Description

Mettrum is the second largest Licensed Producer (“LP”) of medical marijuana (“MJ”) in Canada. The company has ~15% market share in a newly created and protected industry; an industry that is arguably the fastest growing sector that Canada has seen in decades. Revenue will grow in excess of 300% in 2017 with conservative expectations for an 80% top line CAGR over the next four years (2016-2020). More importantly, the business is on the cusp of transitioning to positive free cash flow by the end of this year. The opportunity is simple: the shares trade at absolute and relative valuations that do not remotely reflect the intrinsic value of the business. Despite clear evidence of sustainable revenue growth and EBITDA margins above 40%, the current share price ($2.15/share) values Mettrum at 1.5x EV/Revenue and 4.0x EV/EBITDA based on CY 2017 estimates. This valuation puts the company at half the peer group averages of ~3.0x EV/Revenue and ~8.0x EV/EBITDA. Supported by a strong board and management team, a cash-fortified balance sheet and ample production capacity, Mettrum is exceptionally well-positioned to play a major role in Canada’s medical marijuana market – a market that is experiencing accelerating growth. Based on the peer group average multiple of 8.0x CY 2017 EBITDA and a base case 2018 EBITDA estimate of $21MM, Mettrum’s shares will be trading at $5.50 in 1 year – up +150% from current levels. The current valuation offers investors material upside with the company’s valuation “normalizing” vs. the peer group. The $5.50/share target assumes zero net cash in the capital structure – despite a conservative forecast for a positive net cash balance in 1 year. In addition, the estimates referenced in this report do not include any upside associated with the anticipated opening of the recreational marijuana market in Canada by 2019 – an initiative the current Liberal government is fully committed to. Once introduced, the recreational market would grow the total addressable market (industry revenues) by a factor of 3x-6x. As an emerging market leader, Mettrum is exceptionally well positioned to capitalize on Canada’s medical marijuana and (when defined) recreational marijuana market.

Overview

·       Mettrum is a Toronto-based company and one of 27 Licensed Producers of medical marijuana under the Federal Marihuana for Medical Purposes Regulations (“MMPR”) in Canada. 

·          As of June 30, 2016, Mettrum has over 12,000 registered patients and over 1,810 physicians referring patients to the company.

·     Mettrum has 3 licensed grow facilities: Bennet Road North (Bowmanville, Ontario), Bennet Road South (Bowmanville, Ontario) and Creemore (Ontario). On a combined basis the 3 facilities have potential production capacity of 12,000kg of medical MJ annually, but holds further expansion potential under those licensed properties of >26,000kg/year. For context, in the most recent reported quarter (ended March 2016) Mettrum produced an annualized equivalent of 1,200kg. The existing production footprint offers a material expansion opportunity for modest additional capital.

·         Mettrum’s current total licensed production capacity by Health Canada is 3,550kg/year, however the investment community’s constant focus on the licensed capacity “ceiling” is misguided because any LP in good standing with Health Canada has the ability to increase licensed capacity in a matter of weeks by submitting a license amendment. Health Canada’s core objective is to ensure that all medical patients can receive their full prescriptions in a timely manner, so they have (and will continue to) increase the licensed capacity at LPs – providing the LP’s security and quality control measures remain up to Health Canada’s stipulated standards.

Industry Structure and Patient Growth (MMPR)

·         The MMPR legislation came into effect in April 2014 and is overseen by Health Canada. In its current form, it authorizes three key activities: the possession of dried marijuana (or oil) for medical purposes by eligible patients; the production of dried marijuana or oil by licensed producers; and the sale and distribution of dried marijuana or oil by licensed producers to eligible patients.

o   Specifically, patients must obtain a “medical document” (similar to a drug prescription) from their physician, then register with a Licensed Producer who will supply the subscription via direct mail.

·         Currently there are 33 MMPR licenses in Canada which are held by 23 distinct LPs. Understandably, there is a significant first mover advantage for existing LPs in the market.

o   Over 1,000 companies have applied for a license under the MMPR legislation and it can take nearly two years to obtain a final approval. Health Canada has taken a measured and arguably cautious approach in terms of maintaining control and avoiding oversupply. Security clearance and access to capital are key gating factors (barriers to entry) as there are considerable costs in ensuring that facilities are compliant with government regulations.

o   As a result, Health Canada has increasingly focused their efforts on growing the licensed capacity of those LPs with existing licenses and ensuring these LPs remain compliant. Health Canada sees this strategy as the fastest (and safest) route to ensuring patient access to product.

o   In addition to establishing credibility with the industry’s regulator (Health Canada), the five largest LPs have invested hundreds of millions of dollars in production facilities with capacity beyond current production, have gained significant knowledge and experience in refining their growing processes, and now have the benefits of scale and brand equity that will be difficult for any new entrant to compete against.

o   Under the MMPR regulations LPs are not permitted to market their products to the public, however they are allowed to promote directly to physicians in the same manner a pharmaceutical company does for prescription drugs.

