In covering the cannabis mania which has taken the Canadian stock market by storm in recent years, the high levels of consolidation within the cannabis sector, categorized by increasingly unrealistic valuation multiples, is, to me, reminiscent of the bio-pharmaceutical sector just a few years ago.
In early 2015, Valeant Pharmaceuticals Intl Inc. (TSX:VRX)(NYSE:VRX) could do no wrong. The company was buying companies at 30%, 40%, 50%, or higher premiums to valuations on a regular basis. Investors ignored the implications of the multiples Valeant chose to pay for its targets, choosing instead to focus on the future potential of the synergies of said acquisitions as well as the potential for revenue growth via ever-increasing prices for drugs in the U.S. and global markets around the world.
Anyone who rejected the parabolic surge of consolidation-focused mega-conglomerates such as Valeant or Concordia International Corp. (TSX:CXR)(NASDAQ:CXRX) (then referred to as “baby Valeant”) were viewed as crazed outsiders who didn’t understand the synergies these companies would receive by paying these premiums to acquire firms with low earnings quality or future prospects of potential earnings.
Fast forward to today, and investors will notice that the triple-digit valuation multiples of Valeant and many of its peers have reverted toward more realistic multiples (Valeant’s P/E ratio currently sits at just above five). While Valeant has begun to improve of late, Concordia has been holding on for dear life, and many short sellers have indicated they are holding on for the very end, with the stock price trading around $0.25 at present (it used to be above $100 per share at one point).
While the decline experienced by Valeant, Concordia, and others may not represent exactly the future prospects for Canada’s largest cannabis producers, the startling resemblance between these two sectors given the consolidation phases each has undergone has investors concerned for those choosing to get in at today’s extremely rich valuations.
With companies like Aurora Cannabis Inc. (TSX:ACB) acquiring firms at billion-dollar valuations at breakneck speed, the question remains how much longer investors will continue to support valuations at existing levels. The reality remains that most cannabis firms require equity issuances to remain solvent, with debt issuances difficult and costly to obtain relative to other sectors. I will be keeping a close eye on how such deals are financed moving forward, as it is clear to me the only way such valuations can make sense at current levels is via artificially inflated equity values.
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Fool contributor Chris MacDonald has no position in any stocks mentioned in this article. Tom Gardner owns shares of Valeant Pharmaceuticals. The Motley Fool owns shares of Valeant Pharmaceuticals.