Chief Investment Strategist
Summary: In today's equity update we take a look at the news yesterday on explosive growth in iPhone production planned for next year sending Apple share sup 5% in yesterday's trading. However, the growth is not without risk as Apple has difficulties sourcing all the necessary components in another sign that the physical world has potentially reached a temporary limit for supporting growth without more investments and higher prices. We also take a look at the just announced merger between Aphria and Tilray creating the world's largest cannabis producer. While the metrics are the combined company and the industry are bad this merger might be what is needed to get economics of scale.
Apple shares were 5% higher yesterday pulling the equity market higher driven by a story from Nikkei News stating that the iPhone maker is planning to produce 96mn iPhones for the first half of next year significantly above the current Wall Street estimate. This production target translates into 30% growth y/y and will be a key driver behind the 15% revenue growth expected for the FY21 ending on 30 September 2021. While the news is positive for Apple has it expands and upgrade its ecosystem of iPhone users the real market value driver going forward is still the Services segment which has a higher profit margin and less capex needs. Apple is currently valued at a 3.5% free cash flow yield which is in line with other major technology companies such as Facebook and Microsoft.
A key risk for Apple’s ambitious production target is sourcing of key components. Competitors such as Xiaomi has also put up aggressive production targets for next year and thus everyone in the industry is scrambling to get enough components from semiconductors, memory chips and displays. This risk touches on something we have been talking about lately on our podcasts and presentations with clients. The physical world has reached a limit in its ability to service the demand that is coming through the digital world such as e-commerce, smartphones etc. The past 10 years growth in the digital world has sent signals to investors that they should invest there causing underinvestment in the physical world which is needed to support the online ecosystem. We see more and more signs that costs in the global supply chain is going up from agriculture, energy, shipping to metals. This is a theme we will be writing about tomorrow as this theme also plays into our positive view on emerging markets.
Aphria and Tilray are creating the world’s largest cannabis producer
Aphria and Tilray share are up 12% and 22% respectively in pre-market trading on news that the two cannabis producers are merging to create the world’s largest cannabis producer. The combined company would have generated $764mn in revenue, an EBITDA loss of $132mn and negative free cash flow of $502mn in the past 12 months. The raw numbers do not suggest an attractive company but rather two weak players combining with the hope of strength. This assessment might be too harsh but there is a grain of truth to this. However, on a positive not the combined company has 58% revenue growth y/y suggesting that through compounding the combined company will soon surpass $1bn in revenue and with that hopefully enough economics of scale to begin getting stable and positive operating margins. Prior to today’s market action the combined company would have an enterprise value of $4.56bn translating the equity valuation into an EV/Sales ratio of 6x which is rather high for a manufacturing type company in an industry that so far seems to be a commodity with no clear moats to protect shareholders.
We wrote about the cannabis industry back in February in our industry analysis Can the cannabis industry turn growth into profits?. In this piece we looked at the 22 largest public-listed companies and showed that the combined revenue at the time was $2.47bn generating a negative free cash flow of $3.15bn. These poor operating metrics had led to the leading cannabis index to be down almost 60% since September 2018. Since February not much as changed for the positive with the S&P/MX International Cannabis Index down 54% since inception and thus the industry has not experienced the same attention and speculative fever in 2020 as technology companies. Our view on the industry is still negative, but maybe 2021 is the year when economics of scale becomes evident and maybe this merger is what the industry needs.
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