Topic: Cannabis Investing
TSI Cannabis Investing Bulletins September 5, 2018
Bulletin 4, Volume 1
TSI Cannabis Investing Bulletins reports on two featured stocks with development projects: one a Canadian pharma stock teaming up with a major grower to develop a new delivery system for medical marijuana, the other a U.S. alcohol giant partnering with a big Canadian grower to develop cannabis-infused beverages. You also get insights on the investment outlook on soaring marijuana stocks; five timely news stories on cannabis; plus, our exclusive Cannabis Quality Ratings System for marijuana stocks, and more.
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Table of content
- Medical marijuana wafers show promise, but challenges remain
- Why soaring pot stocks should trigger investor “wariness”
- U.S. alcohol giant, Canadian grower team up for head start on cannabis drinks
- Cannabis in the news
- TSI Cannabis Quality Rating System
- Cannabis performance at a glance
Marijuana Producer
Medical marijuana wafers show promise, but challenges remain
This Ontario-based company is developing fast-dissolving wafers to deliver quick, smoke-free absorption of medical cannabis.
The stock rose when it announced an investment by one of Canada’s largest marijuana growers. Those funds will help it develop, make and market the wafers. However, the company’s products are in the early testing stages and still need approval from Health Canada. Even with the backing of a larger industry firm, this stock carries big risk.
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CTT PHARMACEUTICAL HOLDINGS, $0.67, symbol CTTH on the U.S over-the-counter bulletin board (Shares outstanding: 21.3 million; Market cap: $14.2 million; TSI Cannabis Quality Rating (CQR): 
; www.cttpharmaceuticals.com) is an Ontario-based developer of fast-dissolving film wafers that users can take orally to get a dose-specific, fast-acting and smoke-free delivery of medical cannabis or another active ingredient.
The company’s share price shot up as high at $2.17 after its announcement on May 22, 2018, that Aurora Cannabis, symbol ACB on Toronto, now has the option to acquire 9.14% of its shares. The stock has moved down since.
Aurora is investing in CTT by way of a $1 million U.S. 5% convertible debenture (essentially, an unsecured bond). It can convert this bond into CTT common shares at a price of $0.268 a share, for a 9.14% interest. The agreement also includes the issue of warrants that would let Aurora further increase that stake to 42.5% of CTT’s outstanding shares.
Under the agreement, CTT will give Aurora exclusive rights to develop, make and market its oral thin-film wafers globally. The companies will work jointly towards obtaining Health Canada’s approval to introduce those products. They’ll also work on winning the same kind of approve in other jurisdictions.
The debentures will come to maturity three years from their date of issue and will pay 5.0% interest. At any point before that maturity date, Aurora can choose to convert them into CTT common shares at a price of $0.35 per common share.
Under the terms of its initial investment, Aurora recently appointed one member to CTT’s board of directors. Upon achieving 42.5% ownership, it would also have the right to appoint a second board member.
Aurora’s board member is Dr. Dyck, a professor in the Department of Pediatrics at the University of Alberta and a Canada Research Chair in Molecular Medicine. In addition, Dr. Dyck is the Director of the Cardiovascular Research Centre and the co-director of the Alberta HEART. It’s a province-wide heart failure research program. Dr. Dyck is also an original director on the board of Aurora Cannabis.
CTT’s oral drug delivery systems consist of edible wafers that dissolve without water and within a few seconds after placement in the mouth. The company says its drug delivery system lets medication enter the bloodstream quickly and is convenient and discrete. CTT wafers also allow the cannabis to be administered anywhere.
CTT says that a faster absorption rate is achieved over other drug delivery methods—including edibles such as brownies and candies—because the mouth contains a very thin mucous membrane letting a drug pass quickly into the many blood vessels underneath. The company promotes the film wafers—and this medication delivery system—as free from bitter tastes and less likely to degrade the medication because it bypasses the stomach, and its digestive juices. That may allow for lower dosages. Patient compliance is also improved, especially for those who have a fear of choking or difficulty swallowing. That includes children, the elderly and the disabled.
In addition to marijuana, CTT hopes to use the wafers to release a variety of opioids such as morphine, fentanyl and codeine.
The company’s products are still in the testing stage, and it has yet to generate any revenue. As well, the medical benefits of marijuana haven’t been full proven. Final regulations around the cannabis industry in Canada, at least, are also still in development.
The deal lets Aurora buy into CTT through a debenture that pays it interest—other investors will not receive the same cash flow. Aurora can also buy shares of CTT way below today’s market price—and only if it chooses to.
