5 Predictions for Cannabis Investing in 2017

“The legalization of cannabis is one of the greatest social, economic, and political movements in the past century. Currently, legal cannabis sales are around $5 to $9 billion per year, representing only a fraction of the overall demand in the country and leaving much room for growth,” says Harrison Phillips, Analyst at Viridian Capital Advisors, a strategic and financial advisory firm dedicated to the cannabis industry. “Estimates for the size of the cannabis industry in five years’ time (end of 2020) are between $15 and $25 billion, with most estimates falling near $20 billion.”

Phillips notes that this growth will depend largely on new states “creating legal and regulated cannabis markets.” This is increasingly the trend — in November 2016, seven of eight states with ballot initiatives to legalize medical or recreational cannabis passed. These new states included California, the most populous state as well as the largest cannabis market in the country. Over 70 million Americans now live in a state with legal recreational cannabis, a 275% increase from before the elections. When it comes to medical marijuana, the figures are much higher. Twenty-nine states plus D.C. have legalized medical marijuana, covering two-thirds of the U.S. population.

What’s in store for 2017? Phillips offers a few predictions:

1. Trump’s election likely won’t stymie support for cannabis.

“Even with the election of President Trump and the tapping of Jeff Sessions for U.S. Attorney General, we expect the coming administration to side with states’ rights regarding cannabis, particularly for medical use.”

“We expect additional states to legalize medical and/or recreational cannabis markets in the coming years, and, over the long term, for the federal government [to enable] cannabis to be regulated and controlled at the federal level as well as allowing interstate commerce and the establishment of a truly national cannabis industry,” says Phillips.

2. Investment from PE, VCs, and large strategics will continue to increase.

“Originally, the vast majority of funding in this space came from friends and family of operators,” due to the uncertainty and small size of the industry, says Phillips. “As more states have established legal cannabis markets, more sophisticated investors, such as ultra-high-net worth individuals, family offices, venture capital firms, and private equity firms have begun investing in the space.” Pay Pal founder Peter Thiel’s investment in Privateer, a cannabis focused fund, in 2015 is a prominent example.

According to Marijuana Business Daily’s Marijuana Business Factbook 2016, 18% of financing rounds completed by cannabis companies in 2015 used venture capital or private equity firms as sources of capital, compared to 8% in 2014.

Phillips also points to a number of “larger, strategic entrants” into the cannabis market as evidence of the increasing diversity of participants in the space, including Scott’s Miracle-Gro Company (which has made three acquisitions in the agriculture technology space) and Fortune 150 company Arrow Electronics.

“These moves not only further support the growth prospects of the cannabis industry but also establish the ‘emergence of the exit’ as larger, better financed companies become potential buyers of cannabis firms, providing liquidity events for entrepreneurs in this space,” notes Phillips.

3. Public companies will be among the most aggressive acquirers.

M&A activity has increased in nearly every industry sector YTD in 2016 vs. 2015. Viridian has tracked 136 transactions closed by cannabis companies in 2015 and 2016, and found that “Public companies continue to be the most aggressive acquirers as stabilizing stock prices are used as currency for acquisitions,” says Phillips.

4. More investors will “touch the plant.”

Viridian segments the cannabis industry into two broad categories — those “touching the plant” (e.g., cultivators and retailers) and those providing ancillary products and services, like lighting manufacturers, consulting companies, soil and nutrient providers, software companies, real estate investment firms, and others. “Most investors are more comfortable investing in companies not directly engaging the cannabis plant,” says Phillips, due to perceived reputation risk and federal regulations.

However, “as the industry has begun to mature and investors have watched state-legal businesses generate profits and tax revenue without harming their communities, more groups have begun investigating and making investments into companies touching the plant,” says Phillips. “Some cultivators, retailers (medical and adult-use), and infused product manufacturers have steadily attracted more investment from investors with greater risk tolerance.”

While he notes that investors generally consider biotechnology and pharmaceutical companies the most valuable investments, developing and commercializing cannabis drugs takes time, “especially as the plant’s classification as a Schedule I controlled substance limits the ability to conduct clinical research and development.”

Viridian, through its market intelligence initiative, the Viridian Cannabis Deal Tracker, monitors capital raise, mergers and acquisition, joint venture, and licensing activity for both public and private companies in the legal cannabis industry across 12 key sectors.

Viridian tracked 700 capital raises, totaling over $2.0 billion, by cannabis companies in 2015 and 2016. They found that companies in the “touching the plant” segment of the market continue to raise more capital, primarily driven by the Biotech/Pharma and Cultivation & Retail segments. Companies in the Touching the Plant segment completed 270 raises for a total of $1.4 billion vs. companies in the Ancillary Products and Services segment’s 445 raises for a total of $652.6 million.

5. Valuation multiples may be on the rise.

The Viridian Cannabis Stock Index tracks the performance of approximately 50 publicly traded cannabis companies as a proxy for the stock performance of cannabis companies as well as relative valuation metrics within the industry.

Stock performance is categorized into the 12 different product/technology sectors noted in the section above. These sectors are further differentiated into two segments, those that “touch the plant” and those that are providers of ancillary products and services.

Median trailing twelve-month (TTM) price-to-sales (P/S) multiples for select sectors from the beginning of 2015 through the end of the third quarter of 2016 as of the end of each quarter (e.g. the Q1’2016 multiple was calculated as of March 31, 2016). TTM P/S multiples are calculated by dividing the market capitalization of a company by the sum of its revenues from the last four reported quarters.

“On January 1, 2014, Colorado and Washington State rolled out their recreational cannabis markets, sparking the beginning of an unsustainable run-up in cannabis stock prices as investors rushed into the public cannabis markets. However, the fundamentals of the publicly traded cannabis companies had not developed to support these valuations, so we have seen a decline in the valuation multiples afforded to companies as stock prices continued to correct,” Phillips said. “These multiples continued to decline into the final quarter of 2015 before resurging in 2016.”

Phillips continued, “The P/S multiples were somewhat volatile between the first and second quarters of 2016 but generally continued to decline while the stock performance of our Index over these two quarters was relatively flat. In the third quarter of 2016, the multiples began to rise again, driven by performance in the stocks of the companies in our Index as well as improved fundamentals from doing business in more established cannabis markets.

For the last quarter of 2016, we expect multiples to have risen again driven by further increases in stock prices. During Q4, our Viridian Cannabis Stock Index rose 155.0%, driven largely by excitement leading up to the November elections in the U.S. and the subsequent investor interest from the successful results of said elections.

Note: The valuations for many of the sectors in the Viridian Cannabis Stock Index are derived from only a small number of companies and therefore may not be representative of these sectors as a whole.

Disclaimer: The information contained herein is for informational purposes and should not be construed as Viridian recommending investment in cannabis companies or as a solicitation to buy or sell any security or engage in a particular investment strategy. Investment in cannabis companies entails substantial risk. Before acting on any information, you should consider whether it is suitable for your particular circumstances and consult all available material, and, if necessary, seek professional advice. Viridian Capital Advisors and its affiliates, as well as their respective partners, directors, shareholders, and employees may have a position in the securities mentioned herein and may make purchases and/or sales from time to time. Viridian Capital Advisors, may act, or may have acted in the past, as a financial advisor, fiscal agent or underwriter for certain of the companies mentioned herein and may receive, or may have received, a remuneration for their services from those companies.