The rise and rise of Medicinal Cannabis

Following cannabis’ notoriety and political-driven prohibition for almost a century, its cultivation and use is now progressively being legalised for medicinal use across the globe. The momentum and increasing acceptance of medicinal cannabis offers exceptional investment opportunities to a select list of high-calibre, well-funded, early-movers.

Currently, over 30 countries (including Germany, France, Spain, Israel, Canada and Australia) as well as 29 states in the US have some form of legislation in place allowing patients to use cannabis for medical purposes. Thirteen of these countries have put in place legislation in the past two years, demonstrating the increasing acceptance and recognition of the medicinal benefits of cannabis.

The significant increase in momentum behind the use of medical cannabis
is expected to continue due to its:

1. Wider acceptance of therapeutic benefits;
2. Improved safety profile over existing therapeutics; and
3. Regulation providing material tax revenues.

Medical cannabis generally refers to a range of products, from purified
cannabinoid compounds (including CBD and THC) to those using the whole,
unprocessed marijuana plant. Products are often presented in oil, balms, gel
or capsule forms. The amounts of key cannabinoid chemicals need to be
known for appropriate dosing, in order to treat symptoms of illness and
other medical conditions.

The science is well established

A recent analysis of over 10,000 published, peer reviewed clinical studies conducted by US National Academies of Science, Engineering and Medicine, concluded that there is strong evidence supporting the use of medical cannabis to treat chronic pain, muscle spasticity, and chemotherapy-induced nausea and vomiting. In addition, this study reported that the existing published studies supported its use for treating sleep disorders, anxiety, post-traumatic stress disorder and provide relief from many of the consequences of infection with the HIV/AIDS virus.

With the legalisation of medical cannabis in numerous countries, the body
of data from properly conducted and controlled clinical studies is expected
to grow considerably over the next few years. However, even without these
studies, the anecdotal reports from literally millions of patients who have
successfully used cannabis for medical purposes (either treatment or
symptomatic relief) is extremely compelling and supports a major role for
cannabis in Western medical practice. Such factors have led to overwhelming
support to legalise medicinal cannabis for medical purposes.

The current market leader

The Canadian cannabis market is the global leader in regards to regulation,
production, manufacturing & distribution. Their recreational use market
opens in July 2018 (Canada aims to stop illegal cannabis and convert to
regulated supply) and is expected to be ~3x their medicinal market.
Canadian medicinal and recreational cannabis demand combined is likely to
exceed 750,000kg/yr within 5-7 years.

Currently there are over 79 licensed producers (LPs) of cannabis in Canada with the two largest TSX-listed players being Aurora and Canopy. These companies are actively investing in large scale growing operations (>100,000kg/yr) to meet the large increase in demand that is expected with the opening up of the recreations market. Despite the Canadian industry supply response, deficits are expected.

Australia well placed to capitalise on the export market potential

By allowing recreational use, Canada will formally be in breach of its obligations as a signatory of the UN’s Convention on drug control (the 1961 Single Convention on Narcotic Drugs) which requires very strict government controls on the production of cannabis and only permits it to be used for research and medical purposes. At this stage, it is not clear if this will limit the ability of Canadian producers to export to other countries, such as Australia, that remain abiding signatories to this Convention. Given Australia has a long history of producing controlled, medical-grade, plant derived pharmaceutical actives (Australia produces >40% of the pharmaceutical opioids from poppies), Australian producers should be well placed to achieve export status, giving them both a local and a much larger global
market opportunity.

The Australian medical cannabis market alone is likely to be ~$1b p.a. to ~$2b p.a. by 2025 (~$1b p.a. for cannabis flowers only or ~$2b p.a. for cannabis flowers & extracts). However, the potential of the export market (Germany, Canada, USA) will dwarf this by many multiples (cumulative $20b+ p.a. to $30b+ p.a.). The opening of the export market and the ongoing opening of recreational use markets is likely to result in deficit cannabis markets globally for the medium to long term.

Various market pundits who have been slow to research the sector are reacting as expected – talking down the emerging industry’s opportunity and making ill-informed remarks about the re-rating of various cannabis stocks globally. We’ve experienced the same dynamic in the early stages of various other emerging bull markets where we have been ahead of the curve and subsequently done very well in. As the great Sir John Templeton said, “Bull markets are born on pessimism, grow on scepticism, mature on optimism, and die on euphoria.” We view the cannabis sector globally within the “grow on scepticism” stage and are excited about the outlook for Cann Group (CAN), our key long exposure to this theme.

Our key exposure to the theme

Cann Group (CAN). Cann is Australia’s leading medical cannabis producer,
committed and funded to expand its operations for Australian and export
markets. Over the last three years, Cann has built a strong business base in
Victoria, Australia’s leading state for medicinal cannabis growth and
trialling. Cann is focused on medical cannabis only, including breeding and
cultivation (first permits secured on 30 May 2017), and is the only company
in Australia to date that has been issued with a permit to grow a commercial
cannabis crop.

The first crop was harvested in August 2017 and the company
is now growing its third. Cann secured its complete breeding to packaging
supply chain, has a high-calibre and experienced executive team and
agribusiness board, who are well aligned with strong equity ownership.
We expect Cann to continue being the medical cannabis leader in Australia,
using local partners (AgVic, La Trobe University & CSIRO) and leading
international partners to develop plant breeder ownership of specialty
cannabis for a range of disease treatments. Cann is aiming to obtain licences
for manufacturing medical cannabis products from cultivated plants by
2019. In the interim, Cann has an off-take supply agreement with the
Victorian Government for most of its production capacity. However, under
these contracts it can choose to export its medical cannabis as an alternative
when it is ready and Government regulations allow.

Cann’s production capabilities & well-funded expansion plans comprise of:

1. Phase 1 Established Southern facility with 300kg/yr of cannabis growing capacity;
2. Phase 2 Northern facility under development with 2,000kg/yr of cannabis growing capacity due 1Q18; and
3. Phase 3 Northern facility expansion increasing to produce up to ~25,000kg/yr of cannabis flower.

The company has just completed a $70m+ capital raise at $2.50/sh, with its
largest shareholder and Canadian partner Aurora taking ~$26m (increasing
its interest in Cann to 23%), and Cann directors taking $1.3m. Cann’s
16,000m2 phase 3 project will make it a meaningful player on a global scale,
and compares favourably to Aurora’s three facilities totalling 83,000m² (~5x
Cann’s). Note Aurora boasts a C$3.2b market capitalisation, ~10x Cann’s.

Cann’s phase 3 potential cashflows are $100m+ pa, implying its trading on a
modest forward cashflow of ~3x. Paragon initiated its position in Cann at
$1.15/sh in August 2017. Whilst it is up >2x since, we view the risk-reward
to the upside and remain long the stock.