* Tilray and Aphria are merging in a deal that will effectively result in the former being absorbed by the latter but leaving the former's name.
* This transaction makes a lot of sense conceptually, especially in light of the industry's problems.
* Just how much value can be created from this maneuver is speculative, but investors should be used to that in this space by now.
* Looking for a helping hand in the market? Members of Crude Value Insights get exclusive ideas and guidance to navigate any climate. Get started today »
The cannabis space, once considered a hot market with extreme upside potential, has spent a lot of time in the doldrums lately. Industry oversupply, combined with a race to the bottom in terms of cost, has led a lot of players in the market to downsize their operations and/or seek cost cuts in other ways. This makes sense in and of itself, as does the continued investment in the Cannabis 2.0 movement due to the possibility of creating valuable, differentiated brands, but another strategy that can be logical is merging with other market participants. Such is the case now with Tilray (TLRY) and its decision to be absorbed, effectively, by Aphria (APHA). Because of the planned synergies and the opportunity to cross-sell products, this transaction seems to make sense, but in a space where profits remain elusive, it remains to be seen just how much value will be created by this transaction down the road.
A necessary disclosure
All references to $ or 'dollars', with the exception of per-share amounts and market capitalization amount, are to Canadian dollars unless otherwise stated. Even then, those references will be considered on an individual basis.
A look at the deal
The deal between Tilray and Aphria is simple, but it's a little tricky too. In exchange for each individual of their shares, Aphria's investors will receive 0.8381 of a Tilray share. Upon completion of the deal, the combined company will retain the Tilray name, but shareholders of Aphria will own 62% of the combined company's shares. This leaves 38% of the equity to be owned by the existing shareholders of Tilray. Because of how the deal is happening, it would be more appropriate to label it a reverse takeover rather than a takeover. This is the case because in a takeover the larger company issues stock in itself and generally retains its own name, but, in this scenario, Aphria is giving up its shares while still controlling the majority stock in what will remain.
Prior to announcing the transaction, shares of Aphria closed at $8.11 apiece. In response to news of the merger, its units declined in price to $8.05. Meanwhile, after initially rising much higher, shares of Tilray closed up about 18.6%. This put them at $9.33 apiece compared to the $7.86 they were at previously. Because of the specifics of the transaction, the implied price that Aphria's investors are to receive works out to $7.82 right now, but that could change based on Tilray's price. What we do know from the closing prices of both firms on the day of the announcement is that the market thinks Tilray's stock will rise further and/or Aphria's will drop some between now and the time the deal closes, keeping all else the same. This does create the opportunity of a pair trade with a return of about 2.9% thrown into the mix, but that's not a huge profit by any means.
There exists, at first glance, plenty of rationale for this transaction to occur. First and foremost, you have the prospect of cost synergies. Management forecasts that within 24 months of the deal closing, the firm should realize annual run-rate pre-tax cost synergies of around $100 million. This will come mainly from three areas: cultivation and production, sales and marketing, and corporate. Generally speaking, when it comes to mergers and synergies, the corporate side takes a disproportionately large hit of cuts. This is because many of those corporate functions are duplicative in nature. For instance, you don't need two accounting departments. You don't need two human resources departments.
Having said that, the cultivation and production side will also probably prove to be fertile ground for cuts. Aphria's management, after all, has the distinction of boasting that its cash cost of producing cannabis is below $1 per gram. As of the latest quarter, this figure was $0.87. Tilray doesn't provide a comparable measure, only giving out its net cost per gram of $5.61. However, Aphria's figure looks only at dry cannabis while Tilray's includes Cannabis 2.0 products and the latter's includes non-cash items as well. This makes it impossible to give a side-by-side comparison of the two, but the bottom line is that any cost-savings created by Aphria that's applied to Tilray should be bullish for investors in the combined firm.
Besides the cost side, management expects there to be certain revenue-related synergies generated over time. But they have not said how large these might be. Examples provided by management include expanding the combined company's Aphria brand presence in Quebec while expanding Tilray's in Ontario. Its physical presence in both Canada and the US leaves a lot of opportunity, with the latter involving a combined 40,000 points of sale in 27 states for cannabis products and 17,000 stores for hemp and wellness products. From a brand perspective, the same can be said as well. Both firms have a full slate of offerings ranging from 'economy' priced products like P'Tite POF and The Batch, to what they call 'premium plus' with Broken Coast and Grail. The combined firm will also boast a 17.3% retail market share throughout Canada.
Other opportunities exist internationally as well. Tilray has, for a while now, established itself in markets across Europe for various purposes. Aphria, meanwhile, has a nice presence in Germany. Key to the combined firm's strategy will be its production capacity in Portugal, which will allow it tariff-free access to the EU markets. Collectively, this opportunity is estimated to be worth around $3.9 billion (in US dollars) by 2025. This compares to $2.4 billion (in US dollars) for the adult-use market alone in Canada.
As to whether this deal will make sense, in the long run, is difficult to tell. Operationally, it appears as though Aphria is a superior firm, which means that it makes sense for it to get the lion's share of the combined business. Consider, for instance, just the latest quarter's results. During the quarter, Aphria generated EBITDA of $10.4 million. This compares to -$1.55 million in the latest quarter for Tilray. Admittedly, Tilray is showing signs of improving. A year ago, its EBITDA for the third quarter was -$21.87 million, and for the fourth quarter, the company expects EBITDA to at least break even or possibly even come in positive. By comparison, Aphria has been EBITDA positive for six consecutive quarters now.
Takeaway
Right now, the transaction between Tilray and Aphria is interesting. Conceptually, it's a logical move. It combines two major businesses in the space to create (from a TTM revenue perspective) the largest cannabis and the largest adult-use cannabis provider in the world. Synergies alone are appealing, but the issue of pricing is really difficult. How do you assign value to a company that's struggling through a glut, making improvements to its own results, but that still generates negative EBITDA? I would make the case that you really can't. As with most things in the cannabis market today, it boils down a lot to speculation. But we can judge from the rationale of the move and conclude that any industry progress toward consolidation should be accretive to investors at least.
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.
News 
Market Data 
Discover 
