Why Did Aurora Cannabis Pay Such A High Price For MedReleaf Corp.?

With Canada set to legalize recreational use of marijuana for adult consumers in July, many companies in the space are scrambling to increase their production capacity to meet the demand forecast. This has led to a consolidation in the industry, with Aurora Cannabis (TSE: ACB) being one of the most aggressive players. Post a $1.1 billion acquisition of Cannimed, Aurora announced the purchase of MedReleaf (TSE: LEAF) for roughly CAD 3.2 billion ($2.5 billion) in May in an all-stock transaction, making it the biggest marijuana deal till date. MedReleaf shareholders will receive 3.575x Aurora common shares for each common share they own, implying a price estimate of CAD 29.44 per MedReleaf share. The primary reason cited for the deal was to strengthen the company’s production capacity, as the merged company would have a combined current capacity of 32,300 kgs, with the possibility of reaching over 570,000 kgs a year.

We have created an interactive dashboard analysis to estimate MedReleaf’s valuation based on its expected revenues for FY 2018 (year ended March 31, 2018). You can make changes to these variables to arrive at your own price estimate for the stock.

To arrive at a CAD 29.44 price estimate for MedReleaf Corporation, we used a P/S multiple of 66.17, based on revenue projections of CAD 45 million for 2018, and a share count of 101 million. The market price stood at CAD 24.63 as of June 4, 2018, implying Aurora’s price estimate for MedReleaf is higher by almost 20%.

Besides growth in the overall medical cannabis market, there are a number of other factors that should result in a rise in grams sold. However, with increased supply in the market, the company’s average price per gram has been decreasing, and we expect this trend to continue.

1. Expanded Production: In the first quarter of FY 2018, MedReleaf completed the first phase of the construction of its Bradford Facility and commenced production. As of February 2018, it had completed the second phase, and once it receives the approval from Health Canada, the total annual production capacity will increase to approximately 9,500 kilograms.

2. Distribution Agreements: On March 30, 2017, the Company entered into an exclusive distribution partnership agreement with CannaKorp for the sale and distribution of its patent-pending CannaCloud Pods for a period of three years. Furthermore, in December 2017, MedReleaf announced an agreement to become a medical cannabis supplier to Shoppers Drug Mart, which will sell the company’s cannabis products through its online channels, once it receives the necessary approvals. Moreover, in February, MedReleaf signed a Letter of Intent with Société des alcools du Québec (SAQ) to supply the Province of Quebec with a minimum of 8,000 kgs of cannabis products per year through SAQ’s retail and online stores.

3. International Partnerships: In January 2017, Germany legalized medical cannabis. Governments in other countries such as Australia, Brazil, Chile, Jamaica, Israel, Mexico, and South Africa are also encouraging research into medical treatments with the use of cannabis. Consequently, MedReleaf announced its entry into Germany, Brazil, and Australia.

4. Launch of New Products: In October 2017, MedReleaf launched a topical cream, becoming the first Licensed Producer (LP) to do so, in response to patient feedback for topical applications of CBD (Cannabidiol). This segment is expected to witness strong growth even in markets such as the U.S., with reports suggesting a tripling of sales in the industry since 2014, and forecasts indicating a further tripling of sales by 2019, according to the Brightfield Group. The company also launched a softgel capsule in February 2018, making it the only LP that produces such capsules in a certified ISO and GMP facility.

As a result of the above factors, we expect the revenues to increase to roughly CAD 44.93 million in FY 2018. Using this, together with an expected share count of 101 million and the price per share of CAD 29.44, we have arrived at a P/S multiple of 66.17. On the face of it, that is an enormous premium to pay. However, such high multiples have become the norm in the cannabis industry, with the stocks of many companies in the space trading at multiples touching over 100. The fact that many companies in this field continue to lose money despite increasing their revenue manifold may make it harder for them to support their reasoning for high premiums to shareholders whose stakes get increasingly diluted when such deals occur. On the other hand, while it may be hard to justify such a premium in the short term, without the knowledge of any sort of synergies that the combined company may deliver, it is no doubt a necessity for cannabis companies to increase their production. The opportunity for growth is not limited just to the Canadian market, which is expected to boom once recreational use of marijuana is legalized. Countries such as Germany also remain key for Aurora/MedReleaf to ensure sustained growth in the long term.

The marijuana business seems like an appealing opportunity at the moment. Consequently, it wouldn’t come as much of a surprise if Big Tobacco enters the fray. Companies such as Altria (NYSE:MO) and Philip Morris International (NYSE:PM), whose stocks are down year-to-date, have not made a move yet in this space, but will definitely be looking at how things pan out.

This is the second part of our analysis of marijuana stocks. In the first part, we had created an interactive dashboard analysis to ascertain Canopy Growth Corp.’s valuation.

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