·         Based on company disclosures and Health Canada data, we estimate there are currently over 75,000 patients registered under the MMPR program (June 2016).

o   The market in terms of registered patients averaged 9% month-over-month sequential growth in 2015, however, growth accelerated throughout 2016 and hit 13% in the month of June. This torrid monthly pace is equivalent to a 44% quarter-over-quarter growth and 333% year-over-year growth.

o   Heath Canada and sell-side analysts estimate the total size of the market will be between 400,000 and 700,000 registered patients by 2020. The upper end of this forecast is based on the established medical marijuana markets in Colorado and Oregon which have both grown to ~2% of total population (Canadian population of 35MM x 2% = 700,000)

o   Our model conservatively assumes the low end of the range (400,000 patients); simply put, the low estimate implies a >$1BN revenue market in Canada – equating to $100MM in annual revenue for a 10% market share player (note: Mettrum controls ~15% share currently).

·         The rapid growth in Canada’s medical marijuana market is being driven by the following factors:

o   wider acceptance of the benefits of medical MJ by potential patients and the general population,

o   wider acceptance of the benefits of medical MJ by medical professionals,

o   increased patient access to LPs through a growing number of specialized clinics, and

o   local police enforcement of Federal laws regarding the illegal status of “dispensaries”

Financial Profile and Key Metrics

(Note: Fiscal year ends March 31^st)

·         As of the end of the June quarter (Q1 2017), Mettrum had over 12,000 registered patients

o   The company added ~4,400 patients in the quarter – equivalent to 70 net adds per work day. Patient growth was ~60% sequentially from the March quarter – up from the average 35% sequential growth rate the company delivered in 2015.

o   We conservatively assume the June quarter patient growth moderates to below 50 net patient adds per day over the next 2 years, despite indications that recent industry growth rates are largely sustainable in the near-to-intermediate term

o   Our model also implies Mettrum’s recent market share increase to 15% reverses in the coming years and falls to 10% by 2020, despite our confidence in management’s ability to defend and potentially grow share

·         Patients are currently ordering ~0.6 grams/day at an average selling price of $8.20 per gram in Mettrum’s most recently reported quarter (March, Q4 2016)

o   Despite some noise in these early averages related to churn and despite the industry average in other markets that suggest a ~0.7 grams/day average, we model grams/day remaining at ~0.6 grams

o   The March quarter ASP of $8.20/gram was up from $7.90/gram in the prior quarter. Average selling prices should continue to increase to $10.00/gram based on an improving sales mix of 25% extracts at $16.50/gram and 75% dry bud at $7.80/gram.

·         Based on these factors, we forecast Mettrum to achieve $31MM in revenue this year (FY 2017 ending in March 2017, a 295% y/y revenue growth rate) and $55MM next fiscal year (FY 2018 ending March 2018, a 76% y/y revenue growth rate)

o   Looking out through the forecast period, the FY2016 to FY2020 Revenue CAGR is 83%

·         Mettrum’s cash cost to produce has steadily fallen since production began in 2014 and management is publically targeting a $2.00-$2.25/gram cost by the end of this fiscal year. We then include packaging and lab costs as well as supplemental purchases of wholesale product to arrive at a conservative all-in COGS/gram (excluding FV adjustments) of ~$3.80 in FY2017 and ~$3.25 in FY2018.

o   Notably, this represents the cost using only the current indoor grow format, and does not include any benefit from utilizing a greenhouse format as a component of future capacity expansion that would bring down COGS further (a stated component of further expansion)

o   Gross margins (adjusted to remove non-cash fair value gains/losses related to inventory) should pass through 70% during FY2018.

·         Apart from variable opex related to Sales & Marketing, Mettrum has a meaningful amount of operating leverage related to fixed components of Salaries, Professional fees, Rent and G&A

o   Opex should quickly drop from >150% of Revenue in the recently ended FY 2016 to 58% this year and down again to 38% in FY 2017.

·         Our forecast has EBITDA turning positive in the September quarter (Q2 2017), with full year EBITDA margins hitting 16% before increasing to 38% next year (FY 2017) and up to 44% by the end of the forecast (FY 2020)

·         Following the May equity raise of $7.8MM in gross proceeds, Mettrum had net cash balance of $14.0MM with $3.5MM in capacity on an expandable revolver with Farm Credit Canada at a 4.9% annualized rate.

