Organigram Article: Relative Value Long

The Cannabis space in Canada has been a hot trading market for the better part of a year now, and there doesn’t appear to be much slowing, however, the volatility and valuation metrics are hard to stomach for a value-focused investor. The opportunity below is not for the faint of heart and OGI is just one way to play the space, and we think an interesting relative value long way to do so. 

Which is why we believe Organigram (OGI), given its relatively cheap valuation, is a good way to play the space IF you can stomach the volatility and await federal legalization.

Investment Thesis

·         Leadership from the best:

o   Tilray, a licensed producer based in B.C., has been the model to follow in the cannabis space, in our opinion, due to its quality of product, scale, and execution, but as it is private, Organigram is the best proxy and most similar business model. Tilray is currently a private company and one of the few that has managed its dilution in a careful and measured manner.

o   It is thus no surprise that OGI’s CEO, Greg Engel, is a proven executive in the cannabis space with leadership experience from Tilray. In a little over a year of leadership, cash costs per gram have declined, yields have increased, the company has raised a significant amount of capital, and Organigram has entered into to two key retail supply agreements.

·         Relative value play: Given OGI’s relatively cheap status among Licensed Producers (LPs), and the lofty production and revenue targets the most popular LP names have to meet in order to justify their share prices, OGI makes for a good long in a pairs trade with a short position in one of the other major LPs.

·         Cheap, Premier Grower: OGI’s cost to produce is similar to or lower than its competitors, even while using indoor growing methods which are widely considered to produce higher quality cannabis, although usually at a higher cost. This is because the company’s operations are in New Brunswick, where there are lower labor, energy, and real estate costs – all key cost inputs into the cannabis production process.

·         Takeout Candidate: OGI is considered a prime takeout candidate by either a large substitute industry player looking to enter the cannabis market (tobacco, pharmaceuticals, alcohol industries) or by a larger competitor looking to consolidate.

·         Hot M&A Market: Recent M&A in the space has been conducted at steep premiums to current share prices i.e. Aurora’s acquisition of MedReleaf was announced at a 34% premium to MedReleaf’s price.

·         Showing Strong Potential: It should be noted that valuations seem absurd compared to actual financial performance in this industry, but can be compared on a relative basis. OGI is arguably the cheapest Canadian LP in the market on a relative value basis. Despite having the fifth highest currently built capacity (22,000 kg) and trailing twelve months of sales ($10 million), OGI has the tenth largest market capitalization and enterprise value.[1] OGI trades at 16.1x Enterprise Value to consensus calendar year 2019 EBITDA (EV/EBITDA), which is a significant discount to its peers’ average of 85.5x.[2]

·         Well-capitalized: Finally, OGI has a well-capitalized balance sheet, with $178 million in cash currently. This should exhibit to investors Organigram’s flexibility and risk tolerance going into a period of large uncertainty, as OGI will be able to invest in production efficiencies, expansion, and/or international growth depending on where the market goes and how the consumer experience unfolds.

Cheap Production Inputs Provide Organigram a Competitive Advantage

·         OGI has quietly reduced production costs to a near-market leading cash cost per gram of $1.06, and all-in cost of $1.47 in the month of February, consistent with overall Q2 2018 figures. These numbers have declined dramatically from Q1 2018, and should stabilize, if not decline, due to the company’s cheap key cost inputs.

·         Namely, New Brunswick has the third lowest average wages, only behind PEI and Nova Scotia, and is 9% and 11% lower than the national- and Ontario-wide averages, respectively.[3] Additionally, OGI pays $0.05/kwh for power vs. $0.20/kwh in Toronto.[4]

·         Given how quickly production capacity has come online in the cannabis industry, a mass oversupply of wholesale cannabis should be expected when the recreational market opens. As reference, Aurora (post-MedReleaf acquisition) and Canopy Growth have a combined funded annual capacity of 970,000 kg, while even the most bullish of analysts predict 900,000 kg of market demand in the first full year of legalization. This, of course, does not include the other 102 LPs in Canada currently, who all have capacity online or coming online in the near future.

·         With all of that in mind, producing product at a consistently high and standardized level while being a cost leader will be paramount to creating long-term shareholder value in the cannabis industry. Organigram is one of the best positioned LPs to deliver on this. 

Cheap Valuation Relative to its Peers

·         Organigram has the fifth highest current capacity in the industry, at 22,000 kg per year, with an additional 14,000 kg coming online by June, 2018 which would propel them into fourth in the capacity race.

