PwC Canada's cannabis series

Chapter 7 - Going global: The lure of international markets and benefits of a global strategy

Even before adult-use cannabis legalization came to Canada companies were looking over the horizon to international markets. Their pursuit of global opportunities at this early stage carries significant risk given the number of challenges their rapidly developing domestic operations will face. But done correctly – with a clear understanding of local laws and regulations, well-devised tax plans and sound operational strategies – international expansion might not only prove lucrative, but also ensure the long-term success of the business.

The world at their feet

Canada has just become the first major economy to legalize adult-use cannabis federally, giving domestic players a first-mover advantage to supply and serve international markets. Canadian licensed producers (LPs) have a unique opportunity to establish a global leadership role in the industry at a time when many jurisdictions are considering legalizing cannabis. In fact, Canadian businesses have the opportunity to influence foreign policy development thanks to this country’s leadership position on cannabis. Already, most of the prominent Canadian companies have invested in countries with strong medicinal markets – including Australia, Israel and Germany – and some have set their sights on investments in Columbia, Jamaica and South Africa (primarily through Lesotho), to name just a few locations.

Prudent international expansion should be welcomed by investors who have rewarded LPs aggressive valuations in expectation of oversized returns. The average enterprise value trading multiples for publicly-listed Canadian cannabis companies currently exceeds 50x and 10x estimated Fiscal 2019 EBITDA and revenue respectively.1 As previously discussed in Chapter 6 of this series, the domestic market alone will not be able to support such high valuations for the entire industry, and the supply of cannabis will quickly exceed domestic consumption. Emerging markets overseas will offer significant earnings potential to successful companies. Germany’s medicinal market on its own, for instance, could prove larger than Canada’s medicinal and adult-use markets combined.

Canadian businesses have the opportunity to influence foreign policy development thanks to this country’s leadership position on cannabis.

Source: 1 Capital IQ. Data as of November 12, 2018.

International expansion offers rewards but also carries significant risk. Four challenges to consider are:
 

  • Jurisdictional unknowns

Some foreign governments are struggling to design and implement new laws and regulations for legal cannabis use, creating uncertainty for businesses.

  • Inconsistent regulatory environments

    • Banks in some countries will not finance legitimate cannabis businesses for fear of jeopardizing relations with regulators in the United States, where cannabis use remains federally illegal;
    • Some federal governments restrict foreign ownership of property, including farmland, and foreign ownership of cannabis businesses; and,
    • Import and export rules differ by jurisdiction.
       
  • Financial reporting considerations

Navigating diverse foreign business environments will require LPs to form local joint ventures and distribution arrangements. These business arrangements will create complexity in financial reporting related to control considerations. 

  • Climate

The cost of cultivating cannabis in Canada, which includes building indoor/greenhouse growing facilities, could become a competitive disadvantage as producers in warmer climates come online.

Navigating diverse foreign business environments will likely require LPs to form local joint ventures and distribution arrangements.

To move beyond the short-term market growth expected in Canada, LPs must take advantage of international opportunities. This process starts with a global strategy and a playbook – which, designed and executed effectively, could produce dominant global players with proprietary technology, products and brands.

Thanks to a Good Manufacturing Practice (GMP) agreement between Canada and Europe, Canadian LPs whose products meet GMP and ISO certification enjoy a competitive advantage in European markets.

Canadian cannabis companies also benefit from the absence of major competitors from the United States. As long as cannabis remains federally illegal in the United States, US multinational companies are reluctant to enter the industry and be unable to dominate as they do in so many other industries.

It is important that LPs’ tax and legal structures are designed in such a way as to satisfy the requirements for receiving foreign investment incentives as well as avoiding inadvertent Canadian and foreign tax implications. Extra attention will need to be paid if global production reaches a level that leads cannabis to become an exchange-traded commodity.

A properly designed global strategy will provide operational synergies and the chance to invest in jurisdictions that offer favourable tax rates and tax incentives. Although the global tax environment is in a constant state of flux, there are established strategies that cannabis players can adopt to provide substantial tax savings on profits earned abroad.

For example, Cannabis companies will want to maximize the benefits of the locations of their R&D activities, as well as ownership of their proprietary technology and intellectual property (IP). Specifically, IP that will be leveraged in foreign jurisdictions need not be located in Canada, and can be offshored to leverage foreign investment incentives. It is imperative, however, that there is real substance to the operational activities required to support the development and ownership of IP and that these activities be permitted under local laws.

As markets mature and industry players look to redeploy cash, creating strategies for repatriating earnings will become important. The process should include the design and implementation of tax-efficient operating models, foreign holding structures and international financing structures. The cost of procrastination will be significant, with corporate income tax rates and withholding tax costs each amounting to 30 percent of earnings or more depending on the jurisdiction.

With time, businesses may also want to consider the segregation of operations from real estate ownership as another way to create value for investors, in much the same way as retail and other industries have successfully accomplished.

An initial checklist for companies venturing abroad is:

  • Understand the local laws and regulations in the foreign jurisdiction.
  • Consider all the incentives offered by local governments at all levels.
  • Realize that capital and banking arrangements may be limited in other jurisdictions and have alternative financing arrangements in place.
  • Engage early in strategic operational and tax structuring to develop a playbook for international investment or expansion.
  • Create an inventory of the company’s IP and assess how it can be best leveraged internationally.
  • Consider the accounting implications of investments and other business relationships.
  • Understand how investments and contracts will be accounted for, and how they may affect financial results and valuation models used by industry analysts.
  • Consider where cannabis supplies may be located in the future and whether trading company functions can be centralized to drive efficiencies, improve margins and reduce taxes.
  • Consider the other costs (e.g. transportation), risks (geopolitical, environment etc.) and regulatory requirements of moving abroad.

LPs that have the resources should consider developing early footholds in foreign markets. By building infrastructure to support the growth of the medicinal cannabis market, these companies will be well positioned once regulations evolve to allow the sale of adult-use cannabis.

Tomorrow’s global leaders

It is rare for new industries to emerge as rapidly as the cannabis sector has and even less common for Canadian enterprises to find themselves with a huge lead on foreign competition. International cannabis markets beckon Canadian LPs, who enjoy an abundance of capital and have the distinct advantage of operating in the world’s first fully legalized domestic marketplace. If Canadian companies can pair their expertise in cannabis production and distribution with external knowledge of how to effectively and efficiently expand operations abroad, then Canada will be well positioned to continue its leadership of the global cannabis industry.

Overall success both domestically and abroad will depend largely on their ability to establish and maintain an effective supply chain. In chapter 8 of our cannabis series, we look at how supply chain strategy is built, and how it could determine leaders in the new market.

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