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Is A Consolidation Wave Looming Over the Canadian Cannabis Industry?



Elliot House & Gabriel Kay Goh


 

- MedMen (CNSX: MMEN) a US-based company which cultivates and sells recreational marijuana has acquired PharmaCann, which sells medical-only marijuana. This was an all-stock transaction valued at $682M and the largest transaction in cannabis history. PharmaCann shareholders will own approximately 25% of the combined company at closing. At a macro perspective, while Canada now optimises upon its new recreational market, the scale of this boom may soon plateau, with the US still set to lead the global market with an estimate of 73% of total revenue by 2022. 4 times greater than Canada with $23.4B compared to $5.5B. However, we must first look at the context of the climate.


Currently, there exist two main cannabis markets - recreational and medical, (of which state legalisation in shown in figure 1 below). While the medical market remains largely smaller than the recreational market, especially in states where recreational cannabis is legalised (it is often a lot harder to obtain cannabis- related products through medical channels as a prescription is needed). The medical market has more potential for growth, which is shown in figure 2 whereby the recreational market is predicted to remain stagnant while medical uses are set to boom over the next six years, (research from GVR).


Figure 1

Source: Skye Gould

Time for the industry has never been better. Canada became the 2nd country to fully legalise marijuana earlier this year and since has experienced a ‘flight to profit' as US medicinal companies rush the border to gain valued market share. There are now 90 publicly listed companies in Canada with a market value of about $31B, with the largest being Canopy Growth Corporation, (CGC) with a market capitalisation of $10.53B. From 2017 to 2019, consumption is set to increase by 28% from $4.19B to $5.36B. However, State-side it is a positive but still an evolving story with a recent poll from Gallup stating that 66% of Americans are now supporting legalisation, (this at a growing rate of 2% a year). With continued support from Democrats and Republicans alike, the topic is no longer the partisan issue it used to be, and many estimates believe legalisation will take place in the next 5 years. The deal itself adds tremendous strategic value to MedMen, which follows a vertically integrated business model, allowing it to expand its footprint across important growth markets while strengthening their cultivation and production capabilities.

The size of this synergy optimizes MedMen's market share with not just consumers but legislators too who ultimately provide licenses. This will fit with PharmaCann’s distribution of its other cannabis brands that allow it to get past regulations and increase production capacity in its supply chain. PharmaCann also has high brand recognition in the medical cannabis industry and will provide other avenues for products in different industries of the market.

Meanwhile, MedMen also has its own "State-made" brand products, where they are grown in the specific state it is sold. This allows for MedMen to leverage PharmaCann's existing operations and accelerates these products to market. The industry experiences

frequent supply chain shocks, yet MedMen has been relatively efficient in dealing with these issues due to its business model.


We feel that following an integrated business model in this industry has its merits. In an industry with the highest forms of regulation such as marijuana, lawmakers encourage companies to use vertical integration in their business models, as it reduces the need for greater regulation across smaller business sectors. However, compared to competitors, MedMen’s has prioritised optimising this strategy and thus suffered drawbacks on profits due to the excessive spending to open both supply growers and retail stores for the business. From this commitment, it seems that MedMen is focused on cultivating brand loyalty and distinction as a strategy to its success. These goals display many similarities to Apple and MedMen follows suit in their high-end retail stores. These stores follow an open and minimalist design trend which enhances the consumer’s experience with touch screens displaying pictures and information of products, while specialist ‘Budtenders’ roam to provide personal advice, (reminiscent of Apple’s ‘Genius Bar’). Research from Deloitte stated that 51% of potential users would prefer a private retail store as their preferred purchase channel. This is opposed to 30% of a retail website and 21% of a retail store app. With the products sold manufactured illegally until now, many consumers are still wary of purchasing this through the correct channels, and so a known registered brand is looked upon better. Furthermore, many potential consumers have not tried marijuana before and so meeting a specialist face to face puts these queries to ease. From this, MedMen is in an optimal market position to create this brand orientated growth.

Interestingly, there lies causation between the decline in alcohol sales, (average drop of 15%) and the introduction of medical marijuana in a given state, (from a study taken across a 10-year period). With a decline in alcohol sales, marijuana companies are looking to benefit from the growing proportion of edibles in the market. In the same study by Deloitte, 51% of potential users displayed interest in consuming baked goods such as brownies and 31% of the same group in beverages. Competitors have made substantial investors already with Heineken introducing THC-infused sparkling water through its subsidiary Lagunitas and Constellation brands, (producer of Corona and other wine & spirits) investing $4B to claim a 38% stake in Canopy Growth Corporation in for a new beverage. Constellation will also have the opportunity to acquire CGC in the next 3 years, utilising warrants to buy up to a 78.8% stake in CGC. These investments are yet to generate any real returns as the majority of products are still in R&D, however, could potentially lead to significant market share in what will lead the ‘potential user’ market with 60% of new users willing to consume in Canada alone. Canopy Growth Corporation is focused on the Canadian market, and so there is potential for major beverage companies to work with US-based ones such as MedMen to introduce similar drinks in the US market. With MedMen recommended to optimise this trend to increase its R&D into this market, it is certainly possible for them to do so.


