Cannabis Investment Club

[JohnCM]

Like Marijuana Post-Crash? You'll Love This Company

Feb. 5, 2018
TheBaron Investing - Seeking Alpha

Summary

This is the second time I am writing about Village Farms International, due to the undervaluation that is still present in its price.

If you believe in the future of the major marijuana companies, and you remain bullish on the industry, this investment may interest you.

Although I am a relatively conservative investor, particularly in my predictions about the marijuana industry, we explore applying investor exuberance to Village Farms.

I am still actively searching for relatively cheap marijuana companies, the issue is that they do not exist. As we have seen the last few days, the marijuana industry has begun a flash crash, as new investors looking for a quick buck are getting burned en-mass. However, there is one that has had a serious run upward and is still vastly undervalued from nearly every standpoint. That company is Village Farms International (OTCQX:VFFIF).

Village Farms January Presentation

I have outlined my personal investment philosophy here regarding the company (Budding Marijuana Company In Canada) if you want some background. This article could perhaps be considered a part two. There was a fundamental flaw to my analysis, in hindsight... The fact that the majority of these companies future production is not online yet does not appear to matter when it comes to valuing these companies.

That's quite a statement, let's explore that.

Every Other Major Producers Valuation Depends on Reaching Full Production

Emerald Health Therapeutics Inc. (OTCQX:EMHTF) is already selling medical marijuana and partnered with Village Farms. That adds credibility to its ability to acquire the licence required and find customers for production in the lead up to Canada-wide legalization. What makes this opportunity so intriguing is the relative value proposition of Village Farms compared to all other major marijuana producers. Where is that line of reasoning coming from? Analysts.

Marijuana is becoming legal in Canada, and regulatory agencies in Canada realize there will be a severe shortage of marijuana to satisfy the legal market. Canada wide, there is current production of ~120,000 kgs. This compares to the approximately 734,000 kgs required to meet legal demand, according to the Office of the Parliamentary Budget Office, Government of Canada (2016). This prompted some changes to the regulatory and approval process to get more production up and running in time.

This leads us to something interesting: All major producers now require legalization to justify their price, and the increased production they are targeting are required to meet demand. This means that all of the marijuana industry is priced with full legalization in Canada. This brings us to the big question... Is there any possible way that legalization in Canada can support the prices we are looking at?

There Is No Realistic Way To Justify Current Prices Without Wild Assumptions

Village Farms January Presentation

Above is the estimate, released as part of Village Farms' most recent presentation and represents the expected future production (and current production) of all major producers. As we can see, the planned capacity is so wildly higher than the current production that we can reasonably assume these companies are pricing in this future growth in order to justify their currently high prices. Even after the collapse in pricing we have seen up until this Friday they all remain very aggressively valued.

With all of that in mind, let's look at the second largest current producer and second largest future producer (with some assumptions) Aurora Cannabis (OTCQX:ACBFF) which has become one of the leading producers of medical marijuana in the market (and largest by market cap). Let's begin to look at its current production goals to help get an idea of what the industry leaders are up to in preparation of Canada-wide legalization.

Aurora Cannabis: Leading Producer Requires Legalization To Justify Price
Aurora recently acquired CanniMed Therapeutics (OTC:CMMDF), making it the second largest future producer of medical marijuana (and non-medical marijuana in the future).

As discussed in this article from another SA author (Aurora Cannabis: True Reasons Behind The CanniMed Acquisition), Aurora has become the largest producer by acquiring a lot of current production (and planned future capacity) from CanniMed. The issue that producers have right now is due to a single, major issue:

Marijuana Is Illegal

Outside of medical purposes, marijuana is illegal, and the qualifications for planned production facilities are based on the fact that the underlying product cannot be accessible to regular people. The facilities need to be secure (added cost), need to be capable of lasting the shortened growing season in Canada (enclosed), need to meet certain standards of quality for medical use (hydroponics preferred, though not required), along with numerous other restrictions.

