More from Echelon Capital Seeing the “potential for liftoff,” Echelon Capital analyst Andrew Semple thinks it is “an excellent point” for accumulating shares of U.S. cannabis equities, believing the 2021 underperformance was “undeserved,” “fundamentals remain strong” and touting the “incredible potential remaining” in the industry.
“Last year was difficult for many U.S. cannabis equity investors, an outcome that we find surprising given the strong financial and operational performance of our coverage names,” he said in a research note. “In 2021, the New Cannabis Ventures (’NCV’) American Cannabis Operator Index declined by 33.8 per cent, our tracking group of large/mid-cap US cannabis operators lost 35.7 per cent, while the actively managed AdvisorShares Pure US Cannabis ETF declined by 29.9 per cent. Echelon’s U.S. cannabis coverage modestly outperformed, having declined by 27.9 per cent on average (Top Picks in U.S. cannabis even better, but still down 24.4 per cent). We believe the underperformance was largely owed to capital markets considerations, as US cannabis fundamentals have mostly held up to or exceeded expectations.
“We suspect many U.S. cannabis equity investors might feel caught between a rock and a hard place given the tough capital markets conditions this past year. However, we believe the better analogy is that U.S. cannabis investors stand between a rock and a rocket ship, with the potential for stratospheric returns over time. Our price targets on our 10 U.S. cannabis coverage names imply an average upside of 159 per cent over the next 12 months (149 per cent using consensus price targets). However, we believe even these returns could prove to be conservative, especially in the context of U.S. cannabis federal legalization. If we were to change just three variables across our valuation models to reflect potential benefits from federal cannabis reform (taxation, cost of capital, terminal year exit valuation multiple) to more ‘normal’ levels, this could improve the average implied return across our coverage to more than 300 per cent.”
Mr. Semple thinks federal legalization, which is proceeding slower than anticipated following the 2020 presidential election, is not required to achieve his “bullish” price targets, seeing enough momentum already behind legal cannabis companies and consumer demand to “fuel robust growth for years to come.”
“In addition, states continue to advance their own cannabis reform, creating billions of dollars of annual new market opportunities each year, beyond what we have so far incorporated into our valuation models,” he said.
“There are incredible growth opportunities still ahead for U.S. cannabis, with approximately only one-third of cannabis demand in America having been converted to legal channels so far. We are particularly bullish on limited-license markets, which are states that have capped the number of entities able to operate cannabis establishments. This type of regulatory regime creates high barriers to entry and thus strong economics for licensed cannabis businesses, while also appropriately balancing patient/consumer access to regulated cannabis products. Limited-license markets also tend to have tighter regulatory control for improved product safety, quality assurance, corporate governance, compliance, and taxation collection, leading to an overall healthier and safer cannabis industry for all participants.”
Mr. Semple suggested investors look to his top picks for the first quarter of the year. They are:
- Ayr Wellness Inc. (AYR.A-CN) with a “buy” rating and $75 target. The average target on the Street is $70.
- Columbia Care Inc. with a “buy” rating and $14 target. Average: $13.38.
- Verano Holdings Corp. (VRNO-CN) with a “buy” rating and $40 target. Average: $36.57.
“While we are bullish/aggressive in our outlook, we are disciplined in our selection of coverage names,” Mr. Semple noted. “We find all of our current U.S. coverage to be well managed operators that are fully financed for organic growth, with a focus on attractive limited license state markets. Our selection criteria have resulted in substantial outperformance over time, and believe recent share price declines are a function of near-term transitory factors and timing. Even in a downside scenario where adverse equity market conditions persist, our coverage names are positioned for further gains as they utilize their balance sheet strength, access to capital markets, and internally generated cashflows to drive 1) further consolidation of privately held operators at attractive valuations due to the latter’s relative lack of capital alternatives, and 2) potential share buybacks by year end that take advantage of equity market conditions if they persist. Furthermore, where disappointing performance is associated with delayed movement at the federal level, we are hedged by focusing on names with state specific catalysts, where we see billions of dollars of new market opportunities in the years to come.”