Approximately one year ago, JC Clark authored a piece for Capitalize for Kids on the burgeoning cannabis industry. The report provided a brief history of Canada’s medical market and our expectations as to how the eventual legalization of Canada’s recreational market would unfold. More specifically, we highlighted our top idea in the cannabis sector, MedReleaf Corporation, and why we believed that if the discounted valuation to its peers didn’t narrow, it would ultimately be acquired. At the time of writing, MedReleaf was one of Canada’s largest and most profitable licensed producers. It held approximately 20% market share based on volume shipped, had the highest operating margins in the business, and maintained industry leading cash costs and ROIC. Despite MedReleaf’s obvious operational success, it traded at a material discount to its peers for the most simplistic of reasons. That being, it was a lesser-known story (read: not promotional) and was relatively illiquid due to its high insider ownership. Thus it had a limited following among retail investors, unlike the rest of its cannabis cohorts. Given that these reasons were largely non-fundamental in nature and in certain cases were positives rather than perceived negatives, we felt it was only a matter of time before other investors – be they retail, institutional or strategic – came to the same conclusion. Fast forward 8 months and MedReleaf was subsequently acquired by Aurora Cannabis, in an all-share transaction, valued at over $3 billion. That price was 250% greater than the price of MedReleaf’s shares at the time of our report.

Why is this backstory relevant? Well, the company we have chosen to profile in this report shares many of the same attributes and characteristics of MedReleaf – when it was of a similar-sized market capitalization. The only material difference is that this company presently trades at an unwarranted and even greater discount to its cannabis peer group than MedReleaf did prior to it being acquired by Aurora.

Over the last 4 years, we have learned as much as possible about the business of producing and selling cannabis, and in the process have met with numerous publicly-traded and many privately-owned cannabis companies. Through our analysis, we have concluded that there will ultimately be many failures and that only a handful of companies will truly be successful. With that in mind, throughout this timeframe, we have remained extremely disciplined and very selective with our cannabis investments.

Presently, many of the publicly traded Canadian LPs are priced beyond perfection and the valuations are difficult, if not impossible to reconcile based on anticipated future earnings. As previously alluded to in numerous investor newsletters, many of these companies are presently operating pilot projects of uneconomic size, and their expansion plans require the construction and operation of a facility that differs materially from their existing operational footprint, in both scale and type. It is our belief that many of these companies will fall short of their operational targets and their guidance should be discounted accordingly. Thus, caution is warranted.

Our approach has been to align ourselves with proven management teams with a track record of success. As per our Fund investment strategy, these companies are underpinned by solid valuation metrics, trade at unwarranted discounts to both intrinsic value and their peer group, and most importantly, possess material catalysts that are not fully appreciated or understood by the broader investment community.

Today, JC Clark’s only investment in the Canadian cannabis sector is CannTrust (TSX:TRST), a position we purchased in October 2017 in the mid-$3s, and continued to add to thereafter.

Source: Bloomberg, As of EOD Sept. 24, 2018

CannTrust received its sales license in mid-2014. The company has two producing facilities – an indoor facility in Vaughan and a state of the art, perpetual harvest greenhouse in Niagara. Total cannabis production for 2019 is anticipated to reach approximately 100,000 kg, with greater than 65% of sales to be derived from oil and extracted products, which command significantly higher pricing and yield vastly superior margins – as compared to dried flower – on a gram equivalent basis. Similar to MedReleaf, CannTrust has focused on the science and taken a very methodical and calculated approach to growing its business and meeting the specific needs of physicians and patients. CannTrust’s medical strategy has been focused on the standardization of product dosage, ensuring both a safe and efficacious experience for the patient. This approach to standardization, while also providing multiple, convenient delivery formats, has allowed TRST to amass just under 50,000 medical patients, representing approximately 15% of the registered medical market in Canada. Furthermore, this keen operational focus has resulted in industry-leading production costs and best-in-class yields, which are approximately 70% higher than the average. As a result, CannTrust is one of only a few industry participants that have been able to post positive EBITDA over the trailing 12 months.

Since the company’s founding, management has done an enviable job of creating a multi-vertical, global platform. In late 2016, TRST entered into a strategic relationship with Apotex, a global leader in the manufacturing and distribution of generic drugs. This exclusive partnership was formed to develop proprietary products and dosage forms to distribute through Apotex’s business relationships in over 115 countries. Under this unique joint venture structure, CannTrust will provide cannabis extracts to Apotex at a wholesale price plus a 10% markup. In return, Apotex is required to fund all of the product R&D and commercialization. Significant leverage to Apotex’s team of PhD’s comes with very little up-front costs to CannTrust, yet allows it to capture 25% of all gross profits from every product that the partnership develops and sells globally.

Shortly thereafter, the company received approval from Health Canada to export medical cannabis into countries where cannabis is federally legal. Management has targeted Australia, Germany, Mexico, Brazil and Denmark, to name a few. Where possible, it has established joint venture agreements with domestic partners. Most recently, CannTrust announced it has executed its first shipment of cannabis oil to its Danish joint venture partner, Stenocare. Given the rigorous regulatory standards overseeing the exporting/importing of cannabis internationally, a high level of credibility should be ascribed to CannTrust and its ability to meet and exceed these stringent quality controls.

