Marijuana businesses and investors seeking higher returns and more potential are looking beyond Canada’s relatively small and highly regulated market, according to analysts covering the still-nascent industry.
“Many investors we have spoken to have begun to rotate capital from Canada to the U.S. on the fear that Canadian players will be unable to capture growth south of the border,” CIBC World Markets analyst John Zamparo wrote in a research note about Canopy Growth’s conditional acquisition of New York-based Acreage Holdings for an industry-record $3.4 billion.
CIBC World Markets is a subsidiary of the Canadian Imperial Bank of Commerce.
Zamparo said investors started looking south of the border after Canadian cannabis stocks went on a tear earlier this year.
“I think the impetus for that has been the valuation divergence between the two countries. That’s starting to close a little bit, but it still certainly exists,” Zamparo told Marijuana Business Daily.
“It’s a valuation advantage, for one. The second reason is not simply multiples but the belief that there are real operators south of the border with talented management teams, with meaningful experience in adjacent industries, whether that’s in alcohol, tobacco, pharmaceuticals.”
He said there are quality businesses in the United States that people want exposure to – and they generally come at a slightly cheaper price than businesses based in Canada.
“I don’t see an end to the movement from Canada to the U.S. soon, but that doesn’t mean the successful Canadian companies are not going to be well capitalized,” Zamparo said.
Bank of America Merrill Lynch – which recently initiated coverage of the cannabis sector – estimates that Canada makes up just 3% of the global marijuana industry.
Attractive U.S. targets
Zamparo said the legal status of cannabis in the United States is seen as a “temporary inconvenience” for a lot of investors, “and once there are indications that the laws are going to change federally, you’ll see a significant expansion for U.S. names.”
As a result, Canadian companies are going after targets that provide differentiated services or intellectual property – such as Canopy’s acquisition of U.S.-based hemp firm Ebbu.
There have also been examples of companies buying American assets on the condition there is a reversal of the country’s federal cannabis ban.
U.S. assets that have strong potential outside North America have also attracted interest.
“Sometimes it’s just exclusive of their U.S. operations. Canopy Rivers has deals with Headset and another with LeafLink, which is a B2B platform,” Zamparo said.
“For LeafLink, the deal was for their international operations, not their U.S. operations.”
Risk of capital diversion?
Canadian companies are getting the capital they need “for now.”
“A lot of the cultivators are well capitalized, but there are several that appear to be better capitalized than they truly are once you factor in their build-out plans in the next six to 18 months,” the analyst said.
And some of the companies may experience challenges in refinancing when they need more capital to grow different parts of their businesses.
But as the industry evolves, traditional forms of financing will become more common for cannabis firms.
Bank debt, for example, has been utilized by many more cannabis businesses today than in the past for fuel expansion.
“The traditional convert deal, whereby companies raise X amount of dollars with a conversion option and throw in warrants to investors, we’re seeing fewer of those,” Zamparo said.
“That’s a sign that investors have largely deployed a lot of the funds they’re going to deploy in the capital space, and secondly it’s because the industry is starting to mature and see more traditional forms of financing.”
Funding also will be more tied to performance in the coming months than it has in the previous few years.
“It depends on performance. I think if Canadian companies can start demonstrating competence in this industry and building out international operations, it will signal to investors they’re moving forward in a thoughtful way,” Zamparo said.
Capital still needed
In the Canadian market, areas that could draw attention from investors include retail, extraction and, to a lesser extent, cultivation businesses.
“The biggest and strongest of the sector probably don’t need additional capital for cultivation purposes,” Zamparo said. “But we’re learning as an industry that this plant is a lot more challenging (to grow at scale) than people thought.
“I think, in general, that’s probably true across the industry. More capital is needed to optimize the cultivation.”
Retail is still in build-out mode across the country. Any company that wants to become a nationally dominant retail chain will still likely need more capital to do it.
“Other parts of the industry need financing as well,” Zamparo said. “The extraction companies have been a frequent topic of conversation of late.
“Derivative products are going to be key to unlocking this industry. A lot of these larger licensed producers don’t have the capacity to do extraction on their own, so many of them have outsourced it to dedicated extractions companies, who will need capital to build out their operations to address that demand.”
Matt Lamers can be reached at [email protected]