Earlier this week we saw a game-changing move in the cannabis industry with Emerald Health Therapeutics ($EMH) entering into a joint venture with Village Farms ($VFF), a North American produce-growing company with 4.8 million sq ft of greenhouses in British Columbia, 30 years of operational experience and 750 years of combined "master grower" experience. In the joint venture, Emerald Health will pay $20 million (in tranches) for a 50% stake in the JV that will lease (with the option to buy) 1.1 million sq ft. of existing greenhouse and the option to lease or purchase an additional 3.7 million sq ft. of existing greenhouses owned by Village Farms (for 4.8 million sq ft total). The 1.1 million sq ft. greenhouse is projected for 75,000,000 grams annually and the 4.8 million sq ft. of total greenhouse space should yield over 300,000,000 grams. This puts Emerald Health at the best relative value in the industry by a large margin and also provides the largest margin of safety relative to intrinsic value.
This joint venture with Village Farms might be the best acquisition/partnership that we have seen in the industry so far. At $20 million for 50% of the JV-owned 1.1 million sq ft. and 75,000,000 grams annually, Emerald paid $36/sq ft. (1.1 mil / 2 = 550,000 sq ft. ; $20,000,000 / 550,000 sq ft) and $0.53/gram of annual production ($20,000,000 / 37,500,000 grams); this is comparable to Aphrias' greenhouse construction cost of $50/sq ft. and $0.66/gram of annual production, or to $250/sq ft. and $2.56/gram of annual production for Auroras' acquisition cost for Peleton Pharma (for acquisitions, there are comparable numbers in my article on the Mettrum acquisition HERE); it is even comparable to Emeralds' cost for their existing greenhouse that was projected to cost $10 million per 10,000,000 grams of production. The cost for the retrofit of the greenhouse could exceed $20 million but it would have to double/triple before it becomes overpriced relative to other industry acquisitions/partnerships. The JV deal is also to be paid in tranches with only $2 million up front and $18 million to be paid out as milestones are reached, this saves Emerald on the back end if the deal falls through or isn't finished according to plan. Most importantly, Emerald just paid $20 million for 37,500,000 grams of annual production, which should produce $30,-40 million net, annually, bringing them to 47,500,000 grams of annual production for $40-50 million net, annually.
Emerald will still need to retrofit the existing greenhouses for cannabis production, which according to Village Farms most recent investor presentation, should initiate the cultivation license process in June 2017, the greenhouse conversion process in Summer 2017 (completing March 2018), and the growing process in late 2018. It seems that an in-process tomato crop in the current greenhouse is delaying the process (tomato crop completed Nov 2017) but even with growing starting late 2018, I'm still optimistic. We obviously want production as soon as possible but this is an eternal industry with a lot of variables still left to play out, a 6 month delay from legalization does not ruin the investment merit of this company and the point still stands that they are priced at close to 2-3x net income for 2019 (without the addition 3.7 million sq ft from the JV and further expansion on their own facility). Emerald also has 10,000,000 grams planned for production by legalization from their current facility in British Columbia and up to 100,000,000 grams if the full footprint is built out.
A quick look at market caps and production across the sector show relative value for Emerald.
Market values, planned production, and price per gram of production as of June 8, 2017 (Keep in mind we are projecting $0.50-1.50 per gram for net income ($1/gram net is a good middle of the bell curve while still providing margin of safety))
Aurora - $680 million - 99.8 million grams - $6.5 per gram of production
Canopy - $1.25 billion - 92 million grams - $13.5 per gram of production
Aphria - $720 million - 75 million grams - $9.5 per gram of production
Organigram - $230 million - 26 million grams - $9 per gram of production
Hydropothecary - $150 million - 29 million grams - $5.1 per gram of production
Emerald - $120 million - 47.5 million grams - $2.5 per gram of production
Price per gram of production is a metric that I created to show relative value between companies, based on their planned production relative to their market capitalization. Obviously some companies will deserve a better premium over others based on management, ancillary services, location, competitive advantage, etc.
We see here that Emerald is priced at almost 1/2 of Organigram while producing almost 2x more product. Emerald is also 17.5% the size of Aurora but is slated to produce 50% as much product, if Emerald was priced the same as Aurora (in terms of price per gram of planned production) it would be worth $308,750,000, obviously Aurora is going to be worth more per gram of production because they have a different management, different financing, different location, different medicinal patients, etc. but Emerald still has incredible value when looking at relative industry valuations and valuation relative to net income.
For a better relative valuation, Aphria has 75,000,000 grams projected from their 1,000,000 sq ft. greenhouse completing construction in July-August 2018 (growing starting just before or around the same time as Emerald); Emerald is projecting 47,500,000 grams annually (67% of Aphria production) and is priced at 17% of Aphria. Both of these companies use greenhouses and both are low-cost producers.
