By: Scott Willis

A new breed of cannabis corporation has lately emerged, swiftly captivating the capital markets and drawing substantial consideration from investors.

We are speaking about cannabis extractors.

Place just, extractors take cannabis flower and turn it into hugely concentrated cannabis oil.

Investors have grow to be enraptured at the income prospective of these enterprises.

The pondering goes, ‘think of how numerous new greenhouses are beginning up in Canada and the U.S. appropriate now, spurring enormous prospective demand for processing solutions due to consumers’ preference for oil-infused solutions such as vape pens, edibles, and drinks more than smoking dried flower.’

The future of the extraction business appears vibrant, but investors are placing their funds at danger if they do not completely realize the organization model and each the dangers and possibilities for these organizations in 2019 and beyond.

In this guide, we clarify the extraction organization models, market place possibilities and danger, plus discover if any of these stocks are effectively positioned to emerge as dominant players in the business.

Immediately after reading our deep-dive you need to be capable to make an educated choice no matter whether these stocks are ripe for investment or need to be avoided.

Vertical Integration or Specialization

The Canadian cannabis market place hasn’t however determined if it will be a vertically integrated model comparable to the U.S. or if the market place will fragment into organizations that specialize in every single segment of the worth chain.

In the agriculture business, there is no precedent for publicly traded processing organizations. Processing of corn, wheat, and soybeans is accomplished privately via cooperatives or by person farmers, telling us profit margins are thin.

In the crude oil market place, significant conglomerates have been initially vertically integrated, handling the drilling, creating, refining, and retail sales all inside a single corporation.

More than time the falling profit margins and earnings volatility of the refining organization pushed these organizations to spin out their refining arms into independent entities.

So far in cannabis, significant licensed growers have signed tiny extraction agreements with third-celebration firms though creating their personal in-home extraction capacity at the similar time.

The jury is nevertheless out on no matter whether the cannabis business goes complete integration to get started ahead of specialization requires more than like in the crude oil organization.

If extraction organizations want to retain all the capacity they’ve constructed completely utilized it is really essential to convince the business they possess particular extraction information and processes that can not be replicated anyplace else.

The Distinct Cannabis Extraction Small business Models

Even even though cannabis extraction just turns flower into oil, this approach can be contractually set up in numerous distinctive methods.

  1. Tolling – Extraction organizations are paid a flat charge per gram to take a grower’s flower, turn it into oil and return the completed oil to the grower who will sell it into the market place.
  2. Spot Market place Sales – Extraction organizations can go out and get flower themselves, turn it into oil and sell the unlabeled oil on the wholesale market place.
  3. White Labeling – Extraction organizations get flower, turn it into completely packaged customer solutions which are then bought by cannabis brands who slap their personal label on the solution and sell it to customers.
  4. Retail – Extraction organizations get wholesale flower and turn it into retail-prepared solutions with their personal in-home branding. These solutions can be sold straight to government distributors or dispensaries.

Tolling

Pros: Extractors are assured a charge per gram regardless of what occurs to rates for dried flower or oil. There is no commodity danger. The only way the extractor gets into difficulty is if the corporation they have a contract with defaults or goes bankrupt.

Cons: This is the lowest danger but lowest return organization model. The extractor can not take benefit of alterations in flower and oil rates to improve margins. They also drop out on greater margins from white labeling.

Spot Market place Sales

Pros: The corporation can take benefit of alterations in the cost of dry cannabis and oils to get and sell at opportune occasions. If they time the market place appropriate, margins and profit will be greater than beneath a tolling agreement exactly where the profit margin is fixed primarily based on the contract.

Cons: Costs can be volatile so unless the corporation has some really clever folks who definitely realize the market place, they could make significantly less than with a tolling agreement and in the worst case drop funds. Income will be really unpredictable and differ extensively from year to year.

White Labeling

Pros: By way of providing completely packaged worth-added solutions, extractors can improve earnings. They are offering an extra service to growers by not only turning flower into oil, but also packaging the oil so it can go straight onto retailer shelves immediately after a label has been slapped on.

