Canaccord Genuity Group Inc (TSE:CF) Analyst Matt Bottomley on Cannabis M&A Activity

Canaccord Genuity Group Inc (TSE:CF) (OTCMKTS:CCORF) (FRA:C6U) Analyst Matt Bottomley shares his thoughts on recent M&A activity in the cannabis space. Bottomley breaks down HEXO Corp’s (TSE:HEXO) (NYSE-A:HEXO) (FRA:74H) announced acquisition of Newstrike Brands Ltd (CVE:HIP) (OTCMKTS:NWKRF) (FRA:0N8). He emphasizes that the deal provides HEXO with indoor cultivation, which is necessary to export to Europe, but provided no premium to Newstrike. This represents a significant issue for Tier 2 names, which might have to take smaller deals to grow with bigger names. Bottomley thinks MSOs are the best play for 2019 and believes that while Canadian LPs have greater international optionality, the global industry is a longer term play with more risk. Bottomley is not surprised Nelson Peltz’s deal with Aurora Cannabis Inc (TSE:ACB) (NYSE:ACB) (FRA:21P) sent the company’s stock soaring. Bottomley believes Peltz’s value as a strategic investor will be realized once the US cannabis market opens to international players.

Transcript:

James West:   I’m joined now by Matt Bottomley, the analyst from Canaccord Genuity. Matt, welcome back.

Matt Bottomley:    How are you doing, James?

James West:   Great, thanks. How are you doing?

Matt Bottomley:    Good, thanks.

James West:   Good. So tell me, Matt: what is there in the cannabis space that’s really got your attention this week?

Matt Bottomley:    Well, it’s been a busy few weeks, particularly on the M&A side. So we saw a – not a small deal, but sort of a tuck-in deal that HEXO – I keep wanting to call them Hydropothecary, but I think it’s an easier name, anyways – that HEXO did. So they bought Newstrike in a $200-million-plus deal. That kind of gave them some more, I think, some more provincial distribution, some more fishhooks out there to try and get their product, which is selling very well in Quebec, into other markets. It gets them some indoor cultivation as well, which, as you know, is very important if you want to eventually export into Germany or other international markets; typically, those markets call for EU GMP certification, and it’s, you know, almost impossible to get that in a greenhouse. So adding some indoor cultivation helps that.

But what was very interesting about that deal in terms of my read-through from it was, it was bought for almost no premium on Newstrike, and that’s nothing to speak from a negative standpoint on Newstrike as a company. But I think it goes to show, similar to last time when I was here and we were chatting, that if you’re not a leader in the space – and I consider HEXO to be one of those sort of Top 5 names in the space – there’s not a lot of market share left out there, at least in this first year.

So in order to make use of your, you know, indoor cultivation facilities that are all over Canada and some of these other names that are public companies, but still not in that Top 5, it might make sense to pair off with another larger producer, where you’re able to take their paper in exchange and then, you know, grow with them, as opposed to try and battle in what will eventually be a commoditizing market. So the no premium in the takeout bid, as well as the fact that I think that most of the market share is going to be going to the Canopies and the like of the sector, tells me, I think, that there could be a huge crunch with some of these, for lack of a better term, Tier 2 producers in the space in Canada.

James West:   Wow. A lot of the shareholders of Newstrike voiced their concern, their opposition, to the idea of there not being a premium, because that’s sort of the expectation in, you know, capital markets generally, is that if somebody takes you out there’s got to be a premium, and it’s usually around 20 percent, if things are well. So you’re suggesting that they should be happy, because just having the privilege of riding alongside HEXO’s success with HEXO’s shares should more than offset whatever short term premium they didn’t receive?

Matt Bottomley:    Yeah, I don’t have a view one way or another; I didn’t cover Newstrike before this on whether there should have been a premium baked in or not. But I think it does highlight the risk that it’s very unlikely that there’s a competitive bid process out there for many of these, again, Tier 2 producers, ff they’re able to get an offer in at that level. So I think it definitely might make sense for some producers, whether it’s HEXO or others, to take a smaller premium now if they’re hitched to a wagon that’s someone that could potentially be a leader in the sector overall.

And HEXO has about 30 percent market share in Quebec, and part of this deal is to help them branch out their overall market share, which I think is 10 percent if you do a weighted average on every state. You know, sort of the, A+B=synergies, right? So if you add in this company into the mix, I think they might be better off in the longer run. But I think it is a big of a red flag for everyone else out there that’s a, you know, medium-sized producer, that there may not be these lofty, you know, 50 percent premiums anymore, as the market continues to evolve.