When looking at future potential production, Emerald has a maximum capacity now of 250,000,000 grams annually (at low-end production estimates, more than any other LP) which could net $250 million annually (2x its current market cap). Aurora maximum production is 150,000,000 (50,000,000 of which is dependent on a facility that hasn't been started and is only in the planning/zoning stage, we also haven't heard about the additional facility in quite a few months), Canopy maximum production is 130,000,000 grams (with construction on a large portion of this incomplete/unstarted), this leaves Emerald with the largest potential production for the industry, by far. This is also extremely beneficial for Emerald because, unlike almost ever other LP, these production numbers are backed by actual completed greenhouses (retrofitting is still required, but doesn't require full bottom-up construction and planning like most other LPs). My biggest issue with this industry (and the reason I created this spreadsheet) is that the majority of the LPs have planned so much but have so little construction actually underway, Emerald benefits here by not having to plan and construct new facilities from the ground up.
Village Farms is located in one of the best climates in Canada for greenhouses, the coldest temperatures during the winter tend to stay above 0 degrees Celsius which should help with heating costs. Aurora, for example, experiences a "real" winter that will require higher heating costs that will cut into COGS during the winter months. Village Farms also owns a 7 MW power plant that is fueled by recycling landfill gas, it is unsure if this is going to be used for the JV.
Emerald Health also provides the highest margin of safety relative to intrinsic value out of any LP that I follow. Margin of safety is also most apparent for Emerald in the case of a production limit (something that is very possible in the future once supply overtakes demand); Aurora also provides a strong margin of safety in this case, not because of margin of safety relative to IV but because they own a supply chain in Germany that could take excess product that might not be allowed in Canada.
Emerald (and Village Farms) will still have to raise additional capital to build out the first facility and to retrofit the additional 3.7 million sq ft., this will lead to dilution. I dont have much of a disdain for necessary dilution (especially dilution that pays for itself 2x over within its first year or two of production).
There is risk of the retrofit being more costly than planned or lagging the proposed timeline. Although extra costs are possible (probable?), lagging the timeline is less possible because the $20 million funding from EMH is in tranches to be paid out based on completing milestones.
I would also like to know the leasing agreement for the facility and whether the power plant will be used to subsidize power costs. I would also like to see the costs for acquiring the additional facilities.
I am interested in how the 50% ownership will work for Village Farms, will they sell the product to Emerald? Will they receive their own cultivation/sales license and sell their 50% of production themselves? What prices will they be charging Emerald, if Emerald buys their product, or will they sell it to competing LPs? Are all profits from EMH sales from the facilities split in 50%? Will the JV sell under their own label, with 50% of profits funneling to each partner? Sell under Emerald, with 50% of profits going to each partner? Village Farms is definitely undervalued now, but there are so many questions when trying to determine just how undervalued they are.
It also seems like these acquired greenhouses are not as automated as the Aphria/Aurora greenhouses (although labeled "state of the art" in their investor presentation). Are these facilities going to have a long life? Is there significant capital spending required in the future for upkeep? Are the facilities going to produce significantly less per square foot as the automated facilities (projections are below-average but estimates are said to be conservative)?
There is a risk to operation scale if there is no demand for the extra supply. At 300 million grams total for the JV, they will be supplying more than 1/4 of Canada. If there is a production cap and there is no international markets or licensed producers available to purchase the excess supply, net income potential is capped. The production cap is extremely possible and it is unsure if international markets and their early stages of legislation could handle the excess supply. In any event of a production cap, Emerald Health is still one of the better value picks in the sector.
Im writing an article on price targets across the industry so I wont go into extreme detail here. This is an extremely simplified price target and in no way represents my analysis on the industry, this company or this JV; this is a quick calculation based on net income for the growth phase on an industry that could very well end up completely different based on how various qualitative/quantitative variables play out.
In 2018, Emerald should net $0-10 million depending on how revenues play out from their 10,000,000 gram/100,000 sq ft. facility that is supposed to be finished by legalization. Emerald could net $40-50 million annually from this JV and their facilities combined for 2019 (depending on spending and operations; net incomes should be low for initial phases of legalization due to required spending for expansion). Emerald also has the opportunity to obtain the rest of the 4.8 million sq ft. available, which could push them over $150 million net (47.5 million current + 150 million if all 4.8 million sq ft. is utilized, minus margin of safety; also not including the rest of the 32 acres that Emerald owns that could add another 90 million grams annually if built out).
If this joint venture doesn't hit any major roadblocks, Emerald should be worth well over $800 million by 2019. $800 million represents a 20 PE on $40 million (less than $1/net on 47.5 million grams, a low end projection w/ margin of safety), this disregards any additional expansion on their own 1.4 million sq ft. property or the acquisition of the 3.7 million sq ft. that Village Farms has remaining in the JV contract. I also believe that valuations for this industry could be higher than average because of a variety of reasons that I've listed HERE in my analysis on the industry.
I believe that Emerald now has the best potential to be the largest licensed producer in Canada, based on all current information. It is not crazy to think that Emerald could be worth $1.5-3 billion down the road if there is a market for the 300 million grams that the JV could potentially produce across its 4.8 million sq ft. of greenhouses, plus there is the 1.4 million sq ft. of land that Emerald leases in BC (from the CEO).
At the lowest level, even 3% growth demands a 12PE in a DCF. A 12 PE for Emeralds (low-end) net income for 2019 would be $480 million (4x todays price). This industry is going to grow faster than 3% annually and the industry economics surrounding cannabis should lead to above average valuations (I linked to the reasons why in two paragraphs above, in my analysis on the industry).
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in TBQBF, ACBFF, APHQF, HYYDF, OGRMF over the next 72 hours.