White labeling generates decrease earnings than spot market place sales, but is a a great deal significantly less risky way to make funds.

Cons: Labeling and packaging are extra capital intensive than extraction alone and need extra machines and investment up front.

Retail

Pros: This is the highest margin organization model. Extractors capture the whole cost distinction in between the retail cost of a vape pen and the wholesale cost of the dried flower that goes into creating it, which can be substantial.

By making in-home brands and promoting direct to the customer, extractors can develop brand awareness and drive demand and greater margins for their solutions. They will not be hurt if an extraction client has difficulty promoting its personal oil to buyers and cancels or reduces future orders.

Cons: Competing straight with vertically integrated growers and standalone retailers could hurt organization. A grower may well not sign a white label or tolling agreement with an extractor who is straight competing with them on retailer shelves.

The Players

The 4 leaders in the extraction business are MediPharm Labs (TSXV: LABS, OTCQX: MEDIF) ), Valens GroWorks (CSE: VGW), Neptune Wellness (CVE: NEPT) and Radient Technologies (CVE: RTI).

The organizations are primarily differentiated by their management teams and capacity and have not however created proprietary extraction solutions or substantial intellectual home portfolios at this early stage, even even though the organizations will inform you otherwise.

Existing and Planned Capacity of Every Extraction Corporation

000′ Kilograms Existing Most likely Attainable
MediPharm Labs 150 250 325
Valens GroWorks 240 240 240
Neptune Wellness 30 200 200
Radient Technologies 91 274 548
Total Sector Capacity 511 934 1,283

Cannabis Extraction Sector Money Positions

Seeking at the money positions of the 4 significant extraction organizations we see a significant spread in liquidity.

MediPharm is on the low finish most likely simply because the corporation is really lucrative on an EBITDA basis and has observed a money infusion from warrants and selections in the final two quarters to cover the liquidity gap.

The corporation is nevertheless burning about $five million a quarter on new gear and inventory, even so, so will need to have to enhance sales to break even on a money flow basis or reduce capital spending drastically in coming quarters.

Valens need to turn a profit on an EBITDA basis subsequent quarter and also has $62 million in money, providing the corporation the longest liquidity runway.

Investors need to count on an additional capital raise from organizations with beneath a year of liquidity ahead of their capital expenditures need to have to fall and the organizations can operate sustainably.

Years of Money Left at Existing Burn Price

The Chance for the Cannabis Extraction Sector

The extraction model is not a fad and is right here to keep.

Equivalent to how the crude oil market place functions these days, standalone extractors will most likely get cannabis flower in bulk on the spot market place and sell the oil wholesale or in packaged kind to brands who will then place the solution on retailer shelves.

Canada alone produces 900,000 kg of cannabis so there will be substantial demand for extraction capacity as customer demand evolves previous raw flower to oil infused solutions, comparable to how legal U.S. markets have created.

In U.S. legal markets, demand has quickly evolved from smokable flower to oil-primarily based solutions. Concentrates and edibles are extra than 40% of demand in Colorado and 50% in California and increasing.

Not to mention insatiable customer demand for CBD, which will need millions of pounds of extracted hemp to satisfy.

Market place Share More than Time by Item Format

Supply: Marijuana Policy Group, Leeds College of Small business

At this early stage in the market’s improvement, most growers lack the knowledgeable personnel and specialized information to extract cannabis flower into oil, making substantial demand for third-celebration processing solutions.

As extraction organizations refine their extraction approaches and develop a proprietary library of oil formulations they could grow to be indispensable partners to any grower of cannabis.

The Dangers for the Cannabis Extraction Sector

There are a handful of major dangers investors need to have to be conscious of ahead of they dive into owning extraction stocks.

It is Inexpensive to Join the Game

Per gram of capacity, it is a great deal less expensive to get extraction gear than it is to develop a greenhouse and get started increasing.

For instance, it charges $1.50-$three.00 per gram to develop a cannabis greenhouse compared to $.ten-$.30 cents per gram for extraction gear.