As CannTrust was founded by trained pharmacists, has a JV with Apotex, and has the third largest registered patient count in Canada, it is no surprise that most investors associate the company with the medical market. However, the company has been very diligent in developing its recreational strategy and has assembled a strong team with excellent brand experience in Canada and internationally across CPG (consumer packaged goods), alcohol and retail. The effectiveness of CannTrust’s go-to-market retail strategy is evidenced by the fact that the company has received 8 provincial supply deals in Canada, amounting to what we believe to be greater than 25,000 kg. This ranks the company in the top tier of Canadian LPs in regards to the number of provincial supply contracts won, listed SKUs and the aggregate amount of cannabis to be provided.

The creative structure of CannTrust’s strategic partnerships with Apotex, Stenocare, GreyWolf (veterinary market), and more recently with Breakthru Beverage Group (North American broker/distributor of liquor), have highlighted management’s business acumen and ability to create a global, multi-faceted platform, while limiting shareholder dilution. However, there is an argument to be made that management and the Board of Directors have not moved aggressively enough in such a rapidly growing and evolving industry. Although we don’t have insight into the decisions that have and have not been made at the Board level, the pace of M&A and international expansion on TRST’s part leads us to believe that several accretive opportunities may indeed have been missed over the last several years – opportunities that have been capitalized upon by their competitors and used to promote their own stories.

The truth is, despite all of the aforementioned operational successes that CannTrust has achieved, the company trades at an unwarranted and enormous discount to its peer group. The Company currently trades at a very conservative 10.2X 2020E EV/EBITDA. This compares to approximately 34X 2020E EV/EBITDA for its peer group with market capitalizations greater than $1B. Below we have highlighted the market capitalization of what we believe to be CannTrust’s closest competitors within the Canadian cannabis landscape.

Source: Bloomberg, As of EOD Sept. 24, 2018

To further put this disconnect into context, we have graphed the above companies’ last quarter revenues below. And, to be clear, we didn’t forget to input The Green Organic Dutchman’s (TGOD) revenue – it simply didn’t have any!

Source: Company Filings

Despite all of our due diligence, we have yet to find one good reason for CannTrust’s anomalous valuation relative to its peer group. How is it possible that The Green Organic Dutchman has zero revenue, yet twice the market capitalization? Or, how does Tilray sport a market capitalization 10 times that of CannTrust, yet possesses very similar operating metrics, as can be seen below.

Source: Company Filings

We believe the explanation for these discrepancies in valuation and market capitalization have more to do with qualitative factors, rather than quantitative. Over the last year, we have developed an open and honest dialogue with CannTrust’s management team – something we try to do with those of all our portfolio holdings. While management has for the most part done a commendable job executing on the operational goals they set forth in our initial meeting, we believe they have fallen short on other fronts.

The company should be listed on NASDAQ. The Board of Directors has to be strengthened. It lacks industry and capital markets experience and adds little to the strategic planning process. The fact that two Board members (and also two of TRST’s largest shareholders) resigned is not encouraging. Ironically, they retain a material amount of their shares, whereas other insiders WITH Board representation have liquidated indiscriminately. The company needs a new CFO. Public company CFO’s are highly visible to the capital markets. CannTrust’s CFO has been invisible since the day TRST was listed. A more visible and capital markets savvy CFO would go a long way in gaining shareholder trust and investor acceptance. Eric Paul, CannTrust’s CEO, is very sharp and has enjoyed a long, successful business career. He has played an important role in building, what we believe to be, pound-for-pound, the best LP in Canada. However, shareholders would greatly benefit if Eric developed a clear succession plan, moved up to Executive Chairman and filled the CEO slot with a dynamic and seasoned individual, whose professional background is a perfect fit for where this industry is heading. Such a move would be VERY well-received by the market.

Admittedly, we and our investors have done well with our investment in CannTrust. However, an investment in pretty much any other cannabis-related company in the last year would have done equally well, if not better. What presently concerns us is that although Eric and his team have done a great job creating a unique and fascinating business, they will be left behind in this rapidly growing market if the above changes are not made.

When CannTrust went public in Q3/2017, company insiders owned approximately 44% of the company; large enough to fend off any unwanted overtures. However, as mentioned earlier, in the last year we have seen two members of the Board resign for unspecified reasons. The combined ownership of these two board members was roughly 12% of the shares outstanding. More troubling has been the relentless selling of Fred Litwin, Eric Paul’s long-time business partner. By our estimation, Mr. Litwin and the related entities under his control have sold approximately 4MM shares since the company went public. This rash of selling has left him with modest financial exposure to the company and a lack of alignment with CannTrust shareholders. As a result, current insider ownership resides at approximately 26% of the shares outstanding. Therefore, the company is no longer controlled by insiders; rather it is the outside shareholders that now have the ability to influence the company’s future.

The continued insider selling, resignation of key board members and the recent flip-flopping on a NASDAQ listing has drawn the ire of several large shareholders and key early supporters of the company. As a result, we have received numerous inbound calls from large CannTrust investors. Our concern is that many of these disgruntled shareholders would be happy accepting a takeout offer at a reasonable premium to the current share price. Even if a takeout were to occur at a 100% premium to yesterday’s closing price, the company would still be trading at a material discount to its peer group. While it is always nice to be the beneficiary of M&A activity, our fear is that CannTrust will lose its independence to one of the larger Canadian LPs at a price well below what we believe to be its fair value, which we peg at $34 per share, based on comparative industry valuations and precedent transactions within the sector. We strongly believe that if the company were to act on our recommendations listed above, it would go a long way to narrowing this valuation gap.