Marijuana is a plant and could (should?) be grown outside in warm climates with long enough growing seasons, like any other cash crop. But this plant is illegal in the logical place for it to be grown: The United States. As such, approved facilities need a lot of added expenses. An example is Village Farms' partnership which will spend $20 million to retrofit a relatively new, state-of-the-art hydroponic greenhouse to qualify under the medical licensing requirements.

I am not an expert, but I would hypothesize that a hydroponic greenhouse that was converted from one species of plant to a slightly less resilient one would not require $20 million in straight retrofit costs, even despite the facilities massive size. Much of those funds are going to the extra requirements to ensure it qualifies as a secure medical marijuana facility, a restriction almost all planned capacity needs to meet in order to receive their licence before legalization officially happens in July 2018.

Aurora Cannabis Production Pre-Legalization Versus Post-Legalization
Aurora Cannabis has production of 4,800 kgs of production, plus the 7,000 kgs of existing production from CanniMed. The company has planned production expanding through several major projects that will be done before legalization, raising their production to approximately 20,300 kgs of production online before legalization. At the time of legalization (planned completion is happening in "mid 2018", so it may or may not be completed in time, but presumably it will be) for the big facility, referred to as the SKY facility which will produce more than 100,000 kg/year. That is 120,300 kgs of production in time for legalization from the second largest producer.

As referenced earlier, total expected production when all announced marijuana comes online will be 227,000 kgs per year, nearly double what will be ready for legalization, not including planned production from the recently acquired CanniMed.

Canopy Growth Corporation Production Pre-Legalization Versus Post-Legalization

Canopy Growth (OTCPK:TWMJF) is the largest current producer of medical marijuana and has current production of approximately 20,650 kgs of production per year. As per the attached article (Aurora Cannabis vs. Canopy Growth: Which Stock is More Attractive?) predicted capacity by mid-2018 was 93,000 kgs for Canopy Growth and 100,000 kgs from Aurora. Since Aurora's has grown, we will increase Canopy's estimate as well. It should have approximately 111,879 kgs of production ready for legalization.

As referenced earlier, total expected production once all announced production is up and ready will be approximately 388,000 kg.

Canadian Market

The total Canadian market for marijuana (medical and legal) is about 120,000 kgs. This is based on the understanding that this is what is produced now, and that the price of medical marijuana has been falling under that production amount. That means that each of the two largest producers who will have their capacity ready for legalization would be able to meet that demand by themselves. Canopy Growth would have 120,300 kgs of production by the end of 2018 with facilities ready by July and Aurora will have over 100,000 kgs ready.

Once full legalization has happened and demand normalizes after the "fun" of initial legalization is done, huge amounts of production come online, and these producers need to compete on cost.

As it stands, the market is estimated (in total) 734,000 kgs by 2021 by the Office of the Parliamentary Budget Officer (referenced earlier). The top three producers in Canada by volume that will be online will be Canopy Growth with 388,000 kg, Aurora Cannabis with 357,000 kgs (227,000 kgs from Aurora, 130,000 kgs from CanniMed) and Village Farms' partnership with 300,000 kg.

I am no expert, but it would appear that a realistic total market will be met by the top three producers, by approximately 142%. That is not including any of the other producers, major or minor, that will be bringing production online. This includes major projects like that from MYM Nutraceuticals (OTCQB:MYMMF) which was planning to build a 1.5 million sq. ft. production facility with planned capacity of 150,000 kg.

According to that same article, the market for cannabis in Canada is projected to be between $8.7 billion (including ancillary services) to $22.6 billion. Though that higher estimate requires close to 40% of the adult Canadian market would be trying marijuana, something I find... Difficult... To consider as a realistic possibility, even when considering tourist use, additional medical usage and illegal re-selling to Americans.

Canaccord Genuity estimates total demand of 575,000 kgs (below our other estimate) whereas the CEO of MedReleaf Corporation (OTCPK:MEDFF), perhaps unsurprisingly as a CEO, projects a total demand of 1,000,000 kgs (includes explicit assumptions that most of the illegal market will move to legal). Rather than using those total revenue numbers with their unknown assumption, we will use these three totals: 1,000,000 kgs, 734,000 kg and 575,000 kgs as "realistic" estimates (I, for one, am pretty critical of a 1,000,000 kgs being realistic, but there are those out there who are very bullish on marijuana).

