“Merges” is a nice word.  Its collaborative.  This is not a merger; this is an acquisition.  If the 62-38 Aphria-Tilray ownership did not prove that the 7-2 respective board split should. As should Irwin continuing as CEO and Chairman.

We had heard rumors of these merger talks in early November 2020, before the last financial release of Tilray. We had dismissed the talks when we started to see Tilray clean up their balance sheet with two early converts of convertible debentures on November 23, 2020 of USD 124.3 million at 36% discount to face value, and November 24, 2020 of USD 72.9 million at a 42% discount to face value. 

What likely happened is that Aphria and Tilray were in talks and Aphria gave them some parameters/metrics that would need to be addressed prior to moving any further.  The dilution associated with reducing the convertible debentures was probably one of those metrics. 

Another might have been around inventory, as Tilray wrote off inventory for the third consecutive quarter (USD 13 million after USD 19 million and USD 4 million in Q2 and Q1, respectively) and inventory value actually decreased QoQ by USD 3 million to USD 90 million.  Aphria has a whack of inventory and has throttled cultivation in Leamington.

What to make of the merger?

I listened to the conference call and I do not think I heard “immediately accretive” mentioned, likely because it is not. For this merger to pay off the cost savings and synergies have to happen.  This was not Aphria buying Sweetwater and being EPS accretive.

Merger talks with Aurora did not get very far and rumored talks with Canopy fell apart.  So why Tilray?

Less overlap in assets and control would be my guess.  Both Canopy and Aurora had substantial cultivation assets, with Canopy announcing closure of five facilities and Aurora announcing Sky would run at 25% capacity in the last week alone.  Tilray has two cultivation facilities, after unwinding a third in Leamington earlier on the year: one greenhouse in London, Ontario and one indoor grow in Nanaimo, BC. 

While they did not mention it on the CC, I think London cultivation will be closed (you don’t want to mention that until acquisition is complete), while London processing for edibles will continue.  Nanaimo is a very short distance from Broken Coast Cannabis in Duncan, BC.  I had mentioned yesterday on our subReddit how Nanaimo might be a fit for BCC expansion. And in the CC and presser that was mentioned.  BCC is treated very uniquely by Aphria. It reports directly to Carl Merton, CFO who is very protective of the brand.  BCC has been looking for nearby expansion for over two years.  I had heard they had actually bought property then the municipality turned around and would not allow cannabis cultivation.  Should Kevin Anderson, the master grower at BCC, think he could produce the same quality flower out of Nanaimo, I would think BCC2 might have a home.

With the overlap in cultivation… is there more overlap? 

Brands and Formats:

The biggest overlap is in the Core flower and pre roll brands.  I cannot see them trimming Good Supply or Solei.  Everie is drinks and Chowie Wowie is edibles, so those are safe.

Synergies:

The Sweetwater acquisition will be cozy with the Fluent JV in Canada, the Tilray-Anheuser Busch InBev (ABI) JV that they funded with $100 million ($50 million each) for the Canadian market.  ABI distributes Sweetwater in USA already. Tilray cannot speak for the JV but collaboration is expected.

Manitoba Harvest which sells hemp products into health and wellness and organic stores, was likely purchased by Tilray with the thought that the FDA would be a lot quicker on CBD regulations in the USA than they have been.  This would likely be the distribution architecture for CDB delivery when the FDA finally moves on CBD regs. Given CEO Simon’s background he probably has good vision of Manitoba Harvest forward opportunities without regulatory reform.  Manitoba Harvest has Costco, Whole Foods, Kroger and Amazon as supply channel retailers.

Both Kennedy and Simon indicated that they think medical cannabis would be the first opening for THC participation in the USA that could be fed with imports.  I think if the FDA is taking this long on a single CBD molecule that THC and medical is a long way off.

The Tilray outdoor Portugal cultivation site should fit neatly with Aphria Germany indoor cultivation to feed CC Pharma and its 13,000 pharmacies it supplies.

Another synergy reported on the conference call was that Tilray was purchasing 35,000 KGs a year from third parties.  Looking at Tilray sales over the last four quarters yields sales of 27,415 KGs, so this should be a “projected purchase”.  And we have all seen what projections are worth in this industry (cough cough Nuuverra). So, I am calling bullshit on this being as low hanging fruit as it was made out.  Plus, I was already thinking that Tilray may have been a wholesale purchaser from Aphria.

The combined entity is looking at $100 million in cost savings over a two-year horizon split $50 million each year.  Removing one c-suite, one board of directors and the very costly Directors and Officers insurance is likely the biggest of the low hanging fruit.  Consolidating marketing and sales is another area.

The news release and the deal deck paint the bigger pictures, let us see what a further breakdown can highlight:

My biggest concern is the combined debt of the two entities, notably the Tilray convertible debentures. I always thought as a stand alone Aphria had a fighting chance at generating enough EBITDA to attract a traditional commercial lender to refinance their converts.  Tilray’s converts mature in 2023, with the conversion window opening in 2021, similar to Aphria.  Would lenders take a paydown at a discount so they could redeploy money elsewhere?? Possible.  Would the combined entity use cash in this fashion? Depends on the discount they get.

Cash balance is reasonable and gives room for strategic acquisitions, and both parties capex programs are winding down considerably. 

Aphria adds $225 million in annual revenue, $96 million in adult use cannabis.  Problem is Tilray has been stagnant in this category over the last four quarters ranging from C$23-28 million a quarter.

Adult Use: Peer and Trend

Combined they are 50% bigger than their closest competition and they would have been market leader for the past three Q’s.  That upward trend for APHA TLRY is largely APHA driven.

