How To Capitalize on Canada’s Cannabis Consolidation

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Canada has been the center of attention for cannabis investors over the past three years, ever since Justin Trudeau and the Liberal Party won control of the government with a promise to legalize as part of their platform. That promise is scheduled to be fulfilled on Oct. 17, when Canada’s adult-use cannabis market is set to open.

Billions of dollars have been raised to fund cultivation facility buildouts, and Canadian cannabis stocks have seen meteoric rises in prices. Here is the action since the end of 2015, as illustrated by the New Cannabis Ventures Canadian Cannabis LP Index, which has increased 664% despite a recent correction:

Canadian Cannabis LP Index, 2016 – present

Source: New Cannabis Ventures

Health Canada has issued a total of 115 licenses, with some licensed producers (LPs) holding multiple licenses. There are now 40 publicly-traded companies in the sector, many of which began trading this summer. Those include Tilray (NASDAQ: TLRY), which is owned by Leafly parent Privateer Holdings, as well as several smaller, lesser-known entities.

While the total number of LPs and publicly-traded LPs has been rising, some have been disappearing too. There have been several mergers, with the pace increasing lately. Investors should focus on this trend, in my view, as we are likely to see more ahead.

The Reasons for Consolidation

The oldest of the Canadian LPs are only five years old. None had commercial activity prior to 2014. As any market matures—especially a market served by so many startups—many of the aspiring companies won’t make it. As winners begin to emerge, they typically put weaker rivals out of business or acquire them to build out their offerings.

Smaller companies begin to worry about how they will compete. If they can’t do so on price, they must create a value proposition that will allow them to stand out, like focusing on a niche.

There are several dynamics specific to the Canadian market that will impact the success of a company. Those include geographic location, mode of production, international markets focus, expertise, and access to capital.

Much of the consolidation thus far has been initiated by larger companies seeking to diversify their production, and by smaller companies wanting to partner with companies with a proven ability to raise capital and navigate the public markets.

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Recent Transactions

The first deal took place at the end of 2015, with Canopy Growth (TSX: WEED) (NYSE: CGC), a client of mine at New Cannabis Ventures, acquiring Bedrocan Cannabis. That deal allowed Canopy Growth to position itself with a more “medical” brand.

Canopy Growth, Aurora Cannabis, and Aphria have all closed major deals recently, and Tilray went public in July.

The company followed up with the early 2017 purchase of Mettrum, which gave it additional manufacturing capacity in Ontario, opened the door to a “health and wellness” brand, and added lots of medical patients. More recently, it announced the pending acquisition of Hiku Brands (CSE: HIKU) (OTC: DJACF), a client of mine at New Cannabis Ventures, to enhance its retail presence.

Canopy Growth’s strategic alliance with Constellation Brands (NYSE: STZ), which invested C$245 million for a 10% stake with a warrant to double the position at the same price at the end of 2017, had a game-changing impact on the pace of industry consolidation.

Following that deal, Aurora Cannabis (TSX: ACB) (OTC: ACBFF), a client of mine at New Cannabis Ventures, made a successful bid to acquire one of its largest rivals, CanniMed. Earlier in the year, Aurora Cannabis had bought a Canadian applicant (and now LP) out of bankruptcy, and it went on to buy yet another large rival, MedReleaf, in 2018. That turned Aurora into the current leader in terms of revenue, just slightly ahead of Canopy Growth.

Earlier this year, Aphria (TSX: APH) (OTC: APHQF) bought highly regarded Broken Coast, a privately-held LP with an indoor cultivation facility in British Columbia. Alliance One International (NYSE: AOI) acquired a 75% stake in LP Canada’s Island Garden, the first move by a tobacco company into the space.

Within the past few weeks, there have been two deals that can be viewed as mergers of similar-sized, relatively small LPs, both clients of mine at New Cannabis Ventures. First, Emblem (TSXV: EMC) (OTC: EMMBF), an Ontario-based indoor grower, announced a pending deal with Natura Naturals, a privately-held Ontario-based greenhouse grower in a deal that will allow it to shelve its own plans to build a greenhouse. Last week, VIVO Cannabis (TSXV: VIVO) (OTC: ABCCF), which changed its name from ABcann Global, announced a deal to buy Canna Farms, which will boost its revenue dramatically and expand its presence from Ontario to British Columbia.

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What’s Ahead

I don’t anticipate that Canopy Growth or Aurora Cannabis will to continue to buy up their rivals. Instead, I expect three types of transactions to take place.

First, I expect to see more mergers of equals. The main driver of these transactions is the basic math of “buy vs. build.” In many cases, it’s safer and more economical to abandon new builds in favor of existing licensed operations.

Expect more involvement by Big Tobacco. We should also see the first investment by Big Pharma.

The second and most interesting type of M&A deal I expect to see will be more cross-industry investment. We’ll see more involvement by Big Tobacco, and we will also see the first investment by Big Pharma. The recent approval of cannabis-based pharmaceutical Epidioloex, which was developed by GW Pharma (NASDAQ: GWPH) has likely sparked interest, and many LPs in Canada are pursuing pharmaceutical approvals in Canada for unique formulations of cannabis for specific medical conditions.

Canopy Growth, for instance, is in the process of acquiring its R&D arm, Canopy Health Innovations, which aspires to file new drug applications with the FDA. Tilray and CannTrust (TSX: TRST) (OTC: CNTTF) have forged strategic partnerships with pharmaceutical companies as well.

In Canada, Big Pharma has an easy path to conduct clinical development, and several companies are already on that path. My top pick for an acquisition is CannTrust, which has a medical focus and the best valuation among those companies that have scaled production.

Finally, Tilray, with its newly public and, in my view, expensive currency in its stock, could emerge as a consolidator. It currently has two facilities, with indoor operations in British Columbia and a greenhouse in Ontario.

Bottom line: We will likely see more mergers and acquisitions among the Canadian LPs. Investors can participate by identifying companies that could be appealing to cross-industry or cross-border acquirers. Beyond being acquired at a premium, some of these companies may also benefit from strategic partnerships and/or minority equity investments. Another potential beneficiary of consolidation could be smaller LPs that offer strategic value to rivals trying to expand more rapidly.

Next up: I discuss some of the companies planning to go public in the near future

As an owner of New Cannabis Ventures, Alan works with several publicly-traded and privately held cannabis companies as he discloses here. In the event he mentions a company that is a client, he will disclose it in the article as well.