Oh, wait, if we agree that the largest "reasonable" estimate of marijuana demand is still not enough to absorb production from the three largest producers, who will produce at least 1,045,000 kgs of marijuana products.

If we pretend that the companies listed in the projections from Village Farms enter full production and include MYM Nutraceuticals which is not in the above graphical representation, they represent production of 1,908,000 kg. That does include some producers who produce and sell overseas, but we are also not looking at every producer in Canada. This also, especially at the top end, requires the black market to move almost completely to the legal market. Top that off with many major producers who are completely private companies/entities, like the major push for First Nation reserves to enter the market.

I am skeptical, to say the least, that prices will hold under that kind of pressure.

To put things in perspective when it comes to demand, the highest average demand I will utilize, 1,000,000 kg, is capable of making 1,834,862,385 joints, or 51 for every man, woman and child in Canada (0.545 grams per joint, 36 million Canadians).

New Valuation For Village Farms

Now, we have to make some assumptions. Marijuana in the most recent quarters was priced around $7-8 and is on the decline as production and selling from the black market has accelerated in Canada, which has flooded the market (turns out the black market is capable of ramping up production faster than public companies).

So, there's that (keep in mind that prices have declined since this was released, but the drastic miss-pricing stands). But I am a relatively conservative investor who is skeptical at the size and pricing possible when full scale production happens. So, let us look at what Village Farms, the future third largest producer of legal marijuana in Canada is worth based on the cash it will actually earn.

Assumptions for Valuation of Village Farms

In 2018, assuming everything goes ahead as planned, Village Farms will be able to put forward 7,000-8,000 kgs of production ready for sale. Now, right after 2018, demand will be somewhere between 120,000 (current legal demand) and 1,000,000 (everyone magically tries marijuana and all black market production stops). Since the largest producers will have about 228,300 kgs of production online and a reasonable estimate would be about 200,000-400,000 kgs of demand due to people trying it for the first time/tourist demand/regular users trying the legal market, we will generously assume that the legal market will be larger than the legal production available. This will push prices higher, but I would argue that prices much above $10/gram would cause black market users to return to their dealers, since this is approximately the highest of the Canadian estimates of black market prices, though lower is more common.

This means that, given fairly generous assumptions, Village Farms will earn approximately $40 million in revenue from marijuana alone, meaning more than $20 million in EBITDA since it has a 50% margin at "regular" prices (8,000,000 grams, at $10/gram, split with Emerald for revenue, then 50% of that due to margin) in the final part of 2018.

As we enter 2019, we would expect more production to come online (from Village Farms and the other producers). Village Farms manages to push its production up to 35,000-40,000 kgs for the year. Under pressure from new production (complemented by some new demand from increased medical use, tourism, and stigma decreasing), but there is still the spectre of more production on the horizon, black market competition, etc. Due to these issues, I would say a safe bet would be prices falling in half, to about $5 per gram.

This means, again being fairly generous, Village Farms would earn about $93,750,000 in revenue, and EBITDA of about $23,437,500 in EBITDA (EBITDA margins drop to 25%).

In 2020, when most of this planned production comes online, we have a market that is flooded with legal marijuana production and fully flushed out market for marijuana in Canada that would grow with population over time. With nearly double Canada's highest expected demand estimates of production coming online, we would expect marijuana prices to collapse.

At this point, we would look at prices that we would expect to match the average cost of production for the industry. Although producers claim various costs, I sincerely doubt very many account for all applicable costs. The major current producers who need to jump through all the regulatory hurdles required to bring marijuana production online (for medical use), the cost is generally $2.00/gram. Not having to meet those medical hurdles would bring the cost down, but we will assume that prices go right to that bottom and are priced at $2.00/gram.