Medical and Canadian Medical: Peer and Trend

On a combined basis for both International and Canadian Medical, Aphria-Tilray rank third on a full medical basis at $30 million versus Aurora at $33 million and Canopy at $32 million.  For Canadian Medical alone they are also in third place at $13 million versus Aurora’s $27 million and Canopy $15 million.

That improvement over the last four quarters is all Tilray international.  International sales have been Tilray’s most impressive sale category. From Q4F2019 to Q3F2020 the sales have ramped to C$5 million, C$8 million, C$12 million and C$11 million, respectively. Only Canopy has better International sales at a range of C$18-20 million over the same period.

Aphria will show its first international sales in the upcoming quarter.

Operationally I would suggest readers take a look at the most recent Rundowns for Aphria and Tilray.

EBITDA, Gross Margin and SGA: Latest Quarter

Normally I would start with GM and work my way through SGA to EBITDA.  As I do not have Sweetwater’s GM and SGA I decided to start with EBITDA.

Aphria has generated six Quarters of successive +EBITDA on an increasing basis. They acquired EBITDA accretive Sweetwater. Tilray has improved EBITDA by $41 million over the past four quarters, but $31 million of that has been SGA based.  It is rather shocking they have only made $10 million in headway on Sales and GM over that period.  And Tilray has had cost-based inventory impairments in each of the last three quarters that gets backed out of Adj EBITDA.  If the Tilray impairments are behind them, and they both continue their EBITDA trajectories, the annualized number above should be surpassed with ease.

Gross Margin at Tilray has been hurt by three successive Q’s of inventory impairment on cannabis, while Hemp has generated in the 33-42% range in the past three Q’s.

I am REALLY hoping that Aphria had a good hard look at the inventory and cultivation at Tilray and are comfortable that impairments are a thing of the past. Given Aphria has a growing inventory issue they might see some impairments for slow moving inventory.  With the throttling of the grow last Q, they indicate GM on cannabis should stay above 50%.

Inventory to Cannabis Sales or CoGS if US GAAP:

Tilray (US GAAP) looks to be keeping their inventory turnover in the 3.50-3.70 range.  Aphria is in the low 4.00 range (IFRS) but has been on the uptrend.  Excessive inventory leads to impairments which leads to GM issues.

Lastly, SGA for the combined entity would be in the 34% range. Tilray has worked their SGA down from Q4F2019 of USD 54 million to the most recent Q3F2020 USD 23 million, with reductions in each of the past three Q’s. Is there more juice in that fruit? Last Q was the smallest decrease of USD 4.6 million QoQ.

SGA Peer:

Aphria is the lowest in SGA as a % of sales and Tilray is third best. At a combined 34% SGA the combined company would lead the peer group.

What could be in store?

I think the likelihood of an Aphria cost based writedown this Q or the next is likely.  Aphria’s sales increase in Adult use have slowed by dollar amount in the last two Q’s.  They launched their large format SKUs and Bingo brand in the quarter ended November 30, 2020.  A good spike in sales from these SKUs might do the trick and keep impairments at bay, but I am leaning the other way over a two-quarter period.  The acquisition might give them “cover” to impair inventory if needed.

I think the merged entity will impair PPE and intangibles when they possibly close the London cultivation greenhouse.

These are the near term boogey men.  Further out is dealing with the sizeable convertible debentures.  Will they look to early conversion at a discount? Possibly based on discount and cash needs and war chest maintenance.

The combined entity is billed as the world’s largest cannabis company by revenue.  Given 66% of revenue is “cannabis adjacent” that is a little overplayed, but it will hit investors ears well.  The merger does solidify Aphria’s spot atop the Candian cannabis market: recreational and medical combined.  It fills in gaps in Aphria format portfolio with edibles and beverages. The European operations are complimentary and are a longer-term play that should eventually position them well if regulations open more markets.  The cannabis adjacent USA exposure could prove beneficial depending on US regulatory reform and the pace thereof. 

The Aphria name will go away, except maybe for Candian medical, as Tilray will be the name of the new combined entity.  In my opinion Aphria was hard to pronounce and has “short report” baggage.  Tilray, while being a meme stock for once touching USD 300 a share, has a better US following and will likely be a better ticker moving forward. But make no mistake… the Aphria brain trust that developed Aphria’s low-cost cultivation, brands and product development will be at the wheel. 

To enter the USA in THC regulations would have to change to allow Nasdaq companies to touch the plant.  While there a number of large MSO’s regulations will also play a big actor in their futures as well. We are already seeing retail limits by states have MSOs shifting focus to wholesale.

I think this acquisition was probably the best fit of two large Canadian LP’s to maintain control and with overlap at a minimum.  What I do think it does is position the combined Tilray as a very favorable target for a US MSO that want to become the global cannabis leader by “merging” (likely acquiring) and picking up significant puzzle pieces in Canada and Europe. If Sweetwater remains EBITDA positive and if Manitoba Harvest turns out to EBITDA positive (hoping for better disclosure around this when Carl takes a stab at the MDA) these are two business that can be sold off if they are not seen as complimentary to an acquirer.

I would be way more excited about this acquisition if I were a Tilray investor as their future was cloudy.  But there is excitement for Aphria investors too, just not as short term in nature and it requires EXECUTION, which Aphria has been better at than their peers, in order for it to pay dividends.  If they can get an additional $50 million in EBITDA to fall to the bottom line this year, AND Aphria And Tilray continue their EBITDA trajectories (which Tilray brands will need some Aphria magic to help increase sales) then a solid pay off could be on the horizon. 

CEO Simon indicated they are presently at a 20% market share in Canada and their target is 30%. That alone is a tough target and one that will be referred to in determining part of the measurable success of this transaction.

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.