James West:   Sure. Okay, so how do you, how do you sort of value the premium opportunity in the MSOs in the United States relative to the international landscape, at this point? I mean, I’ve just been hearing a lot of, or observing a lot of, growing competition in the Latin American space, for example, and I’m curious as to your – do you have any sort of sentiment towards Khiron Life Sciences, for example, who’s our client, by the way?

Matt Bottomley:    Yeah, I think Khiron’s a great company. We have another analyst, Kim Hedlin of Canaccord, who covers them. I think for all – and I know they’re not associated with a licensed producer – but I think a lot of the international opportunities out there, whether it’s Latin, whether it’s Germany, Europe, these are much, much, much larger opportunity sets than what the Canadian market is.

And you mentioned MSOs; MSOs have sort of optionality in more states that they can add to their portfolio, and that’s a smaller opportunity overall, but much, much, much more near term.

So we saw another M&A deal in the space, between Harvest and Verano; that was one of the largest deals we’ve seen in the space, and that puts them with the highest pro forma dispensary count. So although they’re not in, you know, Germany, Latin America, and we don’t have any indication of when they might be an international company – if ever, for these MSOs – they have over 120 pro forma dispensaries now that are going to be built out over the next year and a half, which is the most of anyone in the industry. So it’s a little easier to get your head around. You can sort of benchmark it, plus and minus it, if you don’t think they’re going to execute, and that’s up to any individual investor; but a lot of the international optionality that the licensed producer had, and that Khiron has, it’s a much longer road, which means there’s more risk associated with it.

So I think the MSO trade, which has been outperforming over the last couple of weeks right now, is much more attractive in the near term, let’s call it, 2019.

James West:   Sure. Okay, so the MSO trade is the most attractive for 2019. You sort of seem to have the impression that those international opportunities are bigger. I’m thinking of countries like Peru just announced its medical legislation. Peru’s got 32 million people, there’s nobody there servicing 32 million or whatever portion of the population 32 million would generate in terms of patients. So are those opportunities that you think yes, okay, MSOs now, but down the road, big sort of Latin American opportunities or big European opportunities like that represented by the fact that a country like Peru has just gone legal?

Matt Bottomley:    Absolutely. I mean, we’re sort of in reverse order here in terms of where the opportunities are. So if you were go to give, ten years out, the biggest market in the world is going to be ex North America medical, let’s say, as a totality. So that’s going to be the biggest market in the world.

The second-biggest market in the world is going to be the US, whether it’s Federally legal at that point or whether it’s still state-by-state. And then the third, in least the categories we’re talking about, is going to be the Canadian market, right? So obviously everyone right now is looking for the highlights in the earning statements; what are these LPs doing in Canada? And admittedly, there is some contribution in Germany, but that’s really all we can track right now. And then second we can track is the MSOs, and then third is the international.

So what we can see is actually a lot smaller than the overall opportunity out there. So there’s going to be, you know, I think, a lot of great investment opportunities, currently and in the future, in markets like Peru or, you know, pick your international market; but the trouble with it today is, you don’t really know how it’s going to get regulated. You don’t know how it’s going to be taxed. You don’t know how incumbents, or at least domestic economies, are going to be treated when it comes to rolling out those licenses versus allowing, you know, all these other, you know, publicly listed companies in Canada to come in.

So because of all of those unknowns, there might be a huge opportunity on an EBITDA level; but when you risk adjust for it, it might not be really worth much today other than optionality in something that’s great to cobble into an already-existing asset, which is what many of the licensed producers have in Canada. Not a bad strategy, in my view, to be, let’s say if you’re a Canopy, the Number One company in Canada in terms of the recreational market, and then have all this international optionality that potentially could be supported by Constellation’s involvement down the road.

Now of course, with a company like Canopy, you pay for that today, and there’s varying degrees of that throughout the whole opportunity set.

James West:   Interesting. That’s quite a great and thorough analysis. Okay, so then, what about in the, you know, we’ve seen Canopy Rivers and Canopy Growth are expanding their sort of portfolio in Canada, which suggests to me that the Canadian opportunity is not necessarily done yet – at least for the large incumbents. I was kind of surprised to see them making such a big deal out of that, you know, the fact that they’re going to be so active in Eastern Canada.

