BY: MARK NOBLE, SENIOR VICE-PRESIDENT, ETF STRATEGY, HORIZONS ETFS

It has been a rough six months for Marijuana equities. The Horizons Marijuana Life Sciences Index ETF is now negative on a year-to-date basis and down more than 40% over the last six months, as at September 20, 2019. Could it be that the decline in these stocks has fallen too far, and for the first time, these stocks are starting to look (gasp) undervalued?

At Horizons ETFs, we offer five ETFs that provide exposure to the Marijuana equity market, which is the largest family of Marijuana ETFs in the world. Since the launch of the Horizons Marijuana Life Sciences index ETF (HMMJ) in April 2017 as the world’s first Marijuana ETF, our view has been that the Marijuana industry is a viable business with long-term prospects, globally. The recent pullback in valuations could potentially provide an opportune entry point for investors who feel they might have missed getting into the sector.

Before we get into why Marijuana equities potentially look attractive currently, let’s address what’s beaten the sector down.

Disappointing Earnings

First and foremost, the biggest drag on the Marijuana sector’s performance is their reported profits, or rather, lack thereof. The majority of large Marijuana producers have disappointed on earnings and revenue growth in their latest round of quarterly earnings. The two largest Marijuana licensed producers (LPs), Canopy Growth (WEED:TSX) and Aurora (ACB:TSX), were punished after their most recent earnings reports, which showed slower than expected revenue growth and likely no possible path to profitability for either LP over the next 12 months.

In the past, the market has appeared to give these companies a pass on their levered balance sheets, but there’s been a marked shift towards looking for profitability as we near the one-year anniversary on the legalization of recreational marijuana in Canada. The Canadian market is currently the only effective source of revenue for many of the Canadian LPs, which cannot have cultivation and distribution businesses directly in the United States if they wish to retain their TSX, NYSE, or NASDAQ listings.

One explanation for the revenue growth problem is the fact that the rollout of Marijuana legalization in Canada has been inefficient in our view: heavy compliance protocols on testing, approval and distribution of product has resulted in significant supply shortages while LPs are forced to sit on inventory that could reach market. Secondly, the limited scope of store-front retail operations in Ontario – the country’s largest provincial market – continues to constrain the ability to move supply.

As more store-front retail opens up and edibles become legal during Q4 2019, we could see some of these revenue constraints alleviated and more LPs meeting their revenue targets. However, it’s imperative that investors recognize that Canada is likely priced-in, even at these depressed valuations because most consensus estimates (ArcView Research, CIBC, BMO, and Deloitte) put domestic legal marijuana sales forecasts somewhere in the CAD$4 to $6 billion range.

Ultimately, Canada is a small market relative to the global market opportunity but it happens to be the only market that is fully operational from a federal level with clear sources of revenue. For the time being, many of the LPs will have to make or break it on their Canadian revenues. For the larger producers which have allocated significant portions of their balance sheets to investments in markets outside of Canada that are not yet operational, there could be significant delay in attaining profitability.

Health Concerns

Another wrench thrown in the growth of the global Marijuana market is concerns around vaping. A mysterious lung illness amongst both THC and non-THC (or Nicotine) vape users has been documented in more than 800 patients, and is attributed to at least 12 deaths. According to the U.S. Centre for Disease Control (CDC), most of the patients treated for the illness were vaping products containing THC. Currently U.S. health officials are advising people to not use vaping products.

These health concerns have resulted in a reassessment of the future of U.S. and Canadian Marijuana sales. Vaping products containing THC cannot currently be sold in Canada. In the U.S., vaping products are a significant portion of the market, with an estimated 20% of active Cannabis users stating they use these products, as reported by New Frontier Data.

After edibles, vaping was viewed as a key driver of new acquisition in the Marijuana market, with users who prefer not to smoke dry-flower opting for the more socially discreet vaping options. Further restrictions on vaping sales and increased regulations could stifle this potentially lucrative market in the U.S.

It’s possible for the foreseeable future that this segment of the market could be discounted, particularly with Multi-State-Operators (MSOs) that derive significant income from vaping-related sales seeing their stocks impacted disproportionately to the rest of the sector.

Valuations

Valuations have historically been the main concern that investment commentators have used to make an argument against buying Marijuana equities. Valuations on the sector have dropped substantially despite real rise in revenues. Fundamentally, from a valuation standpoint, the sector is likely the most attractive it has been at nearly any point since the inception of HMMJ.

Below is the price-to-book, price-to-sales and sales growth of the top ten holdings of HMMJ. You can see that in most cases, sales growth continues to rise for these companies while the price-to-book and price-to-sales metrics have declined substantially.

Name Sales Growth Price-to-book Price-to-sales Q2 2019 Current Q2 2019 Current Q2 2019 Current HMMJ -6.88 -1.02 -70.36 -23.67 CANOPY GROWTH CORP 80.37% 230.61% 5.98 2.05 133.16 40.28 AURORA CANNABIS INC 205.51% 349.20% 2.45 1.55 123.26 27.44 CRONOS GROUP INC 441.32% 181.45% 10.59 3.73 493.53 175.35 TILRAY INC 69.19% 236.72% 61.73 7.84 100.88 29.96 GW PHARMACEUTICALS PLC 66.43% 601.67% -- -- 234.13 33.37 APHRIA INC 80.62% 542.28% 1.47 1.2 55.42 8.63 SCOTTS MIRACLE-GRO CO/THE -0.31% 18.65% 8.13 6.94 2.13 1.8 CHARLOTTES WEB HOLDINGS INC 171.60% 73.72% -- -- -- -- HEXO CORP 35.55% 671.51% 3.6 2.85 342.25 44.36 ORGANIGRAM HOLDINGS INC 109.38% 484.15% 4.12 2.49 74.82 12.81 GREEN ORGANIC DUTCHMAN HLDGS -- 664.34% 2.06 1.85 788.82 103.2 INNOVATIVE INDUSTRIAL PROPERTI -- 143.46% 4.73 3.72 108.51 44.57

Source: Bloomberg, as at September 20, 2019

As CIBC World Markets recently pointed out, the valuations on MSOs are even more attractive on average than the Canadian LPs. According to CIBC, Canadian LPs are still trading at about 6 times two-year forward sales outlook vs. their enterprise value. The MSOs on the other hand are trading below 2 times.