·         Mettrum spent $5.9MM in capex in FY2016, and we forecast it will spend a further $7.5MM in FY2017, made up of $4MM to build out of their main grow facility (Bennet Road South), and a $3.5MM buffer related to the potential build-out of an industrial scale oil extracts facility.

o   The forecast implies the company will generate positive OCF in Q2, positive FCF in Q4 of this year, and total positive FCF of $14.0MM next year – representing a solid 15% FCF yield

·         At the current share price of $2.15, Mettrum has a Market capitalization of $91MM and an Enterprise value of $77M ($14MM in net cash)

o   Apart from internally generated cash flow, Mettrum will continue to have access to debt financing at attractive rates to optimize its capital structure over time

·         Management and directors are also aligned with shareholders, as insiders collectively own 18% of basic shares outstanding (and they own proportionally more on a fully diluted basis)

Opportunity and Upside

There are 3 primary reasons we believe Mettrum’s shares are undervalued on a relative basis:

1)      Mettrum did not grow as quickly as industry comps in the most recently reported periods. More specifically, the company grew grams sold 9% q/q in Q3 (December) and 32% q/q in Q4 (March) vs. comps growing 30%+ in consecutive quarters.

·         The slower growth in these periods was directly related to capacity constraints in the December quarter that continued (partially) into the March quarter – not well known by the market as management does not hold quarterly conference calls. Importantly, the June quarter has shown a material reacceleration in patient growth as capacity has increased.

·         The Canadian market is showing considerable initial demand for oils/extracts. Mettrum was the second LP to begin selling extracts in January (2016) and the company has a first mover advantage in this important product category. The first mover advantage is material given the apparent stickiness of registered patients when they have signed up with an LP that consistently provides the products the patient requires.

2)      The market has a misguided assumption that Mettrum will continue to have higher cash burn than similar sized competitors. Mettrum has had the highest fixed cost structure of the large public LPs and the recent slower growth quarter led to lowered visibility to cash flow breakeven. We fully expect this perception to reverse when the June quarter (Q1 2017) is reported later this summer.

3)      Given new information related to the reacceleration of patient adds as well as modest continued COGS reduction, Mettrum should begin to show the operating leverage in the business in the upcoming quarters. This progression would show a clear path to OCF and FCF break-even this year.

·         The relative lack of trading liquidity (vs. industry leader Canopy Growth) has resulted in less market participants evaluating Mettrum and fewer institutional investors following the company. Liquidity has improved with the recent equity deal and should continue to improve with positive news flow and the company’s increasing market capitalization.

·         It is important to mention, a significant number of institutional investors in Canada are hesitant to invest in the medical marijuana industry given the lingering stigma associated with the sector. As acceptance grows and legalization in the recreational market occurs under the Liberal government (anticipated in 2017), we expect there will be a flood of capital into the sector.

The Recreational Market

·         The Canadian Federal government has stated many times that to ensure that marijuana is kept out of the hands of children, and the profits out of the hands of criminals, they will legalize, regulate, and restrict access to marijuana.

·         Over the past year, the timeline associated with legalization of the recreational MJ market in Canada has continued to take shape.

o   Recently, Bill Blair, the federal government’s point person on the legalization initiative, stated in a conference keynote speech that the legalization task force intends to deliver its recommendations for the upcoming legalization bill to Parliament in November. 

o   Along with comments from Bill Blair and others involved in drafting these regulations, a recently released government white paper suggests that the LPs are exceptionally well positioned to be the dominant source of production for Canada’s recreational market. 

o   Key dates include the Task Force’s recommendations to Parliament in the fall of 2016, with ensuing draft legislation in the spring of 2017, leading to implementation in 2018.

·         A recent comment in a Clarus Securities Inc research report summarizes the dynamic well: “Given the short timeline (perhaps 12-18 months) from bill introduction to the implementation of legal retail sales and the massive potential demand – we estimate Canada’s recreational market demand to be at least 1.2 million kg per year – we doubt any company not already through the application process and growing successfully could ramp quickly enough to be a viable producer to the recreational market at the outset of legalization. At minimum, the LPs that seek to be the initial suppliers to the recreational market will effectively have a meaningful “grandfather” period where they will be the only available large-scale producers and will be able to secure the lion’s share of wholesale orders with retailers.”

Mettrum has stated publically that the company is exceptionally well positioned to be a major player when the recreational market opens up. From the recently filed MD&A: “While the Company does not expect recreational cannabis to be available in Canada, legally, until some point in 2018, the company plans to launch its first retail oriented products this year.” Mettrum estimates the total recreational market for MJ will total $4.2BN in revenue by 2020. To ensure the company is ready for the recreational market, Mettrum has made a number of strategic moves in advance of the recreational legislation:

·         In 2015, the company purchased a retail goods business and branded it with the Mettrum name. As a producer of over 30 hemp-based products, the “Mettrum Originals” brand continues to grow its distribution and sales with products currently available in over 2,000 stores across Canada. This strategy allows Mettrum to build brand equity and recognition amongst Canadian consumers without breaking Health Canada’s ban on direct advertising rules under the MMPR legislation.

