Description

Long OGI CN

Overview

·         Canadian licensed marijuana producers are trading what seem like high-growth multiples for a medical-only business (~10x ’16 revenue and ~5x ’17 revenue), but low-growth multiples given the significant recreational opportunity over the next 18m (e.g. ~1x potential 2019 revenue).

·         These companies have all traded up as Canada has gotten closer to legalizing Recreational Marijuana, particularly after Prime Minister Trudeau’s election last year, as legalization was one of his five biggest platform issues.

·         The sector received another boost recently in late May following positive comments by Canada’s Bill Blair, the minister in charge of leading the task force studying legalization. Blair was optimistic in his view of Medical Marijuana companies’ ability to safely dispense Marijuana, and his comments were interpreted as foreshadowing future Canadian Government regulations that would effectively give these Medical Marijuana companies a head start into the recreation field.

o   Sentiment toward recreational marijuana has not switched from being an “if” to a matter of “when” as many see legalization as inevitable at this point and the expectation is the creation of bifurcated market similar to that of Colorado.

o   Upcoming action by Parliament is expected in August of 2016, with most expectations that recreational marijuana will officially be legalized sometime next year and that initial sales will begin to occur in late 2018 to early 2019.

·         Of the 4 major licensed marijuana producers, we think Organigram offers the best risk/reward, given its recent inflection to positive operating free-cash flow (before growth capex), strong capitalization and expansion capacity, low eastern-Canada cost base, non-existent regional competition, solid management and in-line valuation (e.g. versus highly-valued comp Canopy).

·         Further Organigram trades at a discount to Canopy (Aka Tweed) and is better positioned to capitalize on the recreational market relative to its medically focus peer Aphria. Meanwhile, Mettrum has yet to show investors much evidence of execution as it has been plagued by growing issues despite significant capital investment.

·         We see $2 per share intrinsic value for OrganiGram based on Medical Marijuana growth and assuming no recreational legalization (nearly 100% upside from current levels), but think that legalization could boost the stock 5 – 10x current levels assuming OGI maintains similar market share in the expanded market.

Industry Background

·         In 2000, Canadian courts ruled that Canadians had a constitutional right to Medical Marijuana and in 2001 Canada implemented its first set of Medical Marijuana (MMJ) regulations titled Marijuana Medical Access Regulations (MMAR) giving access to patients with afflictions such as HIV and other illnesses.

o   Under this framework, patients could obtain MMJ one of three ways,

§  Produce under a Personal Use Production License,

§  Designate an individual to produce under a Designated Person Production License,

§  Purchase dried marijuana from Health Canada (HC) directly, which contracted a private company - Prairie Plant Systems Inc.

o   According to HC data, most patients (~2/3rds) chose to produce their own, with ~20% used Prairie Plant Systems and the remainder chose to designate someone else to produce 

o   Under the MMAR program, enrollment grew from ~500 people in 2002 to nearly ~39K by the end of 2013 and there were an estimated 3+ million marijuana plants growing in Canada.

§  This began creating concerns about compliance and HC’s ability to manage the program given HC had only 15 inspectors for over 30,000 grow operations.

·         In 2013 and 2014, the industry shifted as new regulations changed access rules and shifted to licensed commercial growers from homegrown operations as the updated Marijuana Medical Purpose Regulations (MMPR) came into effect on April 1, 2014 and the old MMAR rules were removed.

o   The main objective of the MMPR was related to safety, as the new framework was designed to reduce risks associated with prior program while providing an enhanced distribution network that allowed for higher quality standards along with greater scrutiny and compliance.

o   Patients now obtain a prescription from a physician, stating quantity of grams permitted per day vs. prior regulations that required a license to possess MMJ.

o   Licensed producers (LPs) register patients directly and ship medicine direct to the patient’s home. There are no legal dispensary store fronts under the MMPR.

§  To change LPs, patients must basically get a new Rx and register at a new LP

§  Although Direct to consumer marketing (DTC) is not allowed, LPs are allowed to promote their MMJ products to physicians in similar fashion as Pharma.

§  The MMPR also provides that LPs are allowed to sell to each other in order to overcome potential short and demand imbalances.

o   Enrollment has grown at 13-17% per month during 2015, but enrollment sped up ~50% in the first 3 months of 2016 vs. 2015, with ~14k new patients added in Jan – Mar ‘16. Total enrollment stood at ~50k patients as of March 31, 2016,

§  Consumption rates average nearly ~1g/day (~1oz/month) for most LPs.