Aurora’s investment in CTT gives it some speculative appeal and likely gives it the funds to keep developing its products until the end of 2019. However, this early-stage company entails huge risk.
CTT has a 1-Leaf Cannabis Quality Rating (CQR). We don’t recommend shares of CTT Pharmaceutical Holdings.
Investors who see promise in CTT’s products are better off participating in its prospects through Aurora Cannabis. We’ll take a close look at Aurora in an upcoming TSI Cannabis Investing Bulletin—but we do see Aurora Cannabis as a speculative buy for aggressive investors who want exposure to the marijuana industry.
Investment Outlook
Why soaring pot stocks should trigger investor “wariness”
It is hardly surprising that marijuana stocks are climbing as October legalization comes closer. But a boom in share prices also sparks “reasons for wariness,” especially with two troubling factors.
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Over the past few decades, we’ve built a list of what we call “reasons for wariness.” No single one of these factors is a sure sign of a bad investment. But we watch out for them when analyzing investments, especially where we find more than one.
When we spot reasons for wariness in a stock, we want to be sure that investors understand the risks.
Today’s soaring share prices for many cannabis stocks spotlight two wariness factors:
Stocks that have gone up far quicker than the indexes for several years make us wary. When companies create that much wealth, that fast, they often carry the seed of their own downfall. That’s especially true of top-performing stocks that owe their success to several other wariness factors. One common combo is dependence on acquisitions, coupled with a boom (or a streak of luck) in a highly unpredictable industry. Both are true of many of today’s cannabis stocks.
Outsized market cap in relation to sales and earnings. Many Canadian cannabis producers have very high “market caps” (the value of all shares outstanding). That means they need huge revenue and earnings growth to justify even their current stock prices.
We weigh and balance all of a company’s risk factors when recommending stocks. Our process demands a lot of judgment calls. We also sometimes recommend stocks despite the presence of one or more of these risks—such as Hydropothecary (see above).
But, at the same time, it’s important for investors to keep aggressive stocks with a number of risk factors—like marijuana producers—to only a small part of their overall stock portfolios. And to show the best long-term results, we still think investors should stick with our three-part Successful Investor program:
- Hold mostly high-quality, dividend-paying stocks.
- Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
- Downplay or stay out of stocks in the broker/media limelight.
Cannabis-Connected
U.S. alcohol giant, Canadian grower team up for head start on cannabis drinks
While a number of established companies are supplying the needs of the marijuana industry, others are taking a more active role in product development.
This company is the largest supplier of beer, wine and spirits in the U.S., with an increasing focus on premium brands like Corona beer. Its new joint venture with one of Canada’s largest marijuana growers may help offset an industry trend—flat beer sales.
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CONSTELLATION BRANDS, $209.25, symbol STZ on New York (Shares outstanding: 167.9 million; Market cap: $40.2 billion; www.cbrands.com), is an international producer and marketer of beer, wine and spirits. Founded in 1945, Constellation has more than 100 brands in its portfolio, owns 28 wineries, breweries and distilleries, and employs 9,600 people.
The company is the largest multi-category supplier (beer, wine, spirits) of alcoholic beverages in the U.S. and the third-largest beer company in the U.S. In fiscal 2018 (ended February 28, 2018), beer accounted for 61.4% of total revenue, wine 33.7%, and spirits 4.9%. International sales (primarily from Canada) accounted for only 3.4% of the company’s revenue.
Constellation’s well-known brands include Corona, Modela, Pacifico, Ballast Point, Funky Buddha, Robert Mondavi, Ruffino, 7 Moons, Svedka Vodka, High West Whiskey, Casa Noble Tequila, Black Velvet, and Paul Masson.
The company’s CEO is Robert S. Sands, and the Sands family holds controlling interest.
Constellation continues to position itself at the premium (high-profit-margin) end of the alcoholic beverage market.
Since acquiring exclusive brand rights to Corona in 2013, the company has invested $2.9 billion in its Mexican beer brands, including $800 million during fiscal 2018. Production capacity in Mexico has increased 315% during that time, from 10 million to 31.5 million hectolitres. The company recently introduced Corona Premium and Corona Familiar, two specialty brands aimed at the high-end beer market.
In its Wine and Spirits segment, Constellation has expanded its portfolio of higher-profit-margin brands through acquisitions: Casa Noble tequila in 2014, Meiomi wines in 2015, Prisoner super-luxury wines in 2016, Charles Smith wines in 2016, High West craft whiskeys in 2016, and Schrader Cellars in 2017.
