Tilray/Aphria: The 30% Merger Arbitrage Is Tough To Play
Feb. 08, 2021 9:15 AM ET
Read the article at this link to see the charts:
Since the merger was announced last December, Tilray shares have detached from the merger price and are trading at a ~30% premium.
Merger arbitrage is best played through a paired trade (long Aphria and short Tilray); market prices indicate borrowing costs of shorting Tilray is much higher than the ~30% merger discount.
We remain bullish on Aphria/Tilray due to their leadership in the global cannabis industry but one should avoid buying Aphria shares simply to take advantage of the merger arbitrage.
Since the merger between Aphria (APHA) and Tilray (TLRY) was announced on December 16, 2020, the two stocks have traded apart and resulted in a somewhat bizarre situation. Current share prices imply ~30% upside in Aphria shares if the transaction were to close tomorrow. However, we outlined below a few reasons why the arbitrage opportunity exists and why buying Aphria shares does not guarantee a 30% return in this case.
According to the deal that was announced which was structured as a reverse takeover of Aphria by Tilray, each Aphria share will receive 0.8381 shares of Tilray. Aphria shareholders will end up owning ~62% of the combined company. On the first day when the deal was announced on December 16, 2020, Aphria shares closed at $8.06 and Tilray shares jumped to $9.33 at closing, which implies that each Aphria share should be worth $7.82; interestingly Aphria shares were actually trading at a slight premium to the implied merger price at that time. However, fast forward to last Friday's closing, the slight premium in Aphria shares has turned into a ~30% discount to the implied merger price. Simply put, if you own one share of Aphria shares now and the deal closes tomorrow, assuming that Tilray share price remains unchanged after the deal closes, your Aphria stake would return ~30% instantly which is an attractive arbitrage opportunity. But why would there be such a blatant arbitrage trade available when both companies are liquid and well-known among investors?
Tilray Share Price (Feb 5, 2021) $25.72
Exchange Ratio 0.8381
Implied Offer price for Aphria $21.56
Aphria Share Price (Feb 5, 2021) $16.67
Implied Upside to Aphria Shares 29%
Typically the reasons why the target's share price trades at a discount to the implied offer price after a merger is announced revolve around deal uncertainties. For example, if the deal could face regulatory review or shareholder vote that might torpedo the transaction then the target would often trade at a discount until these uncertainties are resolved. Similarly, if the deal has no uncertainty and has a high likelihood of closing, then the target should trade at a very slight discount to the implied offer price simply because, in theory, no one would pay exactly the offer price or more. In this case, we think there are a few reasons why Aphria shares trade at discount:
Short Squeeze: Tilray had one of the most spectacular short squeezes within the cannabis in 2019 when its shares soared to an intraday high above $300 months after its IPO at $17/share. The stock remains one of the favorites among short-sellers and borrowing costs typically spike when Tilray shares rally; Tilray shares have gained more than 200% since the November election. The whole sector has been on fire since the election and the borrowing costs on Tilray shares are certainly very high. In January 2019 when the cannabis sector was rallying, the cost of shorting Tilray shares soared to above 900%. While we don't have data on the latest borrowing cost, we would expect it to be quite high given the massive rally in Tilray shares and the broader phenomena of short squeezes in stocks like GameStop and AMC.
The implication of high borrowing costs is that traders cannot easily take on the arbitrage opportunity to buy Aphria shares and short Tilray shares, in what's called a paired trade. Only in a paired trade could one achieve risk-free arbitrage by locking in the ~30% discount without taking market risks (there is also the risk that the deal would fail which is low in this case). If you do not short Tilray shares and simply acquire Aphria hoping to gain 30% when the deal closes, you are taking on price risks by being long Aphria shares. For example, if Aphria shares tank 50% before the deal closes, you would still lose money on the trade even if the merger discount was eliminated. Another way to lose money by holding a naked long position in Aphria is that the merger arbitrage could simply be eliminated by a decline in Tilray's share price without movement on the Aphria side i.e. Tilray shares are just overvalued.
Regulatory: we don't see this as a major concern for the market because the combined company would hold ~17% of the Canadian retail market which is not very high. There remain plenty of competitors and the merger is unlikely to result in higher prices for consumers.
How To Make Money
Based on the discussions above, the ~30% discount is not easy to take advantage of and the only way to profit from this discount is to create a hedged position that is long Aphria and short Tilray. Given the persistent and growing discount, we think the borrowing cost on Tilray is likely very high, certainly much higher than the arbitrage profits of ~30%, and that's why the market looks inefficient at the moment. Investors could also consider using options strategies to achieve the same outcome as a paired trade but that is not our area of expertise so we won't elaborate. We also discussed why investors should not be naive and buying Aphria shares alone does not guarantee a 30% return: if you acquire Aphria shares outright, the only guarantee is that you will receive 0.8381 shares of Tilray but the value of that stake is contingent on how Tilray shares will trade between now and closing.
Tilray shares could simply be overvalued at the moment and a decline in Tilray shares could eliminate the merger discount without affecting Aphria shares.
In summary, we think the arbitrage opportunity is likely out of reach for most investors given the borrowing cost for shorting Tilray shares. Investors should not be tempted to acquire Aphria shares solely on the basis of the 30% discount implied by both stocks at the moment. Instead, our bullish call on both stocks is based on our conviction that Aphria and Tilray would form one of the leading global cannabis players. The U.S. cannabis sector represents the most attractive arena for investors and should take up the largest share of one's cannabis portfolio. However, Aphria and Tilray have valuable assets globally and their access to capital means they could enter the U.S. markets through acquisitions relatively easily once able to do so. Therefore, we recommend investors to hold onto their Aphria and Tilray shares due to their global exposure but avoid buying Aphria shares simply to take advantage of the merger discount due to reasons discussed herein.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.