. While this trend suggests attitudes are shifting toward U.S. federal alignment with that of its northern neighbor, there is still a long way to go.
The seedlings of cannabis legislation may be starting to sprout if the current success of the “SAFE Banking Act”’s journey through the House and December 2018’s passing of the Farm Bill is anything to go by. The latter of which legalized the cultivation of marijuana’s coveted cousin and opened the door, not just for hemp farmers, but cannabidiol (“CBD”) entrepreneurs alike. Big beverage and tobacco companies have also thrown their hats into the ring to become a part of this emerging market.
Nevertheless, there is a lack of regulatory uniformity at state levels which has caused an array of confusion among the business, investor and consumer community. This makes it burdensome for new and existing operators to do business in different states, secure banking arrangements, ensure compliance and perhaps most importantly, differentiate from other not-so conformant entrants.
There have been little to no signs of distress in the global cannabis market with sky-high valuations, soaring stock sales and a multitude of M&A activity. Until now that is…
Marijuana Business Daily (“MBD”) recently reported on the slowing trend in M&A activity in September 2019 when only 16 deals completed versus 29 in the same 2018 period. Further, although the volume of capital raises was up by 10 raises versus the same period, the average value had reduced by $5 million per raise.
Also as reported by MBD, there was a net increase of 36 M&A deals in the nine months to September 30, 2019 however these were weighted toward Q1 of 2019 and, perhaps more interestingly is that 25 of those deals were in the private sector which is potentially an early sign of greater consolidation of smaller participants.
Indices data published by New Cannabis Ventures (“NCV”) shows that, in January 2018, the global cannabis markets were valued at $180 per unit but since then have been declining and, currently, the comparative indices is valued at just $42 per unit – a 77% decline which, despite the many variables and affecting factors, is hard to deny that the sector is experiencing a value correction.
The behavior of this market is hauntingly similar to the first dot-com gold rush during 1995 to 2001 when stocks were purchased based on buzz and hype but, fundamentally, not based on fundamentals such as profit and cash flow.
There is a similar reaction in the case of Cannabis company valuations. Hopes for federal legislation, cures for various ailments, CBD infused everything and high quality agricultural harvest has driven an unprecedented amount of capital into the sector for minimal returns outside of revenue and market share growth.
Data obtained from S&P’s Capital IQ shows that forty-two of the companies referenced in NCV’s index, have combined market capitalization of $32 billion but, in the last 12 months, generated just $3.7 billion in revenues and incurred $1.7 billion (almost half) of negative EBITDA. This is an average valuation of 8.6x revenues – something usually seen in tech companies. It’s hard to believe valuations like this are realistic, especially when only 10 of those companies generated positive EBITDA in the same period totaling $272 million.
In September 2019, New Frontier Data (NFD) estimated that legal U.S. cannabis sales will grow to $29.7 billion by 2025 , the sample mentioned above represents just 12.5% of that total, meaning these companies have some serious catching up to do if the estimates are to be realized, but this is also partly why investors are placing significant valuations on them.
While there are clearly some solid players out there with promising plans, committed shareholders and profit generation, the pricing data and cash flow trend defies traditional business and valuation logic, something which was also partly responsible for the reported $5 trillion investor losses in the dot com crash.
So what does this mean? It is unlikely that this is the beginning of the end for the sector. More so, it seems it is headed for a correction of value as, among other challenges, regulatory and tax burdens together with pricing compression inherent to the current oversupply and competition from the still very active illicit market erode profitability and cash flow.
For business models that are characterized by high operational leverage and require significant capital investment, these issues are likely to create distress for the less nimble participants and it is expected some casualties will be imminent.
For those that are cash generative and have additional access to capital or can weather the cash-burn through the point of federal legalization, there should be value opportunities ahead in the form of cross-sector collaboration and cross-border M&A activity between Canada and the U.S.
Whichever the case, and assuming regulation begins to unify, it seems that in the near future, there will be significant consolidation. The industry will emerge in a stronger position, take advantage of growth opportunities and global capital, and participate in one of the most innovative new industries.
Nick Welch, BFP FCA, FMAAT
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