·         The company hired George Scorsis, former President of Red Bull Canada – an executive with extensive experience in packaged goods and the heavily regulated beverage industry, which includes experience working with Health Canada on the guidelines regulating the energy drink category.  George is a strong addition to the management team and will help lead branding and sales efforts.

·         Mettrum recently partnered with the Molson Amphitheatre outdoor concert venue in Toronto for naming rights to the lawn section of the venue (> 50% of the venue’s total seating capacity). This section of the Molson Amphitheatre has been widely known as the location to “spark up.” The naming rights will help build the Mettrum brand with the targeted demographic of future recreational consumers.

·         Putting tangible financial figures to these estimates would be difficult at this point given the uncertainty regarding additional licensing costs, the different Provincially regulated distribution channels, and whether LPs will be able to participate directly (via direct mail or storefronts) or if product will be sold at wholesale rates to pharmacies or provincially controlled entities (i.e. LCBO in Ontario). Nevertheless, the incremental opportunity related to the recreational legalization of MJ in Canada is a meaningful positive; even if we assume product is sold at wholesale rates of $4.50/gram, Mettrum would be able to leverage their fixed cost base and all-in COGS below $3.00/gram to generate meaningful positive EBITDA. 

o   For example, if Mettrum captured just 5% of the recreational market in 2020 at the low end of market size range, this would equate to incremental sales of 14,000kg/year or $63MM in incremental revenue.  If we assume an opex increase of 30%, the Company would generate incremental annual EBITDA of ~$25MM (on a 2020 EBITDA base of ~$40MM, or a 63% jump in EBITDA). The associated level of capacity expansion would be within current licensed properties and capex payback could be achieved in approximately one year.

o   Also, for new or smaller producers it will be quite difficult, costly and time-consuming to scale up capacity to reach profitability in a wholesale market environment. As such, the current top tier LPs are best-positioned to dominate wholesale production for legalized recreational MJ, and market share could be significantly more concentrated than in the Medical market.

Investment Risks

Some of the key risks to be considered include the following:

·         A regulatory shift away from the current MMPR program. This is admittedly a very low probability event given the success of the MMPR program and its popularity with policy makers. Amendments to the MMPR will likely include the ability for patients to growth their own product. However, as we know, consumers can grow their own food and make their own liquor today – but this has not affected market growth rates. In fact, one amendment to the MMPR may improve access to MJ for patients by introducing new channels of distribution (i.e. pharmacies) which would further accelerate recent the industry’s current growth rate.

·         An infraction with Health Canada at a production facility related to security or quality control. All of Mettrum’s facilities are pharmaceutical grade, built beyond the specifications required by Health Canada. In addition, Mettrum has never had a critical infraction that has resulted in a business/production disruption. The Company has continued to be in good standing with Health Canada – best evidenced by Mettrum’s status as the second LP in the country to receive an extracts production and sales license.

·         A reversal in momentum of patient growth, based on industry growth slowing or from patients choosing other LPs over Mettrum, either due to issues with product availability or better go-to-market strategies. We believe a reversal in the recent growth within the industry is improbable given the fact that the black market for weed in Canada (read: demand) is estimated at $5-7BN annually. For context, the entire regulated MMPR market is doing about $200M annually. Based on publically available information, Mettrum grew faster than any other public LP in the most recent June quarter as demand for dry bud and extracts products led to market share gains.

Valuation and Conclusion

Based on the comparable analysis below from a recent research report from Clarus Securities, using consensus analyst estimates the industry average EV/ FY+1 Revenue is 3.0x and the industry average EV/ FY+1 EBITDA is 8.1x (both excluding Mettrum). Consensus estimates have Mettrum at 1.9x and 4.6x these same metrics – a material discount to the industry peer group. 

Based on our base case forecast, and assuming $7.5MM in cash burn, Mettrum is trading even cheaper at 1.5x FY2018 Revenue and 4.0x FY2018 EBITDA.

Catalyst

Bottom line: Mettrum Health is at a financial inflection point – as patient growth accelerates over the coming quarters the business will transition to positive EBITDA and free cash flow breakeven. The management team is well-aligned with shareholders and is keenly focused on executing on the medical marijuana market opportunity in Canada, ramping sales efforts and ensuring ample supply of high-quality product. Mettrum’s current share price does not reflect the growth and cash flow potential of the core Medical MJ business, but as the Company’s reported results improve over the next year, we believe investors will re-rate the share price at least in line with the peer average. As growth continues and as MMPR regulatory uncertainty clears, there will be wider acceptance of the long term viability of all the Canadian LPs and new capital will chase this compelling investment opportunity, driving the stock even higher. Finally, as regulations open the recreational market in Canada, investors will begin to see (and value) the first mover advantage that Mettrum has established in the market – ultimately pricing in an opportunity that could more than double the size of the business overnight.