§  By the end of 2015, Medical Marijuana in Canada had reached a sales run rate of 10,000 Kg per year, which implies an $80M market size assuming ~$8/gram.

·         More recently estimates peg the current Canadian medical marijuana market at somewhere between $100-150M annually based on Q1 run-rates.

§  Most sell side analysts expect that under the current framework, the MMJ market will grow to over ~100,000 Kg by 2020 (~CAGR of 50 – 60% for the next 5 years).

·         Implies a market size of nearly $1B.

§  Costs under the MMPR are higher than MMAR, as patients could generally purchase MMJ for $2-5 under the MMAR vs. $6-8 from LPs under the MMPR.

§  Health Canada projected total registered patients in the medical program can grow to 450,000 by 2024 (implying a ~28% CAGR thru 2024 from YE15).

o   Meanwhile just 30 LP licenses have been issued (held by 25 companies), relative to over a thousand LP applications that were submitted,  

§  Over 1,000 applicants remain in line for a license, and only one new license has been granted since early 2015.

§  Licenses typically take at least one to two years to obtain, while security clearance is generally seen as the biggest hurdle followed closely by financing given the degree of regulation and compliance involved.

·         More recently, President Trudeau ran on a legalization platform for recreational uses.

o   Notably he does not favor decriminalization, given it would not restrict access to youths and would still facilitate a black market, and instead plans to facilitate the formation of a two tier system for medical and recreational marijuana similar to certain US states.

§  Decriminalization alone would not be a good thing for Licensed Producers, as it would only encourage their black market competition.

·         LPs rather see stronger regulation and enforcement, as this would allow them to recapture share lost to illegal dispensaries.

o   Promise for legislation by Spring 2017 was recently reiterated in April; however with the Federal Government expected to update the MMPR program in Fall 2016, there is also some anticipation that the proposed change will address both medical and recreational marijuana.

§  On April 20^th, Canadian Health Minister Jane Philpott gave a speech at the UN reiterating the Spring 2017 timeline for introducing legislation to legalize recreational marijuana

§  On May 24^th, Canadian Federal Govt Official Bill Blair announced that the legalization task force intends to deliver its recommendations for the upcoming legalization bill to Parliament this November.

§  OGI’s Mgmt foresees legislation being passed in the next 12-18 months.

§  Recreational sales not likely to begin until Mid-2018 to early 2019.

o   Marijuana in Canada enjoys a much more friendly environment in Canada relative to the US thanks to a more liberal outlook and greater acceptance rate among the population,

§  According to an October 2014 report by the Center for Addiction and Mental Health, Canada has one of the highest rates of cannabis use in the world.

·         Support for full legalization is ~70% in Canada vs. closer to 50% in the US

o   Conservative estimates forecast the recreational market growing to $1-2B by 2020, in addition to the estimated Medical Marijuana Market which is expected to surpass ~$1b by 2020.[1]

§  ArcView calculates the Canadian market size potential by using a fraction of their projected US market size ($22.8B) proportional to Canadian’s population (~1/9^th) vs. the U.S.) to arrive at an estimates of $1.5-2.5B.

§  One could also look at Colorado’s performance, with nearly $1B in combined Medical ($408M) and Recreational ($587M) sales in 2015, and multiply this by a factor of 9 given the relative population sizes to arrive at a blue sky estimate for Canada of ~$9bn

§  Importantly even if MMJ players are unable to get recreational dispensary licenses, they could still benefit from wholesale supply agreements for the new recreational dispensaries given such sales are already allowed between MMJ LPs and that they have a significant first mover advantage to set up and scale production.

·         Currently, out of the ~30 licensed medical marijuana producers, only ~4 producers with any scale

o   Unlicensed dispensaries still have material market share; but reports by authorities in late May show signs that they are beginning to be shut down.

§  Estimates for black market dispensaries and their market share are limited, however one estimate pegged Toronto area dispensaries at over 120, while Vancouver has approximately 60 storefronts operating (down from 90 last year).

§  These storefronts traffic marijuana grown by producers grandfathered in by the prior MMAR program who grow over their limits and sell excess to black market dispensaries.