Extractors like MediPharm and Valens generated ~40% gross margins final quarter which are twice as higher as the finest international oil refineries.

This may well clarify how organizations have managed to beef up capacity so swiftly.

The affordable price of entrance suggests we will see numerous extra players enter the field in an try to take some of the juicy earnings for themselves.

Extractors like MediPharm and Valens generated ~40% gross margins final quarter, which are twice as higher as the finest international oil refineries.

There is also a large capital markets incentive to make an extraction corporation.

Public extraction organizations trade for $1.92 per gram of capacity on typical though it charges only $.09-$.30 per gram to get gear to get started your personal extraction corporation. Any one with deep pockets could get gear for $.30, go public and turn that $.30 into $1.00-$three.00, for a fast 300-900% obtain.

If margins and public stock premiums keep exactly where they are, new extraction organizations will continually go public till the effortless funds can no longer be created.

Investors need to be ready for extraction margins and the market place cap per gram to fall more than time.

Public Market place Worth per Gram of Capacity

Supply: Grizzle Estimates

Cannabis Extractors Will Struggle to Fill All That Capacity

The legal market place in Canada sells one hundred,000 kg of dry cannabis appropriate now, with extracts creating up only 13% of the market place, far beneath the 500,000 kg of extraction capacity on the net from MediPharm, Valens, Neptune and Radient alone.

The 500,000 kg will develop to 1 million kg by 2020 and 1.five million by 2021, not even counting capacity from private extraction organizations and growers like Aphria with 200,000 kg of in-home capacity.

Eventually, even beneath the most bullish cannabis oil demand situation, extraction provide will far exceed demand.

Existing Demand: In the final 5 months of legalization in Canada, oil demand has been operating at an annual price of only 13,000 kg dry equivalent.

Base Case: Oil demand is additive to flower demand and causes the legal cannabis market place to double in 2020 to 200,000 kg per year. Oil sales make up 50% of legal cannabis sales or one hundred,000 kg, in line with demand trends in California, the most created cannabis market place in North America.

Bull Case: Demand for oil in vape pens and infused into edibles requires more than 50% of the remaining black market place plus 50% of the legal market place.

The black market place and legal market place combined are estimated at 810,000 kg a year in 2018 according to Statistics Canada. We assume the market place grows to 910,000 kg with oil creating up 55% or 505,000 kg a year.

Existing, Most likely and Attainable Processing Capacity

Supply: SEDAR Filings, Grizzle Estimates, StatsCan, Wellness Canada

The above chart shows us that it will potentially be a challenge for extractors to uncover purchasers for their capacity.

Cannabis extraction organizations can not rely on demand outdoors of Canada either. Sales to Europe from Canadian licensed producers (LPs) are operating at significantly less than two,000 kg a year, requiring enormous development to make a dent.

Federal legalization in the U.S. is nevertheless two years away at least and with multi-state operators creating their personal oil extraction gear or shopping for from currently established U.S. extractors, it is doubtful U.S. organizations will be contracting with Canadian extraction organizations at scale anytime quickly.

Seeking at the capacity of announced binding contracts, Valens has contracts for only 19% of capacity in 2019 and 46% in 2020, though MediPharm has binding acquire agreements for only 18% and 7% of capacity in 2019 and 2020.

Placing even this decrease quantity of contracted capacity in point of view, the committed capacity just for Valens and MediPharm alone is 72,000 kg in 2019 which would need oil demand to develop 500% from the February run price.

But What About CBD?

Some will make the argument that exploding CBD demand demands fields of hemp to satisfy customers and they are technically appropriate.

Canada harvested 135,000 acres of hemp in 2018 or 43 million kg of raw hemp. This dwarfs the 500,000 kg of public extraction capacity.

Having said that, a kg of hemp yields only 18 grams of CBD, though a kg of cannabis yields 170 grams of THC, 10x extra.

Economics are worse also, with wholesale CBD extract promoting for $six.50 per gram compared to THC extract at $40/gram.

