Canada Leads the Global Cannabis Paradigm Shift

[Pages:56]Canada Leads the Global Cannabis Paradigm Shift

Initiating Aphria and Canopy at Outperform

May 2018

Tamy Chen, CFA Cannabis Analyst BMO Nesbitt Burns Inc. (416) 359-5501 tamy.chen@

Peter Sklar, CPA, CA Retailing/Consumer Analyst BMO Nesbitt Burns Inc. (416) 359-5188 peter.sklar@

This report is intended for Canadian & EU distribution only. Unauthorized reproduction, transmission or publication without the prior written consent of BMO Capital Markets is strictly prohibited.

This report was prepared by an analyst(s) employed by BMO Nesbitt Burns Inc., and who is (are) not registered as a research analyst(s) under FINRA rules. For disclosure statements, including Analyst's Certification, please refer to pages 50 to 53. 16:00 ET~

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Table of Contents

Initiating BMO Cannabis Coverage ................................................................................................................... 2 Executive Summary .......................................................................................................................................... 4 Legal Environment Favours Canadian LPs........................................................................................................6 Initial Recreational Market Outlook ................................................................................................................. 7 Current Medical Market in Canada: Opaque ..................................................................................................13 Near-Term International Medical Opportunity: Germany .............................................................................15 Long-Term Industry Outlook...........................................................................................................................16 Company Snapshot: Our Current Coverage Universe.....................................................................................24 Company Coverage: Aphria ............................................................................................................................25 Company Coverage: Canopy...........................................................................................................................35 Comparable Companies - Cannabis................................................................................................................46 Comparable Companies ? Alcohol & Tobacco ................................................................................................47 Glossary ...........................................................................................................................................................48

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Initiating BMO Cannabis Coverage

Aphria: We are initiating coverage of Aphria (APH-TSX) with an Outperform rating.

First Mover Advantage: We believe Aphria will be one of the few licensed producers (LPs) with sufficient product to supply the initial recreational demand and we believe such a "first mover" advantage should enable the company to quickly capture significant share and generate attractive unit economics in an undersupplied market.

Leading Low-Cost Producer: We believe Aphria could emerge as a leading low-cost cannabis producer given the significant commercial-scale greenhouse cultivation expertise held by the management team, and the infrastructure and greenhouse culture that is inherent in the Leamington, Ontario community.

Scale Is Critical to Long-Term Growth: We believe Aphria's scale will facilitate meaningful investment in long-term growth opportunities such as brand development, value-add format manufacturing, the gradual legalization of international medical markets, and advanced pharmaceutical applications.

Valuation: Our target price of $17 is based on a projected enterprise value that is about 17x our Base Case fiscal 2020 EBITDA estimate. We note that our Base Case fiscal 2020 EBITDA estimate assumes that Aphria's facility expansions are only at 65% of full ramp potential versus management's expectation that the facilities will be close to 100% ramp by that time. If these facilities were to reach full ramp by fiscal 2020 and Aphria experiences firmer selling prices, our implied target multiple would be in the high-single-digit range. See Aphria company section for details.

Canopy: We are initiating coverage of Canopy (WEED-TSX) with an Outperform rating.

First Mover Advantage: We believe Canopy will be one of the few LPs with sufficient product to supply the initial recreational demand and we believe such a "first mover" advantage should enable the company to quickly capture significant share and generate attractive unit economics in an undersupplied market.

Head Start in International: We consider the company's current international operations to be more advanced versus most other players, and Canopy appears to be laying the groundwork in markets where medical is not yet legalized, but may soon be. The approach to develop cultivation in "hub" regions like Denmark for export to Germany and eventually Australia for export to the Asia-Pacific region provides the company longer-term access to these markets.

Long-Term Global Branded Leader: Canopy could emerge as a leader over the long term given that the company's scale will facilitate meaningful investment in long-term growth opportunities such as brand development, value-add format manufacturing, the gradual legalization of international medical markets, and advanced pharmaceutical applications. We believe Canopy's strategic alliance with Constellation Brands (STZ-NYSE; US$216.81; Outperform rated by Amit Sharma, BMO Capital Markets Corp.) could prove to be a significant advantage as the industry evolves into value-add formats, and particularly, into cannabis-infused beverages.

Valuation: Our target price of $45 is based on a projected enterprise value that is about 20x our Base Case fiscal 2020 EBITDA estimate. Our target multiple reflects our view that Canopy has a relative head start in brand development and international expansion, and could emerge as a leading global-branded company in the long term. We note that our Base Case fiscal 2020 EBITDA estimate assumes that Canopy's facility expansions are only at 65% of full ramp potential versus management's expectation that the facilities will be close to 100% ramp by that time. If these facilities were to reach full ramp by fiscal 2020 and Canopy experiences firmer selling prices, our implied target multiple would be 11x. See Canopy company section for details.

