Who “won”?

Tilray shareholders got an immediate bonus. Aphria shareholders need EXECUTION. Operational execution has been above par from Aphria in relation to peers. M&A not so much.

Aphria is essentially buying Tilray sales to keep their Leamington campus producing at its pre-throttled pace. We will discuss upcoming quarterly sales cadence below.

IF Aphria alone generates $82 million in year 1 EBITDA, and the expense drop from the combination achieved the $50 million target in year 1 ($132 million EBITDA), the acquisition will be pulling its 38% weight in year 1. (38% is the Tilray portion of the new merged entity). Aphria on an annualized basis plus SweetWater is tracking a touch below that $82 million figure.

So, $132 million in adj EBITDA will be a useful benchmark in year 1 post merger to evaluate the Tilray contribution.

But can they hit $50 million in savings in year 1?

Gross Margin Improvement:

Last earnings CC, Aphria indicated, even when grow was throttled, GM from cannabis would remain in the 50-54% range. A 20% increase in Tilray GM would add USD 20 million or approximately CAD 25 million.

But in order to achieve this improvement, Tilray would need stop impairing cost-based inventory, and Aphria would have to avoid same.  Although I think if an inventory impairment is coming from Aphria the merger might give them the “cover” needed.

I had mentioned that I thought Aphria may have given Tilray metrics in early November talks that they would need to achieve to continue dialogue on merging. One was to reduce the debt. Which they did via early conversion of USD 197 million. The second was around inventory. I went back to my September 2020 Tilray Rundown and found this little tidbit that surprised me when analyzing.

• “Last Q (June 30, 2020) Tilray has indicated their revaluations should be behind them.   With $90 million over the last three quarters, that would be good to see. Yet, this Q they adjusted for another $13 million.”

Hmmm… maybe I was on to something.  Despite stating they were done with impairments in June 30, 2020 Q they whacked inventory again in September 30, 2020 Q. Could Aphria have given them marching orders?

Another tidbit from the last Rundown:

• “(Tilray) indicate they have increased yield at their facilities in Canada by +40% and all product is +20% THC. “

Hoping that was at Nanaimo… as I have heard that Aphria had replanted Phase IV, which was idled in June 2020. (Here is hoping they improved the irrigation and other efficiencies during the idle).

Tilray’s London greenhouse is toast. I would expect a substantial refit of Nanaimo, and an idling of a portion of the facility during same, or an outright stop, would not be a shock.

Kevin Anderson (Master Grower), John Moeller (President) and the BCC team had to retrofit and shoehorn BCC into the existing facility. A greenfield site for BCC2 would have been welcome. Nanaimo retrofit will have to be the compromise.

Eliminating one board and the associated costs… HEXO indicated self-insuring on D&O saves $10-15 million in premiums. Add to that removing a c-suite, audit fees and listing fees.

The rest of savings is in combining marketing operations. With Aphria using Great Northern Distributors and Tilray using Kindred… I am not sure how that will play out… Among other cuts to sales and marketing.

Is $50 million in savings possible in year 1? Looks that way. But where exactly do year 2 savings of an additional $50 million come from? I imagine the additional draw of Tilray sales from Leamington campus would absorb overhead that would otherwise be “unabsorbed”.

Tilray SGA for last Q was USD 22 million. Granted some savings will come from shuttering London cultivation. But you would think those are year 1 savings.

Is there anything else at play for the merger that has not been mentioned?

I think that growth rate from Canada will be topping out. Ontario has opened the throttle to 80 stores a month. I think that 80 stores a month might be a limit. There will still be growth but the % QoQ will start topping out with the denominator getting bigger each Q.

From Stats Canada data, each of the last three months on a DAILY spend basis the size of growth has decreased. From +12% in July, to 8.2% to 5.5% to 1.7% for October 31, 2020. (Note: October 31, 2020 MoM growth of 5% is inflated due to 31 days in October vs 30 in September. Thus, my focus on daily spend.). That 1.7% growth last month was the lowest by half since the April-May 2020 covid impacted growth of 1.8% and 1.1%, respectively.  Personal outdoor harvests may have impacted the numbers.  It will be important to keep an eye on January and February 2021 (post-Christmas driven peaks) to see where the growth is.

The Canadian market is growing just at a slowing pace.

In 2021, with no big Canadian cannabis catalyst, it will be a battle to grow market share, and Aphria might have just girded them against the tightening growth market.

The November 30, 2020 Q will see Aphria benefit from having their large format SKUs in market for the Q. The February 28, 2021 Q should see their aggressive vape pricing strategy provide wind in the sales. Ontario opening 80 stores a month should keep propelling pre roll growth that matches vape growth, both strong suits for the merged entity.

But what about the May 30, 2021 Q? Unless Aphria launched other 2.0 formats, where does the growth come from? Edibles, the second leading category in Ontario is 4% of the market and are not allowed in Quebec. Beverages are less than 2%.

Aphria may have reached out to snatch Tilray’s sales run rate before Canadian sales % growth top out.