The company entered the growing craft beer market by acquiring Ballast Point in 2015 and Funky Buddha in 2017.
In 2016, Constellation sold off its lower-margin Canadian wine business.
Largely as a result of its recent acquisitions, overall revenue increased 23.8%, from $4.87 billion in 2013 to $6.03 billion in 2014. It then rose 8.6% to $6.55 billion in 2015 and 11.9% in 2016 to $7.33 billion. Revenue again increased in 2017 by 3.6% to $7.59 billion.
Earnings jumped 39.0%, from $643.1 million ($3.25 a share) in 2013 to $893.6 million ($4.44) in 2014. Profit then rose 23.8%, to $1.11 billion ($5.43) in 2015 before jumping another 25.2% in 2016, to $1.38 billion ($6.76). Earning then rose 27.3% to $1.76 billion ($8.72) in 2017.
For the three months ended May 31, 2018, Constellation’s revenue rose 6.2%, to $2.05 billion from $1.93 billion a year earlier. Earnings fell 7.1%, to $433.3 million, or $2.20 a share, from $466.2 million, or $2.32. The decline came mostly from higher marketing expenses and transportation costs.
In November 2017, the company acquired a 9.9% stake in Canopy Growth Corp. for $190 million. The Canada-based firm sells cannabis products under the Tweed brand. The two companies plan to work jointly on cannabis-infused drinks in the future.
The partners aim to initially sell those drinks in Canada given expectations Ottawa will legalize edible and drinkable cannabis products as early as 2019. They will not sell those edibles (or cannabis itself) in the U.S. until the U.S. federal government changes its marijuana laws.
Canopy and Constellation will now expand their strategic relationship. On August 15, 2018, the company agreed to buy an additional 104.5 million Canopy shares at $48.60 a share, for a total of $5.1 billion. As a result, Constellation will then own 38% of Canopy. It will also nominate four directors to Canopy’s seven-member board.
As well, the company will receive warrants to purchase additional Canopy shares over the next three years. If it exercises those warrants (worth $4.5 billion in total), it will own over 50% of the cannabis company.
The alcoholic beverage industry is highly competitive and is threatened by a general decline in alcohol consumption. Constellation is particularly dependent upon its Mexican beer brands and brewing facilities. That is a significant source of risk given the trade tensions between the U.S. and Mexico. The company also faces risk from its growth-by-acquisition strategy.
However, Constellation Brands has successfully positioned itself at the centre of the premium market. As well, cannabis-infused beverages offer growth potential and the company hopes to be one of the first to market when these products eventually become legal. (Both Molson Coors and Heineken also aim to develop cannabis-infused beverages.)
Constellation’s partnership with Canopy Growth also gives the company a head start in the evolving cannabis-product industry—both in Canada and internationally as medical and recreational marijuana become legal in more and more countries.
The company holds cash of $210.0 million. Its $9.4 billion long-term debt is 23.4% of its market cap.
At the end of 2017, Constellation raised its quarterly dividend 42.3%, to $0.74 from $0.52, for a yield of 1.4%. The stock trades at 21.5 times this year’s forecast earnings of $9.60 a share.
Constellation Brands is okay to hold.
Cannabis in the news
As articles and opinions on cannabis pile up with just over a month to legalization, we select five articles from the past week that should have the greatest meaning for investors.
1. A group of medical marijuana dispensaries in B.C. has asked the province’s Supreme Court to block Vancouver licensing requirements, arguing the city has overstepped its jurisdictional bounds.
While the dispensaries have been operating illegally for years, in some cases, the City of Vancouver recently moved to shut them down. Winning licenses for their current locations is unlikely given many operate within 300 metres of another dispensary or a school or community centre.
A lawyer for the group argues that Vancouver’s distancing requirements are unconstitutional. They also believe the federal government must amend its Access to Cannabis for Medical Purposes Regulations to specifically protect medical marijuana stores.
2. A one-day, 28% drop in share price for a Canadian cannabis company is highlighting the vulnerability of some of the industry’s fastest growing stocks to short sellers.
Shares of Cronos (symbol CRON on Toronto) ended Thursday’s trading session at $11.77, losing $4.60 and a week’s worth of gains. The drop came after a U.S. short-seller accused the cannabis company of withholding details on the size of its marijuana supply contracts with several provinces.
Cronos has since recovered the ground it lost last week, but the sell-off points to the influence short sellers may have on Canadian cannabis stocks that have soared in anticipation of much stronger sales after legalization in October.
