Covering Cannabis

We have initiated coverage of cannabis, an industry we forecast to grow by 9 times through 2030 amid widening legalization and increased participation for the U.S., Canadian, and international markets.

For the United States, recreational cannabis and medicinal cannabis have penetrated just 8% and 21% of their estimated markets, leading to our expectation for 25% and 15% compound annual growth rates through 2030, respectively. We expect six more states to legalize recreational cannabis and three states to expand commercial distribution. Furthermore, we expect the federal government will recognize states’ rights to decide legality.

For Canada, despite recent recreational legalization, cannabis has penetrated just 12% of our estimated market, setting the stage for a 20% CAGR through 2030. However, increasing competition from other countries could limit the opportunity for Canadian producers to $20 billion.

For the international market (which excludes Canada and the United States), we forecast market potential of nearly $43 billion and a 23% CAGR through 2030 as more and more countries recognize the benefits of medical cannabis.

Our Take on the Companies We Cover

Of the five cannabis companies we now cover-- Aurora Cannabis ACB/ACB, Canopy Growth CGC/WEED, Cronos CRON/CRON, Curaleaf CURLF/CURA, and Tilray TLRY--we think Aurora, Canopy, and Curaleaf offer investors attractive risk-adjusted upside at current prices. We assign all companies a no-moat rating and stable moat trend rating, as they will struggle to earn economic profit as they spend on growth in this early-stage industry.

Aurora Cannabis

Aurora Cannabis cultivates and sells cannabis in Canada and exports medical cannabis internationally. Our fair value estimates are $10 and CAD 13 per share. Our valuation is based on a 10-year explicit forecast that assumes a roughly 41% volume CAGR, about a 2% price CAGR, and a 2028 operating margin before plant adjustments of 35%.

Aurora is focused on becoming a large-scale, low-cost producer by expanding and optimizing its cultivation operations. Unlike its Canadian peers, Aurora has yet to enter a strategic partnership with a major alcohol, tobacco, or pharmaceutical company. It also does not offer investors any U.S. exposure.

Canopy Growth

Canopy Growth grows and sells cannabis in Canada and, to a lesser extent, global markets. Our fair value estimates are $54 and CAD 71 per share. Our valuation is based on a 10-year explicit forecast that assumes a 30% volume CAGR, a 4% price CAGR, and a 2029 operating margin before plant adjustments of 37%.

Canopy offers two unique advantages. First, it will acquire U.S.-based Acreage Holdings, a verticalized cannabis company in 20 states, for $3.4 billion immediately upon a change to federal law, giving it entry into the largest and most attractive cannabis market. Second, a strategic investment from Constellation Brands can help Canopy develop cannabis-infused consumer products.

Cronos Group

Cronos Group cultivates and sells cannabis predominantly in Canada and, to a lesser extent, global markets. Our fair value estimates are $11 and CAD 14.50 per share. Our model uses a 10-year explicit forecast that assumes a roughly 31% volume CAGR, a 3% price CAGR, and a 2028 operating margin before plant adjustments of 35%.

Cronos is expanding its capacity with plans to cultivate in Israel, Colombia, and Australia through joint ventures. Cronos also has limited U.S. exposure through a research and development partnership with Ginkgo Bioworks to produce cultured cannabinoids. In addition, Altria Group’s investment provides Cronos with an experienced partner to navigate strict regulatory environments.

Curaleaf Holdings

Curaleaf Holdings cultivates and sells cannabis in the U.S. with a presence in 15 states. Our fair value estimates are $10.50 and CAD 14 per share. Our valuation is based on a 10-year explicit forecast that assumes a roughly 36% revenue CAGR, a 3% price CAGR, and a 2028 operating margin before plant adjustments of 32%.

Curaleaf offers the advantage of pure-play exposure to the U.S. through a vertically integrated operation that includes cultivation, processing, and dispensary operations on the East and West Coasts. Unlike its Canadian peers, Curaleaf does not operate internationally, which is a disadvantage since the global market looks lucrative.

Tilaray

Tilray cultivates and sells cannabis in Canada and exports to 13 countries. Our fair value estimate is $40 per share. Our valuation is based on a 10-year explicit forecast that assumes a roughly 24% volume CAGR, a roughly 4% price CAGR, and a 2028 operating margin before plant adjustments of 30%.

Tilray has pursued options to improve its international and recreational competitiveness. It has expanded cultivation facilities to Portugal to supply European demand with cheaper production. A partnership with Anheuser-Busch InBev can help it create cannabis-infused drinks, while a partnership with Authentic Brands Group will help it market CBD products in the U.S.

What Helps and Hurts Cannabis Companies We don't believe any of the cannabis companies we cover have an economic moat. Although there appear to be potential sources of competitive advantage through intangible assets and cost advantage, several barriers prevent the companies from earning a moat in the medium term.