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Relative Positioning

Canopy Growth

Aphria

? Could emerge as a large, branded player

? Strategic alliance with Constellation Brands could prove to be a significant advantage as the industry evolves into valueadd formats

? Current international operations appear more advanced versus other LPs; strategy to develop cultivation hubs abroad for international export could provide longer-term market access

? Potential to gain "first mover" advantage in initial recreational market

? Scale should facilitate meaningful investment in long-term opportunities

? Could emerge as a leading lowcost contract cultivator

? Continues to establish strategic relationships in international markets, but appears slightly behind compared to Canopy

? Supply agreement with Shoppers Drug Mart broadens medical distribution reach

? Pressure on the stock following controversy with Nuuvera acquisition, resulting in lower valuation vs. other LPs and provides better return opportunity

Source: BMO Capital Markets.

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Executive Summary

Near-Term Outlook

First Mover Advantage for Larger LPs: Initially, demand/supply dynamics will favour the larger LPs. Anticipated demand from the initial recreational market in Canada is expected to considerably exceed industry production as only a handful of the larger LPs will have sufficient cannabis output at that time to meaningfully fill the distribution channels. As a result, this "first mover" advantage should enable the larger LPs to benefit from the favourable pricing dynamics expected in an initially undersupplied market. See Exhibit 3.

In addition, this "first mover" advantage should enable the larger LPs to initially dominate retail shelf space in the recreational market, which would provide a head start for brand development.

Value-Add Formats Will Mitigate Dried Flower Price Compression: We anticipate in year two of our forecast that supply will begin to catch up to demand, which will result in some pricing pressure on dried flower. However, our Base Case projections anticipate that in year two, federal regulators will begin legalizing value-add product formats, which should carry much higher pricing on a grams-equivalent basis and mitigate the pricing pressure that arises in dried flower (see Exhibits 3 and 4).

Our Base Case forecast assumes that the industry growth rate for medical patient acquisition slows when the recreational market is legalized. Some existing medical patients, and potential future patients, could prefer the recreational market when legalized. However, this may be more than offset if more employers begin to include medicinal cannabis under insurance coverage plans.

Near-Term International Opportunity Favours Larger LPs: For the international export opportunity, we expect that only a handful of the larger LPs will be able to secure the licensing and certification requirements, and develop the necessary distribution infrastructure in those regions.

Longer-Term Outlook

Supply Catches Up in Year Two of Recreational Legalization: We project that dried flower supply will begin to catch up with demand in year two, and potentially exceed demand in the third or fourth year following recreational legalization in Canada.

It is not clear if this projected supply/demand imbalance will weigh on the cannabis prices realized by the LPs as there will be the opportunity to export increasing volumes of medical cannabis to international markets, and the introduction of additional value-add product formats should provide higher pricing to compensate for price compression in dried flower.

Evolution Into Either Branded Players or Low-Cost Cultivators: As dried flower prices continue to settle, we believe the Canadian market will rationalize into a handful of larger, branded players and a handful of low-cost contract cultivators. Beyond the branded companies and lowcost contract growers, it is not clear to us how the many other LPs, outside of niche brands, will survive under this pricing environment.

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Near-Term International Export Opportunity Is Temporary: We believe the current international opportunity for Canadian LPs, which is the ability to export products into other markets at favourable economics, will prove to be transitory. As a result, we believe the long-term global opportunity for Canadian LPs is developing intellectual property and brands.

Long-Term Medical Market Opportunity in Pharmaceutical Applications: We believe the distribution model for medical cannabis in Canada will eventually expand beyond the current channel of direct-to-patient. In addition, we consider that Canadian LPs could eventually be in a position to make efficacy claims that are supported by clinical trials. At that point, medical cannabis could qualify for a Drug Identification Number, which we believe would be a significant catalyst to accelerate growth of the medical market.

Scale Is Critical to Long-Term Growth: Over the long term, we anticipate that only a handful of LPs will be attributed a premium valuation. These long-term industry leaders will be those that capture sizable shares of the near-term recreational market, and possess the scale and resources to invest in the long-term opportunities such as brand development, value-add format manufacturing, the gradual legalization of international medical markets, and advanced pharmaceutical applications.

It is also possible that these LPs could ultimately be acquired by large CPG players in the beverage and tobacco industries or pharmaceutical companies given the potential disruption cannabis-infused products could present.

The Blue Sky Scenario Beyond Our Forecasts: An additional long-term upside would be if other jurisdictions consider recreational legalization, and we understand that Malta is currently drafting legislation to legalize recreational use. If Malta establishes and implements a framework legalizing the recreational market, we believe this could set a precedent that encourages potential recreational legalization in other European countries. Under such a scenario, Canadian LPs would have to establish cultivation in those markets in order to participate as UN treaties prevent international trade of cannabis for non-medical purposes.

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Legal Environment Favours Canadian LPs

In Canada, medical cannabis was legalized in 2001, following court decisions, with the Marihuana Medical Access Regulations (MMAR). Under this framework, approved individuals could grow cannabis or appoint a designated person to grow for them. The MMAR framework was replaced by the Marihuana for Medical Purposes Regulation (MMPR), which only permitted Health Canada approved commercial licensed producers (LPs) to grow cannabis. Following a court ruling in 2016, the MMPR was replaced by the Access to Cannabis for Medical Purposes Regulation (ACMPR), which is the current regulation governing Canada's medical market. The ACMPR framework allows patients to either purchase medical cannabis from LPs or grow a limited amount on their own.

