High Hopes for a Pot of Green Gold
A budding trend that has caught our attention a while back is the increasing global acceptance of medical, and even recreational, use of cannabis.
Domestically, the legislative environment is also starting to look increasingly favourable to local growers and one of the standouts that fell under our crosshairs from our special report on the medical marijuana sector was AusCann Group Holdings (ASX:AC8). After meandering for much of 2017 the shares have surged this year, and it seems appropriate to determine whether the hype is indeed justified.
Recap & Recent Sector Developments
AusCann (ASX:AC8) was a part of our special report on the medical marijuana sector in October last year (FAT-AUS-842). The company was one of several in the sector which we briefly discussed. However, it was first on the list as it attracted our attention given the company’s strong management team, number of licences and strategic partnerships which made it one of the most well placed amongst other players to capture the growth on the horizon.
The company has been bid up recently with mergers & acquisition (M&A) speculation in the sector abounding. Talk has surfaced of a approach for Australian cannabis player, Cann Group (ASX:CAN) from its largest shareholder and Canada’s second largest cannabis company, Aurora Cannabis (TSE:ACB) which currently has a 22.9% stake.
However, we want to clarify that if there are any talks, it is still in a very preliminary stage based on Cann Group’s disclosure yesterday. Though any M&A activity does not directly affect AusCann, however, it sets a very important precedent considering that the company also has a large Canadian shareholder, Canopy Growth Corporation, which has an 11% stake, and where a takeover discussion could see significant share appreciation.
Furthermore, such ongoing media and even investor speculation, in our view, is highly warranted and timely given the recent developments in the space:
First of all, is the fact that The Greens political party is pushing to legalise cannabis use for all adults, compared to its current limit of medical use. Should this take place, the domestic market for cannabis would explode.
Next, and what we believe is the most relevant development this year for the local Cannabis sector is the new legislation pushed this January where the government amended some rules in the Narcotics Drugs Regulation 2016. This will allow growers to export their crop provided that they meet local demand.
This makes Australia the fourth country in the world to legalise export of medical marijuana after Uruguay, Canada and the Netherlands while being ahead of Israel. The most salient takeaway here is that it provides an incentive for players to scale up faster and bring product to market.
That aside, we believe that Australia has the potential to develop competitive advantages in processing cannabis, such as oils, sprays, tablets and patches considering the significant research activity done in this arena whereas countries near the equator (such as Colombia) have an advantage in just raw cannabis.
Again, the investment merit extends globally considering the potential market size. We’ve already noted its potential in our special report though there are new estimates from Grand View Research, a market intelligence provider, that the international medical marijuana market will quadruple in size to US$30 billion by 2021 and surge ahead to US$55.8 billion by 2025. This is captured in the graphic below:
Source: Grand View Research
The growing number of countries legalising medical marijuana will be the pivotal factor in increasing demand for cannabis over the coming years. While the increasing amount of M&A in the medical cannabis sector will provide outsized returns, especially for smaller players as the industry consolidates. Other minor sources of demand (and competitive advantage) would be the growing research and development (R&D) activities.
Brief Company Overview and Company Specific Updates
Moving on, we also briefly recap the company’s background. AusCann Group Holdings (ASX:AC8) is currently the only listed ASX company with the necessary licences required to cultivate, harvest, manufacture and distribute final dose form cannabinoid medicines.
These licences allow the company the option to build a vertically integrated business model to support its supply chain, a competitive advantage that cannot be overlooked due to numerous opportunities to optimise.
Source: AusCann (ASX:AC8) Website
Notably, it is also one of the only two listed cannabis players, alongside Cann Group, actively developing its domestic Australian operations which are estimated to be worth around $1 billion by 2020.
Having domestic operations while also having the potential to export overseas would position the company favourably as it can realise economies of scale while also spreading the risk around.
However, we reiterate that the company is still conducting clinical trials for its medical cannabis products. Nevertheless, the company is already paving the way ahead with its numerous strategic partners. The most easily remembered is Canopy Growth which is one of its largest shareholders, which has also granted AusCann royalty-free access to its intellectual property with its medical cannabis products. The companies also recently (24 April 2018) strengthened their partnership with AusCann receiving an import permit to receive finished cannabis oils from Canopy.
Other partnerships include the company signing a distribution agreement in 22 January 2018 with another listed player, Australian Pharmaceutical Industries (ASX.API), to distribute its products once available across API’s 5,700 pharmacies located throughout Australia. Another was a supply arrangement of raw materials with Knop Laboratories in Chile via its joint venture partner Fundación Daya among others.
Recent Financial Performance
Finally, we take a look at the company’s most recent financial performance covering its results for the first half FY18 (1H18) released last 28 February 2018. The company has yet to generate any revenues from its cannabis products as it is currently in the final stages of its clinical trials. Management notes that they expect to release the final dose form in late 2018.
Once the products are ready for manufacture, we expect a breakout 2H18 given the numerous strategic partnerships while also stepping forward to an increasingly favourable regulatory landscape. The company also ended the 1H18 with circa $12.3 million in cash while remaining well-funded to maintain R&D and other operational activities.
The graphic below summarises the 1H18 financial performance:
Source: 28 February 2018 Company Filing
Though as attracted as we are to AusCann’s potential and solid management thus far, we understand the substantial risks in investing in businesses that haven’t generated cash flow from operations. Furthermore, with the share price surging almost 4-fold since our initial look in the Special Report, we find that the company may be unreasonably expensive and at risk of coming under pressure from profit-taking when momentum drops.
Summary
The cannabis sector has once again fallen under sights with the recent developments in the space especially with the ongoing talks of M&A activity alongside an increasingly favourable regulatory landscape.
That said, AusCann Group Holdings (ASX:AC8) has caught our eye once more due to its experienced management team, R&D program, and partnership with the Canadian giant Canopy Growth Corp among others. We also view the company as one of the best positioned to benefit from the improvement in regulations with its licences and reach.
However, its shares have rallied very strongly whilst still not generating any operating cash flows making it difficult to pass in our value investing lens. As such and in the interim, we Traffic Light AusCann Group Holdings (ASX:AC8). We will continue to monitor developments, and will look for some de-risking of the investment equation.