Regulation Intangible Assets We believe the most likely moat source would come from intangibles stemming from regulation. Cultivators and dispensaries require government licenses to operate in every market where recreational or medical cannabis is legal. As a result, companies with licenses could be protected from outside competition, helping establish pricing power. This could prove particularly true if holding an existing license provides an advantage for when new licenses are issued. History suggests this could be possible, as Illinois' early plans for recreational legalization would hand an advantage to companies with medical cultivation and dispensary licenses. However, even if this were the case, we see sustained positive economic profits for cannabis companies as unlikely over the next 10 years.

Challenges to Economic Profit Because the cannabis industry remains in the growth stage, we think that years of significant investment will be necessary. An extended capital expansion cycle through the next several years means that companies are unlikely to generate returns on invested capital in excess of their costs of capital.

Also, we see both governments and the black market squeezing cannabis cultivators and dispensaries and preventing economic profit generation. With national, state, and local governments reeling from budget problems, the emergence of cannabis as a legal product has come to be viewed as a funding panacea. For example, Washington state has implemented a 37% tax rate on recreational cannabis-- early evidence that governments, with full control over licensing, will attempt to maximize their economics.

All else equal, on the other end of the value chain, consumers would probably bear any government tax increase, as in the cigarette market. However, a large and accessible black market effectively serves as a price ceiling that consumers are willing to pay. When California legalized recreational cannabis with a relatively high tax, the legal market shrank as consumers moved back into the black market.

Companies that are involved in the cultivation and sale of cannabis have the least leverage against the government and consumers. Although there could be years of economic profit generation when supply has been slow to respond with expansions, we do not have confidence that cannabis companies could consistently earn economic profits over the next decade.

Brand Intangible Assets Potentially offsetting the challenge of generating economic profit from regulation intangibles, we think that the creation of brand intangibles would help cannabis companies pass increased costs to consumers, thus protecting their own economic profit. Alcohol and cigarettes are typically highly taxed, but producers have established strong enough differentiation and brand intangibles that consumers are willing to pay premiums.

Although the cannabis companies are attempting to strengthen their brands, we see the creation of a brand intangible within the next decade as unlikely. Canadian regulation restricts packaging to be bare and unexciting and bars direct contact between the company and dispensary workers who provide expert advice and help consumers select their cannabis. Advertising is possible in venues in which only adults will be present, but we think limitations create meaningful barriers to brand creation. We believe that the selection process in Canada will be more like selecting wine than liquor, in which the choice is made on qualities rather than brand.

Restrictions are laxer in the U.S., where there are fewer limitations on packaging and direct contact with dispensaries is allowed. While brand power may strengthen eventually, we think it is highly unlikely that any brand will be strong enough in the next 10 years to command pricing power.

First, because we anticipate that federal legalization will take a few years, cultivation and selling is limited to intrastate. This limits any brand creation to a local level for the next several years.

Second, although a strong relationship with a dispensary worker could provide an advantage, we think these workers would be loyal to whichever company last paid them, requiring significant marketing expense to maintain relationships and eroding economic profit.

Third, while typical consumer product companies, and even tobacco companies earlier in their history, have built brand recognition through advertising campaigns, we expect cannabis will face the same if not stricter limitations as tobacco in advertising in the U.S. We believe this makes it even harder for cannabis companies to build a recognizable brand, as opportunities to address the consumer will be limited. Under the Family Smoking Prevention and Tobacco Control Act, tobacco product advertising faces restrictions on outdoor advertising near schools and playgrounds, sports and entertainment brand sponsorships, and point-of-sale advertising, among others. Advertising on television and radio has been banned since 1971 by the Federal Communications Commission. Although tobacco companies spend roughly $10 billion in marketing in the U.S., roughly two thirds is spent on price discounts to reduce the cost of cigarettes to consumers. While this may help tobacco companies protect brand intangibles with its customers, we don’t think the same strategy could build a new brand intangible in cannabis.

As cannabis shifts from its traditional smoking form to infused drinks and food products, there may be potential for the creation of brand intangibles. However, we think the development and widespread distribution of regulator-approved infused products will take too long for a brand intangible to drive excess returns within the next decade.

Cost Advantage We think it is unlikely that the cannabis companies we cover will be able to establish a cost advantage. Because of the climate, most cannabis in Canada is grown either in greenhouses or indoors. Although this allows for higher-quality cannabis to be grown, these methods are also much higher cost because of the required lighting and climate control. Additionally, advantages in greenhouse and indoors can be much more easily imitated than geographic advantages that may be present in outdoor cultivation.

Cannabis grown in the Western U.S. in states like Oregon is grown outdoors. Without the need for as much equipment, costs are significantly lower, partially offset by fewer harvests and lower quality. However, labor is the single-largest cost of production for any growing method. Thus, countries with cheaper labor that have expressed a desire to establish a medical cannabis industry are likely to produce at a lower cost than any U.S. or Canadian cultivator.