Now, that is still revenue of $300 per plant (using general assumptions from this website give the average of 150 grams per plant. Another estimate I found at this website you can estimate about 50 grams per square foot in a marijuana facility. That is $100 per sq. ft. per year.

Tomato, a plant that is one of Village Farms' current products, generates about 40 pounds per square foot, and at prices of $5-6 per pound equals a revenue for equivalent production of $220 per sq. ft. Presumable tomatoes are easier to grow, so at this price point, its original products would be more profitable for it.

To get a good estimate of this information, we will use Village Farms' internal estimate. It believes that it can produce marijuana at a cost of less than $1.00 per gram. Due to its ability to make money on other vegetables with lower revenue potential, I would tend to believe its estimate. Although it indicates it could be well below $1.00 per gram, we will use that estimate as a conservative number.

With this in mind, in 2020, where prices collapse to industry average cost of production of $2.00 per gram, low enough for most producers to exit and prices to rise again, Village Farms' full production 75,000 kgs will get $75,000,000 of revenue. Its current cost of production (it posted basically no net income the last few quarters) at EBITDA margins of around 6%. So, for this, we would assume, due to it selling at twice its cost, it would be earning EBITDA margins of about 12% (we will use 10% to be conservative), so it generates EBITDA of about $7,500,000.

Valuation for Village Farms

From there, we need to estimate future earnings from all of these eventualities to help us decide what Village Farms is worth today. We will use three estimates:

1) Prices stay at approximately the cost of production and stay at approximately double Village Farms' cost of production moving forward as demand moves up in line with production (production stays excessive in comparison to demand). Thus, EBITDA from marijuana stays at about $7,500,000 going forward, forever, and that number grows with consumer demand (population growth and inflation) of 2.1% annually.

2) Prices improve as companies leave the market and only the low cost producers survive. Prices improve to a more regular price of about $4 per gram in perpetuity starting in 2021 and demand grows at 2.1% per year.

3) Prices improve drastically as many producers leave the market, demand increases aggressively and prices move up to about $6 per gram in perpetuity, and demand grows at 2.1% per year.

Keep in mind that with normalized EBITDA margins of 6.50% for their other vegetable revenue would generate $9,096,815 in EBITDA per year. That too will only grow with population growth of 2.1% per year going forward.

In order to calculate the present value of the EBITDA generated, including the slow growing vegetable production, we utilize a growth rate of 2.1% in all instances, a discount rate of 9.19% (approximation of return from S&P500 annualized) and completed over a 25-year time period. This leads to an EBITDA PV as follows:

Author's calculations

Utilizing the same method of valuation we used in the previous article, in the worst case (but realistic in the mind of this particular author and very bullish projections), the company is worth $13.52 per share or a return of 88.3% from Friday's closing prices ($7.18 CAD).

In the base case, one that matches some of the more optimistic projections for the overall industry, we arrive at a price of $33.67 per share, or a return of 368.9%.

In the best case, the most optimistic projections I could possibly imagine the company would be worth $84.29 per share, or a return of 1,073.9%.

Now, that seems pretty ridiculous, right? Well, let us use the same assumptions, but be extra generous, to our one of the largest producers in Canada, Aurora Cannabis.

Authors Note: If you want my actual predictions of prices going forward and more realistic (read: conservative) assumptions please proceed to the original article, which can be found here. It also outlines the various risks to Village Farms in particular which will affect price until full production is reached in 2021.

Aurora Cannabis Valuation, Under Similar Assumptions

Aurora will produce, giving them full credit for expected production, 120,300 kgs in 2018 with prices at $10, 173,650 kgs at $5, 227,000 kgs at $2, and then production increases commensurate with our growth assumption of 2.1% in perpetuity. As in the case for Village Farms, the price is $2.00 per gram in 2021 for our worst case, $4.00 in our base case, and $6.00 in our best case.