·         The pace at which OGI has been able to get capacity on-line and producing, coupled with impressive sales figures that far outperform their relative market value position, demonstrate management’s ability to execute on its promises to investors and mobilize capital into producing assets efficiently. Both of these factors will be crucial to fulfilling the needs of provincial distributors and servicing recreational market demand.

·         2019 is expected to be the first full year of recreational cannabis sales, and most, if not all, analysts in the space use some combination of projected sales and EBITDA to value LPs in the present. Organigram is currently being discounted heavily to its biggest competitors. OGI is currently trading at 16.1x estimated 2019 EBITDA, while the average 2019 EV/EBITDA multiple of its 6 closest competitors (Canopy Growth, Aphria, Aurora, Cronos, CannTrust, and Hydropothecary) is 85.5x.

·         By applying that same average EV/EBITDA multiple to OGI’s 2019 estimated EBITDA, that would imply an approximately $21 share price (a 300%+ return to today’s current share price).

·         OGI trades at a significant discount to the average of its major competitors’ 2017 and 2018E EV/Sales and 2020E EV/EBITDA multiples. Concerning future production capabilities, OGI’s 113,000 kg of funded capacity ranks third amongst LPs currently.

·         For example, MedReleaf has current built capacity of 16,500 kg (25% less than OGI), funded capacity of 140,500 kg (24% more than OGI), and a 2019 EBITDA estimate of $38 million (5% more than OGI) yet they were acquired by Aurora at a $3.2 billion transaction value, and currently have a $2.4 billion market capitalization.

Ideal M&A Target

·         With a relatively cheap implied valuation and top-tier proven and future production capabilities, Organigram has risen to the top of many cannabis industry observers’ lists of M&A targets.

·         For a large substitute industry player (pharma, tobacco, or alcohol), OGI represents a lower cost entry point into the market, while also acquiring proven management and production with future revenue already locked up. This is important because substitute players would largely view an investment in the cannabis space as a defensive move and would be wary of paying high prices.

·         In respect of a cannabis industry consolidation motive, OGI represents geographic diversification into Eastern Canada, and low-cost operations at a fraction of what other LPs would cost to acquire.

Greg Engel has learned from the best and is now delivering at Organigram

·         Industry experts and observers widely considered Engel’s hiring to be a coup for Organigram, and he has delivered on that positive sentiment in the year he has been with the company. During his time as CEO, the patient count has increased 472%, cash costs per gram have decreased to $1.06, plant yields have increased to 70 grams per plant harvested in the last quarter, and revenues have nearly doubled over the last twelve months, compared to the twelve months prior to Engel’s appointment.

·         Much of Engel’s success can be attributed to his world class experience developed while CEO of Tilray. Despite not being in the public eye as much as many other LPs (as they are not publicly traded), Tilray is considered one of the highest performing companies in the cannabis space, on an operating and financial basis.

·         Tilray is backed by billionaire investor and tech mogul, Peter Thiel, and formed an exclusive alliance with pharmaceutical firm Sandoz Canada. Additionally, Tilray has announced supply agreements with Shoppers Drug Mart, SAQ, the province of Manitoba (via a partnership with National Access Cannabis), and initiated a partnership with German pharmaceutical wholesaler NOWEDA.

·         Tilray was the first ever LP to export medicinal cannabis to the EU and South America. If Greg Engel can take what he’s learned and accomplished at Tilray and continue to apply it to Organigram, the company should be a market leader by the time the recreational market comes into full effect.

Risks

·         With any investment, especially one in such a volatile industry with much uncertainty surrounding it, several risks need to be considered.

·         Building a brand and creating customer loyalty will be key to succeeding in this industry, but with little to no means to advertise or market via traditional means, it makes it more difficult to know which brands/companies will come out as consumer favorites beforehand.

·         A product recall can be extremely detrimental to a LP, and when recalls have occurred in the past, stock prices have tanked with slow recoveries back to pre-recall levels, not to mention the legal, financial, and operational issues that a recall would have on the long-term health of a LP. Organigram actually had a recall in Q2 2017, however, under a new CEO and expanded facilities, OGI has been very focused on delivering good quality product.

·         Finally, as many of the LPs are highly correlated to each other, negative news, events, or shocks to the macro environment can have adverse effects to the share price, even if it does not directly affect OGI.

·         These companies, OGI included, should be considered in its VC-phase which likely means very few of these players survive in the long-term.

·         The cannabis industry’s risk-reward profile is very high. The reward could be great, but that is because risk is just is high that any or all of these companies may not succeed in the long term.