The green flag is officially waving on the legal-cannabis industry. This past October, Canada ended nine decades of recreational-marijuana prohibition and became the first industrialized country in the world to legalize adult-use weed. Soon after, a number of U.S. states legalized medical pot or expanded its use to adult consumers. Then, in December, the groundbreaking Farm Bill was passed in the U.S., giving the green light to hemp and hemp-based cannabidiol products.
This sort of perfect storm of marijuana (and hemp) momentum has led to some very robust growth estimates for the industry. A co-authored report from Arcview Market Research and BDS Analytics that was recently released calls for 38% global sales growth in 2019, and a more than doubling in global revenue between 2018 and 2022 to $31.3 billion. Meanwhile, investment bank Cowen Group, which is arguably the biggest fan of the cannabis industry among Wall Street firms, is calling for $75 billion in worldwide sales by 2030.
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Marijuana buyouts could soon become commonplace
This expectation of rapid growth, coupled with extraordinary demand from consumers in Canada and in select legal U.S. states, has been the impetus behind a wave of cannabis acquisitions throughout North America. Although we're only seeing the tip of the iceberg in terms of consolidation, especially in Canada's pot-growing industry, we have seen a number of modest to large acquisitions made.
As an example, Aurora Cannabis (ACB 12.87%), Canada's projected top-tier grower by peak annual output, acquired CanniMed Therapeutics for $852 million, MedReleaf for about $2 billion, and ICC Labs for almost $200 million, last year. Aurora also announced the $132 million purchase of Whistler Medical Marijuana in January, which has yet to close. There were a handful of additional smaller transactions for Aurora as well.
Canopy Growth (CGC 20.65%), Aurora's biggest rival, at least in terms of peak production, has purchased Colorado-based hemp research company ebbu for about $330 million, Hiku Brands for just north of $200 million, and Mettrum Health in early 2017 for around $325 million. Like Aurora, Canopy Growth has made other purchases, but these are the most prominent.
As the desire for consolidation increases, deals should become more commonplace.
But there's just one problem: Pot stocks aren't very good at valuing the companies they're buying.
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Cannabis acquisitions are making little financial sense in the early going
When one company buys another, it's extremely common for a premium to be paid by the acquirer. In other words, the purchasing company usually needs to sweeten the pot to get the other company's management team, board of directors, and potentially shareholders, on board. The issue is that it's really difficult to value pot stocks right now because the legal industry is still in its infancy. Thus, placing a premium on a value that's nothing more than a dart throw in a pitch-black room is leading to some financial humdingers on company balance sheets.
Though it's a figure the average investor often overlooks, goodwill is telling an interesting story for weed companies that have been active in the acquisition department. Goodwill is a way of quantifying the "premium" an acquirer pays above and beyond the tangible assets acquired. A good way to think about goodwill is this: The more of it there is, the more a company potentially overpaid when making acquisitions.
Of course, things are never cut-and-dried in the investment world. Goodwill can be something worth overlooking if future growth prospects, cost synergies from a combination, or other intangible factors, such as superior branding or a tenured management team, whittle away at this premium paid over time. The question is, "Will that happen with pot stocks?" While it's possible, the sheer amount of goodwill being lugged around by some pot stocks as a percentage of total assets is mindboggling.
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The prime offenders
A few days ago, following Aurora Cannabis' second-quarter report, I singled the company out for its exceptionally high goodwill total as a percentage of total assets. At the end of calendar year 2018, Aurora had $3.06 billion Canadian in goodwill, which represents 63% of total assets. Some 80% of the value of the company's flagship MedReleaf deal has been recorded as goodwill, with every other recent deal being recognized with large amounts of goodwill attached.
But this isn't just an Aurora problem, even if it's the easiest pot stock to point the finger at. Canopy Growth ended the fiscal second quarter (through Sept. 30, 2018) with CA$1.11 billion in goodwill and another CA$103.9 million in intangible assets. With total assets of just shy of CA$3 billion, 37% of the company's total assets are devoted to goodwill, with this figure rising to about 41% if intangible assets are included.
It's not even just a Canadian problem. iAnthus Capital Holdings (ITHUF -3.82%), a vertically integrated cannabis dispensary with a focus on the U.S. market, recently closed on its purchase of MPX Bioceutical. This roughly $600 million deal increases the number of states iAnthus has access to from six to 11, and lifts its retail license count to 63. But take a gander at its most recent quarterly filing and you'll see that CA$7.2 million in goodwill has not so magically transformed into CA$75.9 million in goodwill over a nine-month period, through Sept. 30, 2018. This represents 55% of the company's total assets.
Long story short, it would appear that pot stocks are so eager to consolidate that they're grossly overpaying for their acquisitions. While it's possible the value of these deals could be realized over time, it's just as likely that big writedowns and subsequent revaluations from investors could await.
Check out the latest Canopy Growth earnings call transcript.