Aurora Cannabis has been improving margins lately, but its EBITDA margins have been negative as it spends heavily to grow and acquire others. We would probably be generous to match its EBITDA margins with Village Farms (current gross margin has improved to about 40% compared to Village Farms' 50%+ estimate), but that is what we will do. EBITDA margins will be 50% at $10, 25% at $5, 20% at $4, and 12% at $2 (we will assume its cost of production will decline enough for this to be the case; currently, its cost of production is higher than $2, perhaps we can attribute the difference to any foreign sales it achieves, combined with efficiency gains).

We will, to help us find its current relative valuation, assume that its current EBITDA margin is 50% based on production of 11,800 kgs for this year giving us total EBITDA of $41,300,000 and a price of $8.50 per share, total shares are 380.21 million (YCharts) for a Price/EBITDA of 78.25... Yes, seriously. This gives me the impression it may not be being valued on current production, but I digress.

Author's Calculations

For comparison's sake, we will value Aurora Cannabis's EBITDA values at a P/EBITDA of 8.75, the same we used for Village Farms. Feel this is too low? You can adjust both fair values commensurate with what the reader believes is a more fair P/EBITDA valuation. The average acquisition (of all companies) in 2016 was a P/EBITDA valuation of 11.1, for example, and marijuana is a particularly popular sector, so I believe this could be considered relatively low. Prior to the announcement of entering the marijuana industry, Village Farms traded at a Price/EBITDA of 9, for comparison's sake, with EBITDA margins of 6.5% in a slow growing, though consistent, industry.

In the worst case scenario, we would arrive at a fair value price for Aurora Cannabis of $6.38 per share, or a projected loss of 24.9%.

In the base case scenario, we would arrive at a fair value of $16.07 per share, or a gain of 89.1%.

In the best case scenario, a price of $28.17 per share, or a gain of 231%.

Using the most aggressively positive projections I can come up with, with about 40% of the adult population utilizing marijuana and competition who has active production shutting that production down to raise prices for the surviving firms, the company might be worth three times where it trades today. This compares to the company I am advocating for which would balloon about 1,000x in the same market conditions.

Conclusion

Am I writing this article to indicate that these companies are worth between 200 and 1,000 times more than their current price? Not at all. The fact of the matter is there is nearly no way to justify most of the prices out there. Under what I would consider "realistic but aggressive" growth projections, Aurora Cannabis is worth about $6.38 per share from the Canadian market, even less than its current share price after a substantial decline, perhaps more when we include foreign markets and some other, more aggressive assumptions (in my assumptions, I assumed it could match Village Farms EBITDA margins partly by lowering costs and partly from avoiding the pricing pressure of being purely Canadian, but it might be capable of much higher).

If you believe that the market will open up internationally (read: The United States), then perhaps you can adjust these predictions to give a bigger boost to Aurora Cannabis (and other major producers). You could make the argument that Aurora sells higher margins products than what Village Farms is planning to sell, making a higher multiple make more sense. Perhaps you could make the argument that the market, when the stigma and health ramifications are known, will be more than 40% of the Canadian population. The real issue here is that there is such a huge disconnect here between these firms that I don't see any way an investor would be able to justify Aurora at $8.50 while simultaneously pricing Village Farms at $7.18. Perhaps more indicative is that they are predicting similar future production amounts, but Aurora is valued at a ~3,850 million market cap and Village Farms is at ~302 million.

That is a lot of margin pressure to justify that kind of discrepancy.

If you like Aurora Cannabis, consider Village Farms. If you believe that Aurora Cannabis is ridiculously overpriced but still want to play a part in overall marijuana growth, consider Village Farms. I can't guarantee that everything will work out the way I indicated, and my methodology is unique (to say the least) since valuing firms that are not profitable can be an interesting challenge.

Perhaps I am missing the bigger picture here, perhaps readers believe that Aurora is capable of much stronger margins than it has shown so far? Perhaps prices should be much stronger than what I believe since producing twice the Canadian market's projected demand will not affect pricing the way I think? Perhaps I simply miscalculated some key differential or variable that will influence assumptions enough to change this terribly one-sided valuation prediction?

Whatever the reason, I am very curious what justification there could be for the price differential from readers.

Thanks for reading, and happy investing.