Merrill Lynch Jumps on Legalized Cannabis Train, Sees Large Potential Upside

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Merrill Lynch has started coverage of the legalized cannabis industry with a mostly positive view. It noted that the Canada distribution channels are likely to crimp sales near term from a lack of stores, but the firm believes the market is well aware of these issues and that domestic constraints could actually prompt international activity with strategic actions to buffer the supply limits.

While there are more Buy ratings than not from Merrill Lynch, investors might want to at least consider here that the firm’s projections are by and large below consensus for 2019 and 2020 for all the names in this new coverage. The firm is more in line with estimates after 2021, based on some of the generalities mentioned above.

While Merrill Lynch is under consensus, the report points out that the “consensus” is unreliable when compared to more mature industries. The report also says that being above or below consensus does not mean that any or each of these stocks are or are not necessarily attractive. Another issue worth noting is that the performance has lagged of late and that additional pullbacks in these names could create attractive entry points for new investors.

While the timing on any cannabis sector calls is risky, Merrill Lynch was actually out ahead of the launch of a new actively managed cannabis ETF from a very experienced portfolio manager in the field of “sin stocks.”

Canopy Growth Corp. (NYSE: CGC) was started with a Buy rating and assigned a $52 price objective, with the firm noting that Canopy is a top pick due to its scale, capital and vision, with more chances of catalysts (namely in the United States). Canopy is also said to be investing in areas of the value chain that can bring more attractive long-term growth. The risks to Canopy are valuation and deploying capital into “value destructive assets.”

Shares of Canopy Growth were last seen up 2.4% at $42.67, in a 52-week range of $20.99 to $59.25. Its market cap is now $14.6 billion.

Aurora Cannabis Inc. (NYSE: ACB) was started with a Buy rating and assigned an $11 price objective. Merrill Lynch believes that this company is taking steps to establish long-term leadership in the cannabis segment and is building international scale. The report also noted that Aurora could announce partnerships with companies in more traditional sectors as peers have done.

Aurora Cannabis shares were last seen trading up 1.5% at $9.02, in a 52-week range of $4.05 to $12.52. It has a $9 billion market cap.

HEXO Corp. (NYSE: HEXO) was also started as Buy and was called Merrill Lynch’s most attractive cannabis stock, with huge upside to its cash flows. HEXO’s price objective is $10 as its “preferred supplier status” with Quebec for a five-year period deserves a premium. The firm also noted that its pending acquisition of Newstrike could add additional capacity to serve the Canadian market.

HEXO was trading up 3.8% at $6.17 a share, and it has a 52-week range of $4.91 to $7.60 and a $1.3 billion market cap.

Cronos Group Inc. (NASDAQ: CRON) was started with an Underperform rating. The report actually agrees with the Cronos cannabinoid development strategy, with potentially the highest margins with Altria, but it is difficult to recommend the stock based on its current valuations.

Cronos shares traded up 0.8% at $15.92. The 52-week range is $5.50 to $25.10, and the market cap is $5.3 billion.

Christopher Carey, the analyst behind the call, believes that channel constraints could prompt international actions:

In our view, the longer the distribution channel is constrained, the more likely companies will be to accelerate international strategies, especially larger companies with capital. We think this happens via CBD (legally, markets are opening much faster than psychoactive cannabis globally) and potentially ownership structures in cannabis companies, especially in the US, which do not become legally active until law changes.

In a separate research note, Merrill Lynch’s Bryan Spillane reiterated his Buy rating and $216 price objective on Constellation Brands Inc. (NYSE: STZ) to be aligned with the cannabis sector call. That compares with a current $190.50 share price. The company sees 2020 EPS of $9.03 (versus a $9.16 prior) and assumes a base-value of $183 per share for underlying shares and an additional $33 per share in value for its 38% stake in Canopy Growth.

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