Lawmakers encourage companies to use vertical integration in their business models, as it reduces the need for greater regulation across smaller business sectors. However, compared to competitors, MedMen’s has prioritised optimising this strategy and thus suffered drawbacks on profits due to the excessive spending to open both supply growers and retail stores for the business. From this commitment, it seems that MedMen is focused on cultivating brand loyalty and distinction as a strategy to its success. These goals display many similarities to Apple and MedMen follows suit in their high-end retail stores. These stores follow an open and minimalist design trend which enhances the consumer’s experience with touch screens displaying pictures and information of products, while specialist ‘Budtenders’ roam to provide personal advice, (reminiscent of Apple’s ‘Genius Bar’). Research from Deloitte stated that 51% of potential users would prefer a private retail store as their preferred purchase channel. This is opposed to 30% of a retail website and 21% of a retail store app. With the products sold manufactured illegally until now, many consumers are still wary of purchasing this through the correct channels and so a known registered brand is looked upon better. Furthermore, many potential consumers have not tried marijuana before and so meeting a specialist face to face puts these queries to ease. From this, MedMen is in an optimal market position to create this brand orientated growth.


Interestingly, there lies a causation of the decline in alcohol sales, (average drop of 15%) when medical marijuana is introduced in a given state, (from a study taken across a 10-year period). With a decline in alcohol sales, marijuana companies are looking to benefit from the growing proportion of edibles in the market. In the same study by Deloitte, 51% of potential users displayed interest in consuming baked goods such as brownies and 31% of the same group in beverages. Competitors have made substantial investors already with Heineken introducing a THC-infused sparkling water through its subsidiary Lagunitas and Constellation brands, (producer of Corona and other wine & spirits) investing $4B in Canopy Growth Corporation in for a new beverage. These investments are yet to generate any real returns as the majority of products are still in R&D, however, will claim significant market share in what will lead the ‘potential user’ market with 60% of new users willing to consume in Canada alone. Canopy Growth Corporation is focused on the Canadian market and so there is potential for major beverage companies to work with US-based ones such as MedMen to introduce similar drinks in the US market. With MedMen recommended to optimise this trend to increase its R&D into this market, it is certainly possible for them to do so. The acquisition of PharmaCann was an all-stock transaction which we view positively compared to fuelling the acquisition via debt. This is backed by MedMen’s considerably lower leverage ratio, with a Debt/Equity Ratio of 0.5578, (55.78%) compared to Canopy Growth Corporation at 0.73, (73%) and the industry average at 1.12, (112%). With a lower leverage ratio, MedMen is in an ideal position for an expansion into the edibles market. While Canopy Growth Corporation was a target of investment, MedMen could pursue a different strategy through the creation of a subsidiary and then partnering with a beverage company such as Coca-Cola to supply its growers to the drinks. This idea is not farfetched given that Coca-Cola displayed interest in the market only this year. With increased competitive pressure, this recommendation would allow MedMen to catch up with competition in the event that they fall behind in this valued sector, using the resources they currently possess.

The acquisition of PharmaCann was an all-stock transaction which we view positively compared to fuelling the acquisition via debt. This is backed by MedMen’s considerably lower leverage ratio, with a Debt/Equity Ratio of 0.5578, (55.78%) compared to Canopy Growth Corporation at 0.73, (73%) and the industry average at 1.12, (112%). With a lower leverage ratio, MedMen is in an ideal position for an expansion into the edibles market. While Canopy Growth Corporation was a target of investment, MedMen could pursue a different strategy through a corporate partnership with a beverage company such as Coca-Cola to supply its growers to the drinks. This idea is not farfetched given that Coca-Cola displayed interest in the market only this year. With increased competitive pressure, this recommendation would allow MedMen to catch up with competition if they fall behind in this valued sector, using the resources they currently possess.

Figure 2


Source Data: Grand View Research

However, looking deeper into MedMen’s finances paints a far more concerning picture. While sales in F2019 Q1 grew 1094% to $21.5M from F2018 Q1 ($1.8M), net losses ballooned this at $66M, a near equal rise of 1100% from $5.5M. Just in November, their equity offering was reduced from $89.7M to $56.06M (-37.5%) which saw MedMen's stock drop by more than 20%. Not forgetting that MedMen only recently went public through a reverse takeover on the Canadian stock exchange and has had many large capital financing rounds since it is no surprise why investors are concerned about the financial health of the company. Besides, their CFO left in the middle of their financing round, adding to the concerns of the investors. It seems like MedMen is a culprit of reckless spending. Cheap money has likely caused the company to over-extend itself by committing to too many openings and overspending in many other acquisitions in a short period, taking out a fixed loan of $70.9M to acquire single pharmacies and medical dispensaries, regardless of the PharmaCann deal. MedMen is also currently the single largest financial supporter of progressive marijuana laws at all levels, giving directly to pro-legalisation groups, industry organisations, and political candidates.


While we believe that this deal was needed from a strategic standpoint to increase and gain market share in the early stages of different segments of the industry, it is important that the company re-evaluates their operating strategy going forward. Furthermore, although the edible and beverage market is extremely appetising regarding the profitability and high- potential the market will carry amongst new consumers, (as well as MedMen’s low equity ratios) given MedMen’s financial situation we do not recommend expansion into the market at this given point in time. Instead, creating relationships with major food and beverage companies may allow future partnerships to provide an entry point into the market. Restructuring solutions and consolidating internal financial stability is by far the biggest challenge to overcome if MedMen is to become not just an industry leader, but a profitable one at that. Ultimately, planning for the future is of no use when you cease to exist in the present. Therefore, while this deal is good for MedMen strategically, its financial rewards are yet to be seen. However, in prospective terms, the deal acts as a leading indicator of a consolidation wave that could be witnessed by the industry.


 

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