·         Only a handful of publicly traded Canadian MMJ companies listed, all of which have a first mover advantage in the budding industry.

o   Aphria (APH), Canopy Growth (CGC), Mettrum (MT) and Organigram (OGI)

o   Canopy Growth (Formerly known as Tweed) is the largest of the group and has spent the most in terms of branding, pursuing licensing deals with Snoop Dog and has significant scale given its 4 licenses and an estimated 20% of market share with over 8k patients. Canopy is attempting to become the lowest cost producer via its 350k sq ft greenhouse in Niagara and trades at a premium to its peers.

o   Aphria is based in Ontario and currently has ~2,500Kg of capacity, but is pursuing an expansion plan targeting 360k sq ft of greenhouse near term (with up to 60k kg grow capacity). The company’s Mgmt team is particularly strong given it is experienced in greenhouse and manufacturing operations given its CEO was previously led Canada’s largest vitamin and supplement manufacturer.  Aphria hopes to have its capacity license increased to over 3,000Kg when it comes up for renewal in September. Currently Aphria has an estimated 8-9% market-share.

o   Mettrum is one of the largest LPs, having received its first license two years ago; it now has three licensed facilities located in Ontario. Under its current license from Health Canada, Mettrum can produce up to 3,500kg of marijuana annually, and Mgmt touts actual capacity of 6,000 Kg, expandable to 12,000. The company is making up for lost ground after hitting a number of milestones in recent months including the commencement of selling oils, full cycle harvests and approval of its 3^rd production facility.

§  Each of these companies has recently raised capital in the ~$10M range earlier this spring.

·         OrganiGram raised $10M in late May

·         Mettrum raised $7.8M in Mid-May

·         Canopy raised $11.5M in April

OGI CN

·         OrganiGram is Canada’s only East-coast based licensed med marijuana producer.

o   Incorporated in 2013 and licensed in April 2014, OGI is the only New Brunswick based LP, with a facility in Moncton, NB. OGI completed its initial harvest in August 2014, but its first sizeable harvest was not until March 2015 (~43Kg) due to grow issues.

§  Although more isolated than other LPs, OGI benefits from lower costs such as labor and power, along with a larger veteran user market given NB demographics

·         Electricity costs are ~50-60% in NB vs. Ontario.

·         OGI also received a provincial tax break from New Brunswick in the form of a payroll tax rebate of up to ~$900K.

·         Veterans (PTSD) generally have higher usage rates, of nearly 2g/day vs. avg of ~1g/day.

·         Given a lack of regional competition as OGI is the only LP in NB province, the company is positioned to not only capture any growth in the medical market, but unlike its more urban peers, OGI is better positioned to enjoy a significant head start in the regional market once recreational marijuana is legalized.

§  OGI’s name is due in part to its focus on organic manufacturing, using no synthetic chemicals, and ECOCERT Organic certification making them the only licensed fully organic producer.

o   OGI recently turned CF positive, with a current revenue run-rate C$5.72M, the ability to produce over 2,000kg of product (expanding to 3,500 kg by November) and expected licensed capacity of over 1,000kg by year end.

§  Annual product sales at current run rate 170kg/Q or 680kg/yr generating annual revenue of C$5.7M at ~34% of full capacity and ~100% of licensed capacity.

·         Mgmt expects imminent approval of increased license capacity to over 1,000kg.

o   Typically LPs request additional capacity after completing expansions, adding patients and when renewing their annual licenses with HC.

o   It seems that such approvals are granted so long as the LP can show there is actual demand (to prevent excess supply for ending up on the black market).

§  Assuming licensing for full capacity of 2,000Kg, this would represent C$16M in revenue, while 3,500kg would represent C$28M in revenue.

o   Currently has 2,200 patients, and Mgmt has stated that patient intake growth has remained steady.

o   Represents ~5% market share in terms of patients and dollar share.

§  Remains to be seen whether patient churn becomes a factor and results in price competition.

·         Despite its licensed capacity limitations, Mgmt has been aggressive in expanding its facilities to accommodate a future ramp up of production in the near term.

o   Currently OGI has two buildings on 5.5 acres with full production capacity of 2,000kg, and recently raised capital for an expansion in the works to bring to capacity 3,500 Kg by Nov’16.

§  Recently completed a $10M financing deal to fund this expansion.

o   Mgmt also touts its ability to raise capacity to 19,000 Kg/yr given its existing property.

§  41,000 sq ft of post-production space for edibles, oils and extracts.

·         This phase of expansion will likely remain pending until recreational legalization has a more definite timeline.

o   OGI’s CEO has made statements publicly that he is adamant about their expansion plans, and that while planned year end capacity expansion to 3,500kg represents approximate sales of $25M, the company will still continue to preparing and expand for the expected recreational marijuana marketplace with nothing south of 10,000 – 15,000 Kgs, equating to roughly ~$100M in sales.