If extractors approach hemp rather of cannabis their income prospective would be drastically decrease and they would wildly miss consensus estimates.

The a great deal decrease income chance from hemp suggests that even if extractors are operating complete out creating CBD they will nevertheless miss income estimates.

Processing Hemp Does not Spend Compared to Cannabis

C$MM Annual Capacity (kg) Max Income from Cannabis Max Income from Hemp
MediPharm 250,000 $771 $15
Valens 240,000 $288 $14
Neptune 200,000 $428 $12
Radient 273,750 $586 $16

Supply: Grizzle Estimates, SEDAR Filings, AG Canada

If the only point MediPharm extracted was hemp the corporation would max out at $15 million of annual income, compared to consensus of $one hundred-$300 million more than the subsequent 3 years.

Valens is comparable, producing only $14 million of annual income from hemp compared to consensus income estimates of $52-$170 million.

Greater-yielding hemp strains are in the operates, but the timing of when these strains will be planted and harvested is unknown at this point.

Analyst Estimates are Also Higher

The table beneath lays out consensus income and EBITDA estimates (a measure of cashflow) for Valens, Medipharm, and Neptune.

If consensus is appropriate, there will be impressive development for all the extraction stocks.

MediPharm and Valens, in unique, would see income development of 180% and 500% in 2019 compared to 2018.

Cannabis Extraction Sector Consensus Estimates

VGW 2019 2020 2021
Income 52 125 171
EBITDA 23 63 84
EBITDA Margin 44% 51% 49%
LABS.V 2019 2020 2021
Income 116 201 317
EBITDA 26 64 90
EBITDA Margin 22% 32% 28%
NEPT 2019 2020 2021
Income 54 114 176
EBITDA ten 28 48
EBITDA Margin 19% 25% 27%

As of Could 1 2019 Supply: S&ampP CapitalIQ, Altacorp Capital.

Having said that, when we appear at the capacity necessary to hit these EBITDA and income numbers, these organizations are pretty much assured to disappoint investors more than the subsequent 12-24 months.

Primarily based on final quarter’s EBITDA margin of $.12 per gram, Neptune requires to approach 194,000 kg in 2019 and 211,000 kg in 2020.

MediPharm has a superior margin of $.30 per gram but nevertheless requires to approach 80,000 kg in 2019 and 140,000 kg in 2020 to meet estimates.

The trouble for each organizations is they’ve signed contracts for significantly less than these amounts.

Valens only has contracts for 45,000 kg in 2019 and 110,000 kg in 2020 though MediPharm’s contracts are smaller sized at 27,500 kg and 16,000 kg respectively.

Each management teams need to have to sign extra contracts quickly or see customer demand explode so they can fill the rest of their unused capacity via spot purchases and sales.

Valens Consensus vs Contracted Capacity

Supply: Corporation Filings, Grizzle Estimates

MediPharm Consensus vs Contracted Capacity

Supply: Corporation Filings, Grizzle Estimates

Even if these organizations handle to sign extra contracts or get wholesale flower to run at complete capacity or close to it, the market place just does not need to have that a great deal cannabis oil.

Consensus EBITDA estimates for Valens, MediPharm and Neptune alone add up to 330,000 kg of sales in 2019 and 560,000 kg in 2020 though cannabis oil demand is only operating at 13,000 kg a year. This is a enormous gap that will by no means be closed with the present restrictive regulations in impact.

Extraction Capacity is Far Above Stagnant Oil Demand

Supply: HealthCanada, StatsCan, Grizzle Estimates, SEDAR

A Note on Contract Language

Even even though capacity beneath contract is anticipated to be a certain point, the language of the contracts in between extraction organizations and growers leaves a great deal flexibility.

A sample agreement in between a cannabis extractor and a licensed producer reads like this:

Beneath the 18-month agreement, MediPharm will provide up to 900kg of cannabis extract for sale to Canopy Development and its subsidiaries. Canopy Development has committed to buying a minimum of 450kg with an alternative to acquire an extra 450kg.