Should the deal close in second calendar Q of 2021 Aphria will get a partial Q boost in May 30, 2021, and the full Q boost in August 30, 2021. (Note: these latter two Q’s might be June and September depending on closure of deal, as Aphria consolidates under Tilray ticker whose reporting cycle will they go with?).

When their competitors are fighting hammer and tong for sales increases, the merged entity should be working on expanding existing segments.

Can the merged company achieve 30% Recreational Market Share?

It was noted that combined the companies hold 17% market share. CEO Simon indicated that it is his goal to get to 30%. (He also mentioned a $10 billion market cap.)

The ONLY way to 30% is to hold roughly that share in biggest three segments: dried flower, vapes and pre rolls. For illustrative purposes these three segments are 87% of the Ontario market.  And Aphria is not as strong in BC as they are in Ontario and Quebec.

I have Aphria at > 35% in pre rolls in Ontario in Sept 2020 Q and 31% the prior Q. In Ontario, Vapes: Good Supply alone, I have them at 17%. Add Canaca and you are at 22%. With Solei, RIFF, and newly arriving Broken Coast vapes… 30% of vape market in Ontario does not seem a stretch.

With no vapes in Quebec and a 20% excise in BC on vapes dampening demand, those segments would deviate from Ontario. Thus, making dried flower segment all that more important.

Failing to get to 30% in dried flower cannot be made up by getting to 30% in edibles, beverages and concentrates.

In Ontario, Good Supply and RIFF alone are at least 11% of dried flower.

To get to 30% market share Dried Flower will be the hill. Pure SunFarms, the Ontario market share leader stand-alone brand, has 12%. They would need to add a PSF sized increment to their wallet. Can Bingo and the other brands combined climb it??

The Combined Debt

This is where I start getting operational gas from the merger.

Aphria was well on their way to service upcoming debt via adj EBITDA, recording $10 million in Adj EBITDA (plus the addition of SweetWater +$9 million = $19 million/Q) last Q.  Aphria upcoming debt service is approximately $40 million.  Annualized EBITDA would have been $76 million.  Easy coverage of 1.90:1 for next twelve months.  If we were to amortize all Aphria debt at a 10-year amortization (same amortization they received on Diamond loan), P+I would be $85 million.  So, Adj EBITDA was closing in on that figure. Promising.

Layering Tilray debt service for the next 12 months would add another $18 million, aggregating to $47 million in 12 months forward debt service.  Serviceable from annualized Aphria and SweetWater of $76 million.

The issue becomes the convertible debentures due in 2024 for both companies, almost 3 years post-merger.  A ten-year amortization of combined P+I across all debt is close to $150 million.

So, the combined companies debt service would increase from $85 million to $150 million three years out.  A lot can happen in three years.

They need the $50 million in merger benefits from year 1 and then some.

Look for the combined entity to payout the 10.5% loan from Tilray and refinance.  And if they can get some discounts on early convertible debentures, I can see them doing some more house cleaning.

Other odds and ends from the merger:

I imagine the move to the Tilray ticker means USD accounting, US GAAP and a possible move to a December 31 year end. No more reporting solid performance (that hopefully continues) a month before peers only to be deflated by Canopy and Aurora announcing their results. Or does the increase in audit costs from having a December year end outweigh the perceived benefit? (Audits in December are priced like vacation rentals at Christmas – higher!). Given the cost-conscious DNA at Aphria, I would not give odds to moving the reporting cycle.

One other thing I have been musing about is whether Canopy tries and drop a fresh bid on Aphria. With the acquisition they have a “mark” of value they would have to beat.

Molly has been musing that Canopy might have given up on the Canadian market but have not announced it, like Cronos has.

They reportedly put in a bid on Aphria, which was reportedly STZ supported. (Although STZ would probably like nothing more than to re price options again, and this would open that possibility. So, dual advantage for STZ.) They could get Aphria for cheaper than what they have already paid for a portion of Canopy.

With Aphria in hand Canopy would enter the US when legalized as the #1 market share with resonant brands, cultivation and distribution in Germany, cultivation in Portugal, and EU GMP processing facility in Malta.

If they do not make a play for Aphria they likely limp into US legalization while other MSOs show operating prowess. Not what a “market leader” looks like.

I think Klein has a duty to shareholders to make the call.  Aphria did not look to merge with Tilray to attract a new Canopy bid, but there is enough premise to suggest the possibility.

Back to who won?

Tilray shareholders.  Aphria shareholders will have to wait and see if execution in Canada manifests.  Europe is still a long game unless Germany votes in a cannabis friendly government in September 2021.  With bumps and bruises we have seen across the industry likely to continue, investors will have to make some choices as to riding it out or look for better entries as de-risking occurs.

The preceding is the opinion of the author and is in no way intended to be a recommendation to buy or sell any security or derivative. The author has a position in Aphria and will not add or divest in the next five days. The author has no position in any of the other mentioned companies and will not start one or divest in the next five days.