Peter Epstein Blog | #Cannabis Majors To Spark M&A Bonanza, Who Will They Acquire? | Talkmarkets
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#Cannabis Majors To Spark M&A Bonanza, Who Will They Acquire?

Date: Monday, September 24, 2018 2:34 PM EST

#Cannabis Sector Overvalued, but Strong Takeout Candidates Could Soar

Most of the top 50…. #cannabis (#weed / #hemp / #marijuana)– related stocks are overvalued, some wildly so.  I’m tracking 198 Canadian & U.S.-listed companies.  As of Friday, September 21st, the top 10 had a combined Enterprise Value (“EV”) [market cap + debt – cash] of C$61.4 billion, or C$6.1 B per company!  The 50 largest had a combined EV of C$78.6 B, an average C$1.6 B per company…. (see charts).

Make no mistake, there’s a bubble in this sector.  Look no further than Tilray, Inc. (NYSE: TLRY).  Shares closed on Friday at US$123, (after briefly touching US$300 on Wednesday!).   Its EV is C$15 B.  That’s C$15 B for a company that had quarterly revenue of ~C$12.6 M (~C$50 M annualized).  It’s trading at an EV/Sales ratio of 292x and a trailing 12-month EV/Sales ratio of 409x!  Readers should note, it’s not just Tilray that’s overvalued.  There are 15 others in the top 50 trading at > 100x EV/Sales, those 15 sport an average trailing 12-month EV/Sales multiple of 310x

The bull argument for the cannabis / hemp sector is that since sales (revenues) have barely begun flowing, one needs to look towards 2019 or 2020 operations to assess a company’s investment merits.  However, even 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 C742 M (up ~1,372%), the EV would still be ~20x prospective sales.  

At what EV/sales multiples do global world-class Food & Beverage, Retail, Technology and 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 409x would fall to ~30x.  From a pro forma 30x 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 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 198 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 (14 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.  

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