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For the past couple of years, we and others pointed to better fundamentals and valuations for large American MSOs than for Canadian LPs, and the recent price performance illustrates just how quickly sentiment has shifted. In 2020, each of the four largest American MSOs by market cap has outperformed the largest Canadian LPs:
The separation is most evident by looking at the action over the past three months, with the four MSOs up 83-106% while the very best Canadian LP is up 23%:
Driving the separation, in our view, is a better appreciation of the financials of American operators relative to the Canadian LPs, optimism surrounding the expansion of state-legal programs and potential improvements in federal policy. Over the past few months, the Canadian LPs have reported lower revenue levels and growth, larger operating losses and big write-downs of inventory and even production facilities. The largest MSOs are on a tear, with likely three of them to report Q2 revenue in excess of $100 million. The table below, converted to American dollars, illustrates this point:
The 9 companies are sorted by the most recent quarterly cannabis revenue, with 4 of the top 5 spots belonging to MSOs, all of which more than doubled cannabis revenue in the most recent quarter. Not all of this growth was organic. The adjusted operating income, which does include impairments, indicates that all five Canadian LPs had lower income than the MSOs, two of which were profitable. We include market caps, which are based on fully-diluted in-the-money shares, and, with the exception of Canopy Growth, all of the MSOs have higher market caps now than the Canadian LPs.
We didn’t include net debt positions, but doing so would not change the conclusion here that investors are now valuing the largest MSOs above the LPs. Since Canopy Growth is the one exception, we note that the company does have net cash, but it also has been seeing the largest cash outflows. Cronos has substantial net cash, while Aphria has a small amount. Aurora and Tilray have net debt. Each of the MSOs has net debt, though it’s not particularly large relative to the market cap.
On Monday, Canopy Growth will be reporting its fiscal Q1, and the company is expected to have seen revenue up about 4% from a year ago and to see a rather large operating loss. It’s not clear to us why its market cap exceeds the combined total of its four peers, but clearly investors value the Constellation Brands strategic partnership. The more interesting question that investors will surely debate ahead is what is the right relationship between the valuations between MSOs and LPs. Clearly, revenue level, revenue growth and profitability favor higher valuations for the MSOs, and, with the exception of Canopy Growth, that is the case.
We remind our readers that cannabis remains illegal federally in the U.S., and this is something that valuations need to reflect. Taking that idea a bit further, it’s important to remember that American operators are subject to onerous taxation (280E). Further, federal illegality prevents American operators from pursuing some global opportunities. So, in our view, investors need to understand that there are some extra risks and costs that must be factored in when evaluating MSOs relative to Canadian LPs.
Looking ahead, we think the fundamentals will remain quite strong in the U.S. and improve in Canada, where LPs have been rationalizing their production assets and inventories as they adjust to the reality of a market that is less robust than they had anticipated. The roll out of new types of products and the expansion in the number of retail stores could help improve the fundamentals as well. Investors have clearly shifted their interest to the MSOs, but if the Canadian LPs are able to resume growth and continue to make progress in their cost structure, investors could be rewarded over time.
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