Morningstar - Winter 2019 - 28

Spotlight: Cannabis

Investors' Cannabis Playbook
Whether it's investing in widening international
medical cannabis legalization or U.S. federal
legalization, we see options for investors seeking
exposure to different trends.
Widening International Medical Legalization:
Canopy Growth CGC, Aurora Cannabis ACB,
Tilray TLRY, and Cronos CRON
All four Canadian cannabis producers under our
coverage export to the international medical market.
We think Canada will struggle to maintain its
position as the top exporter as lower-cost producers
emerge around the world. However, all four
companies have opened or are opening production in
countries that allow for cheaper outdoor production
and have lower-cost labor. As a result, we think
all four companies will still benefit from widening
international medical legalization.
U.S. Federal Legalization: Curaleaf CURLF
and Canopy Growth
We expect the U.S. to become the largest cannabis
market in the world. Individual states have been
legalizing medical and recreational cannabis, in
contrast to federal laws that prohibit cannabis for any
purpose. We believe, however, that the federal
government will eventually let states decide their own
cannabis laws. A change in federal law would allow
U.S. cannabis firms to gain access to normal banking
services, pay more normal tax rates, and accelerate
demand growth. Operating solely in the U.S., Curaleaf
provides pure-play exposure to U.S. legalization.
Canopy Growth also provides investors direct exposure
through its agreement to acquire U.S.-based Acreage
Holdings immediately upon federal legalization.

Cannabis-Infused Recreational Products:
Canopy Growth and Tilray
Edibles constitute just 11% of cannabis consumption
in the U.S. today. However, we expect to see
significant growth in cannabis-infused food and drinks,
particularly among people who do not consume
cannabis currently but will when recreational
cannabis is legal. Through strategic investments from
Constellation Brands STZ and Anheuser-Busch
InBev BUD, respectively, we think Canopy Growth and
Tilray are well positioned to benefit from growing
demand in cannabis-infused products.
Low-Cost Production: Aurora Cannabis
Unlike many of its peers, Aurora Cannabis is focused
on becoming the low-cost cultivator of the industry
by developing advanced automated production.
We think that most production-based cost advantages
could be eventually imitated by competitors.
But for investors who want to invest in the cultivator
that leads the way in driving production costs
down, we think Aurora is the best option. It is the
only major Canadian producer that has yet to
receive a strategic investment from a major alcohol or
tobacco company.
Cannabis Exposure Without Touching the Plant:
Scotts Miracle-Gro SMG
Scotts offers investors exposure to attractive cannabis
growth without the regulatory challenges. The
company holds an estimated market share of 40% to
50% for hydroponic growing equipment. Despite not
"touching the plant," Scotts will see cannabis account
for 40% of companywide profits by 2028 as the
largest equipment supplier in the U.S. and Canada.

Cannabis Coverage
Economic
Moat

Fair Value
Estimate ($)

Current
Price ($)

Morningstar
Rating

Canopy Growth CGC

54.00

22.93

QQQQQ

None

7.8

Aurora Cannabis ACB

10.00

4.40

QQQQQ

None

4.4

Tilray TLRY

40.00

24.74

QQQQ

None

2.3

Cronos CRON

10.00

9.05

QQQ

None

3.1

Curaleaf CURLF

13.50

5.41

QQQQQ

None

3

105.00

101.84

QQQ

Narrow

Company/Ticker

Scotts Miracle-Gro SMG
Source: Morningstar. Data as of 09/30/2019.

28

Market
Cap ($Bil)

5.6

that would conflict with state laws. However,
in January 2018, former Attorney General Jeff
Sessions, a noted opponent of cannabis
legalization, rescinded the Cole Memorandum,
directing U.S. attorneys to decide for themselves
how to handle disagreements between
federal and state laws.
Of the numerous federal bills currently proposed,
the Strengthening the Tenth Amendment
Through Entrusting States Act, or STATES
Act, enjoys the most bipartisan support, including
President Donald Trump. The STATES Act would
prevent the federal government from interfering in
states' legal cannabis operations but would
not legalize cannabis nationally or remove it from
Schedule I under the Controlled Substances
Act. As such, it would not necessarily remove all
the confusion that surrounds federal policy.
For example, questions related to interstate trade
would need to be decided in the courts,
as the law would appear to protect trade across
two legal jurisdictions, but federal law would
still prohibit interstate transportation of Schedule
I substances.
We think that the most likely resolution to
the federal and state legal discrepancy
is a change akin to the STATES Act. The federal
government would be legally prevented (and
not simply directed to by the attorney general)
from interfering in cannabis operations and
consumers operating within a state's laws, but
it would not legalize cannabis federally.
For the purposes of our forecast, we've included
the impact from states with a high
likelihood of expanding cannabis laws. Should
more liberal legislation for national legalization
be passed, we estimate the market to be
nearly twice the size of our forecast at more than
$160 billion. (For more on cannabis regulation,
see "Beware the Rent Seekers," Page 14.)
It's worth mentioning that acceptance of cannabis
for recreational purposes has been gradually
increasing in the U.S. On average, the percentage
of people who consumed cannabis has grown
by about 25 basis points and 23 basis points
per year for those aged 18 to 25 and 26 and older,
respectively, from 2002 to 2016, according to the
Morningstar - Winter 2019

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