3. A leading U.S.-listed ETF—largely focused on Canadian cannabis producers— just experienced one of its biggest monthly surges.
ETFMG Alternative Harvest ETF (symbol MJ on New York) took in roughly $22 million in August. That represents its largest monthly inflow since February and also makes it one of the top performing U.S. ETFs in August, according to Bloomberg.
Of the 38 cannabis companies the fund holds, roughly 60% are Canadian firms.
Canadian cannabis stocks soared in August as the industry ramped up production ahead of the Oct. 17, 2018, legalization of recreational cannabis. High-profile investments in cannabis-infused beverages also contributed to the gains. Those investors include Constellation Brands and Molson Coors.
4. Cannabis producer Cronos Group Inc. has now partnered with a biotech company in an effort to genetically engineer some of the active compounds in cannabis.
The company and Ginkgos Bioworks—its partner in the $122 million deal—will first work to identify rare cannabinoids in the plant, which appear in low concentrations. They hope to then extract the DNA and produce the cannabinoids in a lab using a low-cost fermentation process.
If successful, the partners could use the lab-engineered cannabinoids for medical applications, including relief of chronic pain and nausea. Cronos shares gained as much as 16 per cent Tuesday on the news.
5. Researchers at the University of California are now preparing for the largest-ever scientific study of cannabis and its medicinal benefits.
The public consumption of cannabis has already outpaced scientific study of the drug, says Dr. Jeffrey Chen, UCLA’s director of the Cannabis Research Initiative. “We really desperately need to catch up.”
To start, Chen and a team of scientists aim to map marijuana’s effects on pain. Their goal is study patients who struggle with pain and are now on opioid painkillers such as oxycodone.
If researchers succeed at identifying cannabis as an effective treatment for pain, that could spare some patients from developing the kind opioid addiction many Canadians now grapple with.
TSI Cannabis Quality Rating System
Our Cannabis Quality Rating (CQR) considers a range of factors to determine the investment-quality rating for a cannabis producer. Individual ratings range from a 1-Leaf CQR—for stocks we believe lack almost all of the fundamental quality markers of even speculative cannabis stocks—to a 5-Leaf CQR for the highest-quality cannabis stock.
All told, we look at 13 factors in determining the quality rating of a marijuana stock:
13 QUALITY FACTORS
- Does this cannabis producer have rising revenue?
- Is its revenue stream significantly diversified?
- Is the company currently in production?
- Does the company have a sound balance sheet—cash and low debt?
- Does it have international operations?
- Industry prominence?
- Is the firm free from high dependence on a single customer?
- Does the cannabis producer have a prominent client list?
- Is its cost structure competitive?
- Is the stock’s market cap in line with the company’s sales (not an outsized market cap in relation to sales)?
- Is the company focused on organic growth rather than growth through acquisition?
- Has the stock’s price risen in line with the market average (not gone up faster than the market average)?
- Is the company outside of the broker media limelight?
Marijuana producers with most if not all of those factors earn a 5-Leaf Cannabis Quality Rating (CQR) for their sound investment quality and reasonable valuation compared to their current price and market cap.
Companies with many of these factors, receive a 4-Leaf or 4.5-Leaf CQR. That means they offer reasonable investment quality, but are somewhat overvalued at their current price and market cap.
Companies with a 3-Leaf or 3.5-Leaf CQR have a few of those key factors, which suggests they have reasonable investment quality. Still, they are likely overvalued at the current price and market cap.
Companies with a 2-Leaf or 2.5-Leaf CQR have a number of investment flaws and are very likely overvalued at the current price and market cap.
Companies with a 1-Leaf or 1.5-Leaf CQR have little investment quality and are almost certainly overvalued at the current price and market cap
Note: Even a 5-Leaf CQR is not the same as a BUY recommendation. In a new market where production is just now ramping up and both demand and supply are uncertain, most of these stocks lack fundamental value. Plus, most move up or down on the latest swings in investor interest and momentum regardless of their individual quality rating.
Cannabis performance at a glance
The HORIZONS MARIJUANA LIFE SCIENCES ETF (Toronto symbol HMMJ) invests in North American firms that are legally involved in the cannabis industry. Canadian companies—including Aurora Cannabis (12.1% of assets) and Canopy Growth (11.0%)—make up 80% of the portfolio. As such the fund’s performance—specifically, its Daily NAV* and trading volume—reflects the ups and downs of this country’s cannabis producers.
*Net asset value (NAV) per unit is the underlying value of the ETF’s stocks and other assets at the end of each trading day divided by the number of outstanding units.
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