Following the election of the Trudeau government in 2015 and the report of the McLellan Task Force on Legalization in December 2016, Bill C-45 was drafted as the proposed regulatory framework to legalize recreational cannabis. On June 7, 2018, the Senate is scheduled to hold a final vote on Bill C-45. However, there are a number of issues that could delay legalization. Provincial governments will receive a period of eight to twelve weeks following the effective date of Bill C-45 in order to secure supply and establish retail locations. In addition, some members of the Senate are recommending the federal government delay Bill C-45 for up to a year to address concerns related to Indigenous communities, although Prime Minister Trudeau has indicated that there will be no delay. We believe it is unlikely that the recreational market will be legalized before the fall.

In the U.S., cannabis is considered by the federal government as a Schedule 1 narcotic, although several states have legalized medical and recreational use. This federal-state conflict exists, in part, as a result of the Ogden and Cole memoranda issued by the U.S. Department of Justice during the Obama administration that deprioritized enforcement of the U.S. federal cannabis prohibition in certain instances. These memoranda were rescinded pursuant to a memorandum issued by Attorney General Jeff Sessions on January 4, 2018. As a result of the federal status of cannabis, U.S. cannabis companies in legalized states are unable to supply international markets.

The international flow of cannabis, which is considered a controlled substance, is governed by three United Nations treaties, and only permitted for medical purposes by countries with a legal federal framework. Several countries have legalized medical cannabis, including Germany, Denmark, Netherlands, Italy, and Australia, and more countries are expected to progress towards medical legalization over the next several years. However, we note that Canada is the only developed country with a comprehensive regulatory framework, permitting both medical consumption and domestic cultivation. The lack of domestic production in many countries with legalized medical use has created the opportunity for Canadian LPs to supply international markets.

Sizing Up the Industry in Canada

No. of Licenses1 Industry production in 20171 Industry revenue in 20171

Prices in medical market4 Prices in illicit market4

Avg. annual yield for indoor3 Avg. annual yield for greenhouse3 Cost of production5

104 81k kg $239 mm

$8 to $9 / g $7 to $9 / g

100 to 300 g / sq. ft. / yr. 60 to 120 g / sq. ft. / yr.

$1 to $2 / g

Note (1): Statistics Canada. Note (2): Deloitte. Note (3): BMO Capital Markets. Note (4): Statistics Canada, company filings. Note (5): Company filings. Excludes shipping & packaging.

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Exhibit 1: Top 10 Publicly Traded Companies (by Market Capitalization)

Company Canopy Growth Aurora Cannabis

Aphria MedReleaf Cronos Hydropothecary

The Green Organic Dutchman

CannTrust Organigram

Cannabis Wheaton

Ticker WEED ACB

APH LEAF CRON THCX

TGOD

TRST OGI

CBW

Source: BMO Capital Markets, company filings, FactSet. Note: BMO Capital Markets is restricted on Aurora Cannabis

Market Cap. C$ mm $8,697 $4,793

$3,198 $2,809 $1,673 $1,179

$1,040

$877 $788

$716

Overview Facilities across Canada and a portfolio of medical and recreational targeted brands. Constructing three hybrid facilities in Alberta and Northern Europe. Announced acquisition of MedReleaf. Operating greenhouses in Leamington, focused on becoming a leading low cost producer.

A premium-branded medical supplier. Announced it will be acquired by Aurora.

Indoor facilities in Ontario, recently established facility in Israel.

Quebec-based, signed 5-yr Quebec supply agreement. Early-stage. Developing first facility to grow organic cannabis. Signed uptake agreement with Aurora. Licensed producer. A leading player in the medical market.

NB-based, has a partnership with Colorado-based The Green Solution. Cannabis investment company. Provides LPs with resources in exchange for financial or product uptake.

Initial Recreational Market Outlook

We believe initial demand in the legal recreational market will likely be below many industry estimates. This is based on our view that several factors will initially temper the level of illicit market displacement (see Exhibit 2 below). For example, several provinces are only establishing a modest number of retail stores in the first year of legalization, and it is not clear to us how prevalent e-commerce sales will be initially. In addition, we are concerned that many of these stores will be situated in locations that are too far from convenient urban centres (i.e., Ontario's first four sites). Finally, we note that initial recreational legalization will only permit three product formats: dried flower, oils, and gel capsules, which is relatively limited compared to the breadth of categories available in the illicit market.

We believe meaningful displacement of the illicit market will take several years, but over the long term, we expect consumers will participate in the recreational market due to the legality, safety, and convenience of product formats that will be offered.

Exhibit 2: Key Factors Influencing Illicit Market Conversion

The uptake in demand from existing illicit market users could be lower than expected if: -There is an insufficient number of stores initially -Stores are in inconvenient locations (such as the first four sites in Ontario) -Other formats in the illicit market (edibles, concentrates) will not be permitted initially -If retail prices are not competitive with the illicit market

Slower illicit market displacement could be countered by: -New users who did not want to participate in the illicit market -The migration of some medical patients whose underlying use was recreational

Source: BMO Capital Markets.

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