Tilray Brands Inc (TLRY)

[FUNMAN]

Tilray, Sundial May Be In A Bubble But This Group Remains Attractive
Feb. 17, 2021 4:07 PM ET

Read at this link to see the graphics:

https://seekingalpha.com/article/4406747-tilray-sundial-are-in-bubble-this-group-remains-attractive

Summary

Canadian cannabis stocks have surged in 2021 and a few of them have exhibited irrational exuberance such as Tilray and Sundial.

U.S. cannabis stocks continue to trade at a substantial discount despite possessing significantly stronger fundamentals.

The valuation discrepancy is incomprehensible; it is clear to us that U.S. names are undervalued and represent the better trade here.


Our new series Cannabis Industry Analysis is where we analyze the latest and hottest topics in the industry to help you stay ahead of the curve.

2021 Reefer Madness
As we have covered extensively in recent weeks, the cannabis sector is experiencing a strong rally across the board. However, a select few cannabis stocks in Canada have entered bubble territory. We have analyzed and warned investors of names like Tilray (TLRY) and Sundial (SNDL) and both stocks plunged towards the end of last week. However, the outperformance in Canadian cannabis names remains meaningful which we would like to analyze in this article. Furthermore, we would like to make the argument that the rally in Canadian cannabis stocks as shown by Canada-focused cannabis ETF (MJ) is misplaced and based on the ill-informed idea that potential federal legalization would benefit Canadian cannabis names disproportionately. On the contrary, we believe the U.S. MSOs as shown by U.S.-focused cannabis ETF (MSOS) is best-positioned to benefit from federal legalization, and their underperformance to date highlights an attractive entry point for U.S. cannabis names.



(Source: Bloomberg)

It is also important and imperative to have the background that Canadian cannabis stocks have underperformed U.S. names by a wide margin in the last 12 months. The U.S. cannabis sector has significantly outperformed Canadian peers due to stronger financial performance (revenue growth, profitability) and a more supportive macro backdrop. This distinction is very important because it further supports our conclusion that the recent outperformance of Canadian stocks is irrational and a reversal is likely to happen.



(Source: Bloomberg)

U.S. Federal Legalization
The biggest reason why cannabis stocks have rallied strongly is that the November U.S. election and subsequent Georgia Senate run-off created a best-case scenario for cannabis legalization. Senate Majority Leader Chuck Schumer and two other Democratic senators recently voiced strong support for federal cannabis reform and vowed to release new draft bills in early 2021. It is no surprise that the cannabis sector has seen strong investor interest since November but the optimism in Canadian names is questionable.

The biggest benefits of federal legalization include access to banking and capital markets, removal of IRS Code 280E and tax savings, the potential for interstate commerce, and national expansion. However, any federal legalization would likely keep existing state-level legislation in place which means that Canadian companies won't be able to enter existing U.S. markets organically. For example, in states with a limited license regime, a company like Tilray or Sundial won't be able to open a business unless they acquire existing operations or wait for new license awards which can be expensive and time-consuming. By that time, the assets would be much more expensive, so it is unclear whether it would be value-creating for Canadian LPs to acquire U.S. assets. In any case, incumbent U.S. MSOs are best-positioned to benefit from increased market access and growth in cannabis sales.

Canadian cannabis companies also already enjoy standard corporate tax treatments in Canada and have ample access to capital. Aurora Cannabis (ACB) and Sundial are two examples of companies whose survival to this date was only made possible by their ability to issue practically an unlimited number of shares due to insatiable demand from the market. However, U.S. cannabis companies have long suffered from an inability to list on major U.S. stock exchanges, which limited their access to capital and the ability for investors to invest in their shares due to obscure foreign listings. That is why the current reefer madness in 2021 has concentrated on Canadian names listed on U.S. exchanges while U.S. cannabis names have largely been stable.

Massive Valuation Discrepancy
As we discussed above, Canadian cannabis companies have much less to gain from federal legalization, but their shares are trading at a massive premium to their U.S. counterparts. As shown on the chart below, Canadian companies trade at eye-popping EV/Sales figures led by Cronos (CRON) at 81x. Sundial, Canopy (CGC), Aphria (APHA), and Tilray all trade north of 35x sales. Even the second-tier Canadian names trade at elevated multiples such as OrganiGram (OGI) at 16x and HEXO (HEXO) at 20x. In stark contrast, the U.S. names are trading at a significant discount. The leading MSOs, including Trulieve (OTCQX:TCNNF), Green Thumb (OTCQX:GTBIF), Curaleaf (OTCPK:CURLF), and Cresco Labs (OTCQX:CRLBF), all trade at 10-15x EV/Sales. The magnitude of the valuation disparity is truly appalling. Yet the stocks of Canadian names continued to surge on Tuesday, which shows that the market is engaged in speculative trading with no fundamental support. We believe the Canadian names will inevitably fall back to where they belong and continue their multi-year underperformance as dictated by their fundamentals.



(Source: Author)

The difference in financial performance and growth potential is also massive between Canadian and U.S. cannabis companies. Whereas U.S. cannabis companies are highly profitable and growing at double or triple-digit on the top-line, Canadian companies are generally still reporting negative EBITDA and meager organic growth two years into legalization. In our mind, there is not even a question here that Canadian cannabis companies should trade at a discount due to inferior asset quality and earnings. However, the only reason why Canadian stocks are trading at these crazy multiples is their listing advantage. The easiness of trading Canadian cannabis stocks means their valuation has totally detached from reality.

However, this anomaly has created a perfect situation for smart investors to acquire U.S. cannabis names at attractive multiples. After all, maybe the market is willing to value cannabis companies at 30-50x EV/Sales and the U.S. names are just deeply undervalued due to obscure foreign listings. And if U.S. names could uplist to NYSE and Nasdaq, they should also trade at these multiples. In either case, we see a unique and potentially temporary window for investors to invest in high-quality U.S. cannabis names.

Conclusion
Cannabis stocks have traded up significantly since the November election. However, some of the Canadian names, exemplified by Tilray and Sundial, have gone up way too much and are clearly in bubble territory. While the political development has created the perfect storm for cannabis stocks to soar, we believe the U.S. names are the biggest potential beneficiary. We also showed that U.S. cannabis names are trading at a massive discount to their Canadian counterparts despite reporting significantly better financials on almost every metric. Therefore, we think it would be wise to take profits on overvalued Canadian names such as Tilray and Sundial and consider reinvesting the proceeds into attractively-valued U.S. names such as Trulieve, Green Thumb, Cresco Labs, etc. We believe volatility will remain high for Canadian names as demonstrated by a one-day 50% drop in Tilray shares last week. Meanwhile, the U.S. stocks have been far more stable and reflect the long-term secular bull market that hasn't been disrupted by the recent market volatilities.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.