§  Based on current expansion plans, it seems likely that run rate capacity will hit 10,000 Kgs sometime in H2 2017.

·         OGI FQ’2 ended on Feb 29^th, during which OGI sold ~170k grams for net revenues for ~C$1.425M or ~C$8.42/gram with a gross margin of 76%.

o   This is a marked QoQ increase from FQ’1 when OGI sold ~142K grams for C$1.029M or ~C$7.20/gram.

o   Given 2,200 patients, the average OGI patient used ~0.9grams per day, use by active users is likely higher than this as some patients probably inactive.

§  Last year OGI reported a usage rate of closer to 2g/day for ~1,000 patients last year.

Valuation

·         Under the current Medical Marijuana only framework, assuming OGI expands its capacity and patient base, it could generate ~C$8M of EBITDA in 2018, based on sales of C$24M consisting of ~3,000 kg @ an ASP of C$8/gram, assuming a 33% EBITDA margin.

o   At its current EV, this represents ~9x multiple on 2018 EBITDA and would require revenue to grow at a 105% CAGR in terms of medical marijuana’s impact on OGI’s estimates

o   Given recent QOQ medical revenue growth of 30 - 40%, this annual CAGR is not unrealistic

·         If recreational use is approved, OGI is trading at closer to 3x 2019E EBITDA

o   Assuming a total combined market (MMJ + Recreational) size of C$2B in 2019, and that OGI is able to add ~2,000Kg of capacity annually and achieve an EBITDA margin in the mid-30s, this means OGI could have 2019 EBITDA of ~ $21M based on revenues of ~$60M comprised of sales of ~7,500 kg @ an ASP of ~$8/gram, basically this would also translate to a ~3% total market share, which would be the equivalent $2b market share divided by ~30 licenses.

§  Expansion to 7,500 kg would likely require an additional $10-15M of Capex based on previous Mgmt commentary.

o   Assuming a total combined market of $2.5B in 2020, and the above assumptions, this would imply ’20 EBITDA of $28M, representing ~2.2x EV/EBITDA multiple

o   Under a Blue Sky scenario with a Canadian combined market of $5bn+, OGI could potentially have $100mm+ of EBITDA vs. its current EV of ~$60mm  

·         Note, above calculations do not factor in contribution from oils[2]

o   In Colorado, ~40% of users eventually convert to oils.

o   Recent data suggests that oil products in Canada are becoming increasingly popular; despite a smaller number of licensed oil producers, oil product sales tripled between Feb and March to 397 kg and accounted for over 25% of March’s total MMPR unit volume.

o   Oils are generally higher priced and higher margin products for LPs as they can be created in part by using by products and include other cheaper ingredients yet command a higher price.

Opportunity:

·         See the below sensitivity of the stock price to different assumptions of OGI’s shares of the combined medical & recreational market in 2020

·         OGI’s current EV is $70mm… while even a small share (3%) of a conservative-sized combined market ($2bn in 2020) – equating to ~7.5k kg of volume – at a small discount to current price $8/g – results in ~$60mm of revenue and ~$20mm of EBITDA

o   Depending on multiple estimates, at an ag multiple of 8x, that’s a $160mm EV, while at a branded consumer product multiple of 14x, that’s $280mm of EV, with a future stock price of b/w $1.50 - $3.00 (depending on dilution) or 1.5x - ~3x current levels – and that’s a conservative case      

§  Discounted back to today at 10%, this results in a share price of ~$1.00 - $2.25 vs. current OGI CN price of $1.01

o   The tables below also show more bullish cases with up to 6% of a $3bn market, where OGI generates $50 - $60mm+ of EBITDA and the stock goes up 6x or more, plus Blue Sky cases with EBITDA > $100mm and OGI stock goes up > 10x

Catalyst

Catalysts

·         Forward momentum on legalization proposal

·         Crackdown on dispensaries leading to increased growth for medical market

·         Expansion into oils

o   OGI has already struck a wholesale agreement with another LP to have oils produced with plant byproducts.

o   Received its Oil production license in Feb 2016

·         Potential sector consolidation

Risks

·         Regulatory

o   Slow action on recreational legalization

o   Failure to crackdown on un-licensed dispensaries and/or modifying the licensing process to include them

o   Licenses are renewed annually at the discretion of Health Canada

§  Greenleaf Medicinals had its production license revoked in 2014 due to production compliance issues

·         Failure of OGI brand to gain traction vs. well-funded peers like Canopy with recreational users

·         Operational risks/Crop failures 

·         Increased competition, additional licensed producers