Couple of of the contracts have minimum volume commitments and most are non-binding with an alternative to use the processor not a contracted requirement. To take into account the prospective upside for extractors, we consist of optional capacity as effectively as committed capacity in our evaluation.

Share Unlock Information and Other Vital Information and facts

MediPharm Share Lockups

Founders, workers, insiders and seed shareholders owning ~40% of diluted shares are locked up beneath the following schedule:

  • 25% released on the Listing date (Oct. 1, 2018)
  • 25% six months immediately after (April 1, 2019)
  • 25% 12 months immediately after (Oct. 1, 2019)
  • 25% 18 months immediately after (March 31, 2020)

Valens Share Lockups

Valens’ biggest shareholder, Noreen Dale Spanell, disposed of three.five million shares out of the 15 million she beneficially owns (12% of widespread shares) on Jan. 30 and agreed to lockup her remaining shares for six months (July 30, 2019).

The purchasers of the three.five million shares agreed to a four-month lockup (Could 30, 2019).

Neptune Legal Proceedings

A prior CEO of Neptune sued the corporation for $eight.five million of unpaid wages and extra stock. The initially hearing dates are Could and June 2019.

The similar CEO is alleging remaining royalties from the krill extract organization have not been paid and is in search of complete payment. The court ruled in favour of the prior CEO at the finish of March and Neptune now has to spend the CEO 1% of income from March 2014 to these days. The quantity has however to be determined but need to be at least $1.7 million.

So What Will Occur to Extraction Stocks in 2019?

Extraction stocks have been the cannabis sector darlings of 2019 so far with MediPharm, Valens, and Neptune up 214%, 153% and 51% respectively, handily beating the general cannabis sector.

These cannabis extraction stocks could have extra upside left in the brief term if management teams announce new contract signings, but as we move via 2019, the organizations will struggle to meet wildly optimistic consensus income and EBITDA estimates.

Provided that the stocks have run and retail investors are all-in on this sector, we consider there is extra downside than upside as the organizations disappoint earnings expectations quarter immediately after quarter.

From a longer-term point of view, none of the extraction organizations have confirmed they will grow to be the licensed growers’ preferred providers of extraction solutions.

They have not constructed sufficient intellectual home and specialized processing know-how to demand a great deal greater prices than what a licensed producer would invest processing cannabis in-home.

If a significant licensed producer announces an additional in-home processing facility, it could throw cold water on the market’s expectation that independent extraction facilities will capture the majority of oil processing organization as Canada rolls out edibles, infused beverages, and vape pens.

In the mature crude oil markets, refiners struggle to earn their price of capital and the finest refiner is only separated from the worst by the reliability of its assets.

Cannabis extraction organizations will have to operate to develop proprietary extraction approaches and intellectual home to stay away from the commoditized fate of their crude oil peers.

EV/EBITDA Estimates

Supply: S&ampP Capital IQ, Grizzle Estimates

Consensus EV/EBITDA Various 2019 2020 2021
VGW 18.9x six.9x five.2x
LABS 28.3x 11.5x eight.2x
NEPT 37.4x 13.4x 7.8x
Weighted Typical 27.9x ten.7x 7.2x
Licensed Producers 37x 19x 11x
U.S. Multi-State Operators 35x 14x Not readily available

Value to Sales Estimates

Supply: S&ampP Capital IQ, Grizzle Estimates

Consensus Value/Sales Various 2019 2020 2021
VGW 9.6x four.0x two.9x
LABS six.8x three.9x two.5x
NEPT 7.4x three.5x two.3x
Weighted Typical 7.7x three.8x two.5x
Licensed Producers 11.0x six.0x three.0x
U.S. Multi-State Operators eight.6x five.0x Not readily available

The opinions offered in this write-up are these of the author and do not constitute investment assistance. Readers need to assume that the author and/or workers of Grizzle hold positions in the corporation or organizations talked about in the write-up. For extra info, please see our Content material Disclaimer.

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