Matt Bottomley:    Well, there’s still, I’d say there’s still a lot to happen in the Canadian market when it comes to execution. I mean, I think there will be M&A as I mentioned before, where players that might be, you know, slightly lagging behind, and others that want to increase their overall size and scale, it might make sense for them to pair up to get some efficiencies, there. But there’s not a lot of big-ticket assets to buy, right? Right now it’s more in the execution: are you going to be able to get retail in Ontario, which I know is a very difficult process right now? Are you going to execute in, let’s say, a better market, like Alberta?

On the east coast, I mean, it’s obviously not overly material to the overall opportunity, but it still is a good niche to have. So I think there’s more execution to happen in Canada, and I think a lot of the cash on the balance sheets that still have hundreds of millions, and then Cronos and Constellation case, is 2.5 billion and 5 billion, there’s a lot of cash that can still be deployed and a lot of stock that can still be issued. And I think most of the opportunity sets that that will be deployed to will be international markets, and I bet they’d love it if it was US as well, but obviously right now it’s not available to TSX and NYSE-listed companies.

James West:   Sure. So the idea of riding a unicorn from infancy to billion-dollar-plus company in a relatively short time frame relative to other industries, is still alive, in your view, in the international context, definitely in the US context selectively, and in the Canadian context, very little is left for that massive value creation exercise now that it’s so mature?

Matt Bottomley:    Yeah. I would say that the problem, you know, with riding the unicorn, as you say, up to whatever, you know, tens of billions of dollars of market capitalization is, there’s still going to be turbulence on the way up, assuming that these are going to be the winners on a global scale. So as much as I think, if Canopy and – I’m just using them because they’re the largest – if they end up being the global leader, I mean, there’s multiple, you know, there’s 2, 3, 4, 5 times upside from where their valuation is today, which says a lot considering it’s almost a $20 billion company. But on the way up, you know, you could easily see a 50 percent reset in the Canadian market this year, right? Because people are only going to wait so long, you know, to get two, three, four quarters into the recreational market. If Germany and other international markets aren’t turned on, I mean, investor sentiment might go the other way. And in this sector, it can turn on a dime very, very sharply.

So as much as I think the leaders in this space still have upside in valuation, I think all investors should be expecting, at some point, there is going to be a reset to the downside. But it’s hard to know if that’s going to happen from current levels, or if they’re going to go up another factor before that happens.

James West:   Sure. And one of the other events that I don’t think we’ve had a chance to discuss in detail, is Aurora brought on Nelson Peltz as an advisor, and that immediately added $2 billion to $3 billion in market cap in the same week. Do you think that’s a reflection of an overreaction to Nelson Peltz’s contribution, or do you think it’s fair value, or do you think he’s going to add a lot more to that yet?

Matt Bottomley:    Well, it’s hard to say it’s fair value, considering just the quantum of, you know, they have a billion shares outstanding and it jumped up $2. So, but I don’t have an issue with it, and I’m not surprised that that happened, because one, Nelson Peltz brings a breadth of experience in consumer goods, right? With all of his exposure with Wendy’s and other CPG companies over the years. That’s where this industry is going. Also they disclosed, obviously, what the warrant strike price is, and I think people are, you know, jumping the gun a bit, saying okay, well, if he’s coming on board, he’s coming on board to be successful, which he’s a very successful investor. Then obviously that levels – so there’s almost a self-fulfilling element to that, and the stock price jumped above it.

The one thing I think it might telegraph that not a lot of investors are talking about, and again, I’m just speculating, is I don’t believe someone like Nelson Peltz is coming onboard for the Canadian opportunity. So that tells me he either a) believes, or could be both, a), believes that the international optionality, what Constellation is doing, is real, or b), eventually this is going to be brought to the US, and maybe Aurora is going to be a vehicle that it’d be favoured.

So if, for whatever reason, licensed producers were allowed to get involved in the US, that’s a great – then, I think his value as a strategic investor is well worth whatever the accretion was in value that day. But admittedly, when the stock jumped up $2, obviously it’s a bit more excitement than anything else, but I’m absolutely not surprised.

James West:   I thought there was a third option there, and that is that he’s already got an idea in mind, that that bringing him aboard was just a way to formalize his compensation for an idea that has yet to be announced. That’s all speculation, obviously.

Matt Bottomley:    Could very well be.

James West:   All right, great, Matt. We’ll leave it there for now; thanks so much for your participation. As usual, it was great, and we’ll have you back soon.

Matt Bottomley:    Yep, see you soon.

James West:   Thanks very much.

Original article: Canaccord Genuity Group Inc (TSE:CF) Analyst Matt Bottomley on Cannabis M&A Activity

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