The clock is ticking for Tilray (TLRY) as we move closer and closer to the expiration of the IPO-lockup period. With the valuation still out of control, shares may be primed for a rude awakening next month, as even the most optimistic expectations make shares appear still too expensive. Shares are a strong sell.
Big Dreams and Promises
I have been vocal about my skepticism that these Canadian marijuana plays would be able to achieve significant global market share. TLRY for its part has heavily hyped up its exposure to Europe:
TLRY has also made claims of being a global pioneer in the $150 billion global market:
While TLRY does have operations in 29 countries, it is a huge stretch to state that this will lead them to become a global leader (which is what their stock price valuation seems to imply). Most countries arguably are still many years, if not decades, away from legalizing recreational cannabis, meaning that TLRY would only have access to the relatively smaller medical marijuana markets. Furthermore, logistically speaking, it does not make sense for TLRY to be able to supply cannabis globally from its headquarters in Canada, which is not exactly the ideal location to cultivate cannabis (which is why so many operators have resorted to using greenhouses). If TLRY would need to build production facilities abroad - then I counter with an important question: why wouldn’t a local operator simply beat them to the punch? These are the two huge assumptions that I do not think investors should be taken as givens. If TLRY was valued much lower, then I could see the global growth thesis as being worthwhile - it’d be the icing on the cake. But as the main reason for owning the stock, the global growth thesis makes for a rather flimsy cake.
Taking Advantage Of The Bubble
TLRY deserves credit for taking advantage of its valuation to issue $450 million in convertible notes, which bear interest at 5% annually and is convertible into common stock at a price of $167.41 per share. Given that the stock is more than richly valued, it may be unlikely that this conversion will lead to dilution, and even if it does, it would be done at an attractively low cost of capital. The notes mature in 2023, making the 5% interest rate look very attractive and made possible only through the inclusion of the conversion feature (which, as just discussed, would be very beneficial for TLRY).
Dropping My Estimates
TLRY did manage to nearly double revenues, and this strong growth should continue next quarter as we see results from adult-use sales. As we can see below, however, stock-based compensation came not just high, but distinctly higher than total revenues:
Investors should keep a close eye on stock-based compensation as a percentage of revenues. I would be very skeptical if they continue to be even more than 20% of revenues moving forward.
TLRY revealed that their average net selling price per gram dropped significantly to $6.21 due to increased wholesale prices:
Using their comments in the conference call of C$8.22 price per gram for non-bulk sales, and their notes that bulk sales made up 50% of revenues, we can estimate their bulk sale pricing to be very low at C$4.26 per gram, or US$3.17. Competitor Aurora Cannabis (OTC:ACB) disclosed bulk wholesale prices of C$5.50 per gram, or US$4.10. I anticipate adult-use sales to see pricing more like bulk-sales than direct to consumer - thus, this should be cause for concern for those long the stock.
Management also indicated that they expect this downward trend to continue, saying, “We expect our average selling price to decline as a result of stronger growth in our wholesale channels compared to our direct to patient channels.”
Furthermore, costs to produce each gram has risen significantly to $3.82 - they attributed this to needing to outsource product from other licensed producers to meet demand. This looks like it’s due to not having large enough production capacity to meet demand. While being “sold-out” is typically a good thing, in this case, it just represents missed opportunity. In my analysis of Canopy Growth (CGC), I had estimated that the total market would be 1.1 million kg annually (using the high end of consensus estimates). If we assume TLRY achieves 15% market share, which looks too optimistic considering that by 2020 the top cannabis producers are expected to be able to produce north of 3 million kg annually, then this suggests TLRY would be able to sell 165,000 kg long term. Using an estimated $4.50 price per gram (which is high considering bulk sale numbers), this would result in $742.5 million in revenues - far short of my previously estimated $1.1 billion in revenues. I also assumed TLRY could achieve 25% net margins which looks unlikely seeing the rising costs and the fact that gross margins currently aren’t much higher than 30% - now I instead am projecting 15% net margins. This results in $111 million in net income. Further downsides to this estimate include, among others, failure to achieve 15% market share, downward pressures on price, and inability to achieve 15% net margins. I should also note that they will need significant investment spending to ramp up production capacity to each of these estimates. When compared to their market cap, this projection proves too low.
Lock-Up Ending Soon
As many readers know, TLRY is an interesting case in which there is a very low amount float of stock right now. TLRY has 16.7 million of common shares outstanding, but there are 76.5 million in additional shares which will become active after the lock-up period ends on January 15, 2019. This results in about 93.2 million shares outstanding, or a market cap of about $9.3 billion. This means that TLRY trades 84 times my projection for long-term earnings. That’s a lofty multiple and suggests that TLRY will have to execute more than perfectly to justify its valuation.
My 12-month price target for TLRY is $48, or about 40 times my estimation for long-term earnings. This price would arguably still be very rich, but would give more opportunity for upside surprise from their global expansion - something which I believe the current price does not.
As we get more financial results which include adult-use sales, we should see the stock price more closely track actual financials instead of hopes and dreams. This, combined with the expiration of the IPO lock-up period, suggests that we may see a large influx of highly motivated sellers that will help allow the price target to be reached.
Risks
CGC has money. Their apparent backer, Constellation Brands (STZ), has a history of doing large deals in the cannabis industry. Considering that other names are also quite richly valued, especially CGC, it would not be without reason if we see some M&A activity as it's arguable that almost any acquisition would be accretive given where shares are trading. That said, STZ is unlikely to take part due to it being vocal of treating CGC as their partner, and there are unlikely to be potential buyers other than CGC due to the fact that TLRY is the 2nd largest by market cap. I nonetheless view the probability of a takeout by CGC or others to be very low, and am thus not so worried of such an outcome.
If TLRY can show that non-flower sales have significantly more margin potential, then they may be able to meet or even beat my estimates. Regulation, however, has not been passed for non-flower sales so it is still unclear how the distribution channels will look like. Furthermore, I am skeptical that there will be significant pricing power even in non-flower sales. Those hoping for upside from non-flower sales may have to wait several years, but even then, how much is priced in already?
Because TLRY has such a low float and simultaneously appears to be a very obvious short, cost to borrow is very high, reaching 370% as recent as September. TLRY is very volatile making it potentially difficult to short outright. Those looking to short are thus advised to potentially use some creativity and consider using options to help construct the trades.
Conclusion
The moment of truth is coming for TLRY next month, and I predict that shares move sharply lower due to increased share count liquidity as well as more financial results. TLRY trades at a lofty valuation which appears to be built mainly on their ability to expand globally, but investors should carefully scrutinize such an argument, as after all, Canada did not discover cannabis. TLRY is a strong sell with over 50% downside in the next twelve months.