Given the discrepancy in the potential size of the Canadian and U.S. markets, the MSOs seem quite undervalued, relative to Canada. For context, according to Arcview Research and BDS Analytics, if the U.S. market grows at its current pace with Marijuana use fully legal in the current 11 states, the U.S. market could breach US$30 billion by 2024, which only accounts for growth of spending in legal state markets. That’s already six times the size of the projected size of the Canadian market. Many of the MSOs are fully operational and generating revenue in these legal state markets.

A key reason why Canadian LPs remain attractive is because they have cash reserves to expand into the U.S. market and potentially acquire smaller U.S. Multi-State-Operators (MSOs). The shareholder approval of a US$3.4 billion takeover by Canopy of Acreage Holdings in June provides a strong template of how Canadian companies can expand into these markets, even if they are not yet federally legal. Under this agreement, Canopy Growth would fully acquire Acreage as soon as marijuana cultivation is made federally legal in the U.S.

Investors can access indirect exposure to the U.S. opportunity through HMMJ, or directly by investing in the Horizons Marijuana US Marijuana Index ETF (HMUS). Between both ETFs, investors can achieve full geographic exposure to the long term opportunity in the North American marijuana market.

SAFE Banking Act and States Act

In late September, U.S. Congress passed the “Secure And Fair Enforcement (SAFE) Banking Act”, which seeks to provide clarity to banks and credit unions that would provide banking and financial services for U.S. marijuana companies. From a political standpoint, there is still a long road ahead for this bill to become law – it will still need U.S. Senate approval – but it does potentially open the door for U.S. financial institutions to get more directly in involved in the financing of marijuana cultivation and distribution companies, regardless of whether marijuana becomes legal at the federal level.

Symbolically, the initial passage of the SAFE Banking Act makes the likelihood of progress on the much broader sweeping “Strengthening the Tenth Amendment Through Entrusting States” (STATES) Act, more likely. The STATES act is a bipartisan bill that if passed, would protect Marijuana businesses operating in legal states from federal interference.

This bill would likely allow for wholesale access to financial services, including potential listings with the major U.S. stock exchanges. In many ways, this bill could have the same intended consequences as full-scale legalization, so it remains a potentially significant catalyst for the Marijuana equity sector.

Q3 Rebalances

There were not as many additions to our ETF portfolios this quarter versus Q2 – largely a result of the poor performance of the sector. The opportunity for new entrants to the sector to attain the appropriate market-cap weights to be added to our ETF portfolios was limited.

HMMJ

The HMMJ portfolio recently expanded to include the following two constituents:

Company Name Ticker Exchange Akerna Corp. KERN NASDAQ Fire & Flower Holdings Corp. FAF Toronto Stock Exchange

HMUS

This was the second rebalance of HMUS since the ETF was launched in April. This rebalance included the addition of one stock, Akerna Corporation.

Company Name Ticker Exchange Akerna Corp. KERN NASDAQ

HMJR

The HMJR portfolio recently expanded to include the following 12 constituents:

Company Name Ticker Exchange Acreage Holdings Inc. ACRG/U Canadian Securities Exchange Althea Group Holdings LTD. AGH Australian Securities Exchange EXMceuticals EXM Canadian Securities Exchange 4Front Ventures Corp. FFNT Canadian Securities Exchange The Flowr Corporation FLWR TSX Venture Exchange Green Growth Brands Inc. GGB Canadian Securities Exchange Integrated Cannabis Company

Inc. ICAN Canadian Securities Exchange Jushi Holdings Inc. JUSH/B AEQUITAS NEO MPX International Corp. MPXI Canadian Securities Exchange PharmaCielo Ltd. PCLO TSX Venture Exchange Wildflower Brands Inc. SUN Canadian Securities Exchange TerrAscend Corp. TER Canadian Securities Exchange

Performance Update as at September 20, 2019*

1 Month 3 Month 6 Months YTD 1 Year Annualized Since Inception HMMJ -9.17% -26.23% -38.96% -0.67% -43.70% 19.53% NAMMAR Index -8.05% -27.59% -38.04% -3.08% -44.46% 9.19%** HMJR -10.94% -27.35% -43.15% -19.38% -50.74% -39.26% EMMAR Index -11.32% -26.59% -44.93% -22.38% -53.60% -41.53%***

* Source: Bloomberg, as at September 20, 2019.

** Since HMMJ’s inception on April 4, 2017.

*** Since HMJR’s inception on February 13, 2018.

The indicated rates of return are the historical annual compounded total returns, including changes in unit value and reinvestment of all distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. Additionally, index returns do not take into account management, operating or trading expenses that may be incurred in replicating the index. The rates of return above are not indicative of future returns. ETFs are not guaranteed, their values change frequently, and past performance may not be repeated. The index is (indices are) not directly investible.

The views/opinions expressed herein may not necessarily be the views of Horizons ETFs Management (Canada) Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.