6 minute read 30 Oct. 2019
Cannabis

Seven questions about valuation in the Canadian cannabis sector

One year after legalization, the perception of risks and opportunities has changed for the cannabis sector.

Cannabis valuation insights continue to evolve. One year after legalization in Canada, some key factors to consider include key internal factors — including the level of success experienced in supply chains, operating efficiencies, products, branding, management and governance — as well as external factors such as the impacts of regulatory changes and outlooks, evolving estimates for market size and consumer preferences, the expanding options for raising capital, M&A activity, and the pricing and financial results of indicative public companies.

In the next phase of legalization, we ask seven key questions around the valuation of companies.
 

1. How are valuations of public cannabis companies performing overall?

The news isn’t good. Generally, despite new share offerings, market capitalization growth rates in the last 12 months for North American public cannabis companies have narrowed to a significantly lower range than the high growth rates from one year ago. For many of these companies, the growth rates have flipped from positive to negative.

We found that 60% of the largest North American companies experienced a decline in market capitalization for the 12 months ended 30 September 2019, and the entire range of growth rates lowered dramatically.
 

2. In the past year since legalization, did companies live up to earnings and share price expectations?

Overall, public company EBITDA results fell short of expectations.

When we looked at cannabis valuations a year ago, we provided an analysis of the 25 largest cannabis companies on the Canadian stock exchanges. At that time, available outlooks generally predicted that EBITDA would improve significantly in a year. Unfortunately, the levels generally did not meet expectations.

Public cannabis companies are attributing the disappointing 2019 EBITDA results to many factors on both the demand and supply sides. Regardless of the causes, these shortfalls tell the market that companies have been spending funds that are not currently producing income.

The market has reacted strongly to the EBITDA shortfalls, with share prices at 30 September 2019 typically falling below prices from the prior year.
 

3. How much did buyers pay for intangible assets, and how significant is the early-license advantage?

Deals included significant payments for intangible assets, most notably large levels of goodwill. Generally, the smaller the transaction, the larger the proportion of goodwill, and the larger the transaction, the higher the percentage allocated to licenses, permits and other assets.

When we analyzed the financial reporting of approximately 100 deals reported by North American public cannabis companies, we found that a large portion of the deal price was typically allocated to goodwill. Licenses and permits also typically had significant purchase price allocations, particularly for larger transactions and for targets headquartered in the US. Allocations to other assets — such as working capital, facilities and equipment, brands and distribution networks — were noteworthy on a collected basis, but not significant individually.

The allocations to licenses and permits may appear surprisingly low. However, the value of these intangible assets will depend on the regulatory environment of each jurisdiction. Valuations consider the legalized cannabis products and uses, and the extent of the local barriers that prevent additional entrants from obtaining licenses and permits. Other important considerations include the expected pricing and margins, which also vary across jurisdictions.

In performing cannabis valuations, the devil is clearly in the details. The extent of the early license advantage must be carefully considered.
 

4. Are goodwill and investment write-offs coming?

The economics of booked goodwill and investment values will be considered on a case-by-case basis, by looking at the carrying value (originally based on the historical price paid) and the current valuation. Many stakeholders will be watching for indications of impairment.

Because the post-legalization performance of many cannabis companies in Canada missed expectations, and given the significant levels of goodwill recorded in business acquisitions, sector stakeholders will naturally be watching for indicators of goodwill impairment, and over-valuations in general, on the balance sheets of cannabis companies.

Common questions will include whether recent or near-term performance shortfalls are temporary, which performance gaps can be closed, what are the fundamental changes in the sector and its industries over the past year, and what do we know now that we didn’t a year ago.

For large goodwill and other asset values recorded based on deals executed at high valuation multiples, as time passes the historical deal metrics will become increasingly outdated and therefore less compelling as protection for current valuations.

So far, there have been only a handful of notable significant goodwill or investment impairment adjustments reported pertaining to North American public cannabis companies. However, impairment adjustments are likely to increase as the sector matures, identifying with the benefits of hindsight the successful business acquisitions and those that are struggling.

5. Is the cannabis sector getting organized around key metrics for comparability?

At this early stage, many companies are using non-standardized metrics to describe production, capacity, volumes and earnings. Such metrics are prone to subjectivity and comparability issues.

Management and analysts are frequently using non-standardized metrics to describe cannabis business performance — metrics that are not defined by the accounting standard setters. Examples of such metrics include revenue per population, cash cost of sales per gram, cash cost to produce per gram, operating cost per square meter, production capacity/facility size/canopy area, and normalized or adjusted EBITDA.

Since there are no standardized methodologies for calculating such specialized metrics, one company’s approach to such calculations may differ from another’s. This divergence can lead to comparability challenges.

With this divergence of practice for key metrics, it would be prudent to look at the details of the calculations of these non-standardized metrics, rather than accepting them at face value. Adjustments to reported metrics across cannabis companies may be required before using the metrics for valuation or capital allocation decisions.

6. What are the impacts on earnings that companies are expecting from planned improvements in operating processes?

As cannabis companies mature, not surprisingly they expect to realize operating efficiencies that they expect will result in EBITDA flipping from negative to positive. Companies are expecting that operating efficiencies will come from many areas, including improving their facilities, honing and automating their processes, and improving quality control measures.

Innovations in technology and rapidly advancing know-how in the talent pool will be key drivers for these improvements. This means companies and analysts are generally forecasting profit margin improvements for cannabis companies over the next few years.

We analyzed the forecasted gross profit margins and EBITDA margins of the 25 largest North American public cannabis companies at 30 September 2019 and found that they expect gross profit margins to improve on average from 54% in 2019 to 62% in 2021, and while most (68%) reported negative EBITDA for the past year to 30 September 2019, the majority (88%) are forecasting positive EBITDA by 2021.

The cannabis sector expects that its future cash burn will translate into positive EBITDA by 2021 — a turnaround from the generally negative outlook currently held for 2019.
 

7. Which valuation approach works best in the current environment?

It depends on the available information. In practice, valuation professionals use professional judgment to select the appropriate valuation approaches and techniques, depending on available information. In the cannabis sector, income- and market-based valuation approaches are frequently applied given the relatively early stage of development, and a variety of key metrics are considered.

Guidance from the accounting profession may be helpful in contemplating valuation approach. International Financial Reporting Standards and US Generally Accepted Accounting Principles provide a framework for measuring fair value for various business elements in financial reporting. These principles establish a hierarchy for the inputs used to derive fair value, requiring an entity to maximize observable inputs and minimize the use of unobservable inputs.

Where the valuation target is listed on a stock exchange or is in a jurisdiction where there are comparable precedent transactions, the market approach, using observable inputs, may be the appropriate primary approach. Market-based approaches will often include adjustments for factors such as control premiums and non-public information. However, when meaningful market data isn’t available, the income approach — in particular, the discounted cash flow technique — even with its unobservable inputs, will often be applied.

For complete methodology and valuation data, download our PDF report.

Summary

In Canada and globally, the cannabis sector is still evolving through the early stages of commercializing legalized recreational cannabis. Businesses, both private and public, as well as lenders and institutional investors often need external valuations or fairness opinions to support major corporate transactions and decision-making. Acquisitions, divestitures, restructuring, optimization, financing, and supporting financial statement assertions such as purchase price allocations and impairment adjustments — these are just some of the areas where valuations are essential business requirements.

About this article

By EY Canada

Multidisciplinary professional services organization