Much like doing a Structure on Curaleaf ($CURA), I’ve not been looking forward to taking Ayr Wellness’ (AYR.B) Note 14 apart.

We’ve seen some glimpses of the exotic in Note 14, alluded to in our last Structure on $AYR.B. It’s expansive and complex. And it contains an odd valuation of warrants within contingent consideration (at least to myself). They don’t even calculate the liability from these using a notional ‘volume x price’ – despite being an $11CAD strike attached to them. If it’s zero….that would increase the reported liability.

Perhaps a closer look at this Note will clarify, I couldn’t find anything in IFRS guidelines that would support the calculation.

I also took a cursory cut at $AYR’s financing in a post before Xmas, when I was on a relative tear about how share price accretion in the MSOs would bring some numbers into the liabilities. I’ve often pointed to TerrAscend’s ($TER) debt addition as an example of where an acquisition can come back to bite a company in the ass.

It’s easy enough for an outfit say ‘we expected that’, or, pre-empt having to by saying ‘we’re fully financed’. I asked a question on that very point in our AMA with $AYR.B back in early February. I didn’t see a great deal of clarity in the answer. Despite pointing to $4MM/mo in free cash flow, we saw in our last Structure that $AYR.B’s build is consuming far more cash than that, which is discordant with a presentation of their assets being ‘turn key’. I suggest nothing ominous. But, $TER sits there as a shining example of the importance of capital planning.

<I honestly can’t wait for Jushi’s ($JUSH) financials at the end of this month. They’ve hit a relative jackpot with their share price, and I’m interested to see how much balance sheet oxygen a doubling of their $77MM warrant liability will consume. I expect many will be ‘surprised’ by reported losses>

Anyhow, Note 14 is officially known as ‘Derivative Liabilities’, and its’ comprised of 2 components: ‘Purchase Consideration and Contingent Consideration, and, ‘Fair Value of Warrants‘.

Let’s have a look at the latter first.

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‘Fair value of Warrants‘

The table presented reveals that some 6MM of an initial 16MM warrants were struck during the year:

Straightforward enough to see the math here. The valuation of Dec 31, 2019 was at a notional $2.29/share, but share price was lingering around $11.50 – not much more than their SPAC debut on the NEO.

During the year, 5.5MM of those warrants were exercised, valued with a notional price around $10.31 – and a reduction in the liability greater than its’ notional value. Yet none were struck until their third quarter (between June and September), when 42,000 of them were exercised. It’s here we see the first reval of the warrant liability:

From this third quarter, we see a notional reduction in the liability at a notional share price of $1.61, and an increase of the liability of $28MM – averaging to about $4/warrant. The average share price during the period is ~=$14-$15 – so, I’m guessing it’ll thumbnail to a linear warrant valuation of [(market price – strike price) x # warrants]. In this case, [($15-$11) x 16MM] = $65MM.

Looking again at year-end, we see this changed to include an incremental 5.534MM warrants being exercised at an average price of $10.37:

The incremental ‘fair value adjustment‘ of $86.8MM ($151.9MM – $65.1MM) represents an increase of fair value on each warrant of $8.27 each during the quarter. This is when share price at Sept 30th was $16.80, and on Dec 31st, it was just north of $30. An absolute value change of $13.20.

Confused? Let’s look at it this way:

Warrant Liability Valuation:

• Dec 31, 2019: $2.29/warrant, share price $11.50
• Sept 30th, 2020: $4.00/warrant, share price of $16.80
• December 31st, 2020: $14.49/warrant, share price of $30.05

I’ve ignored the forex translation: I don’t think heading into that rabbit warren will be useful. What I think has happened here is that a place with big growth and in formation simply didn’t have a back office in place who had a clue what they were doing. Perhaps the CFO did (an open question) but had no bandwidth to deal with it.

Hey – this happens all the time. Despite our mental images of a staid professional in a calm environment of $3,000 suits and mahogany on the walls…this is how shit in the real world gets done. The year I spent as a controller at an investment bank taught me that every day – the business is going to bring you stuff that’s new, untested, and you have to be able to value it to get it into the books – or stop the thing dead. In accounting, a core principal is that of ‘conservatism’ – which simply means if there’s a range of values for an asset (or liability), you report the most conservative number. In the case of a liability, you report it at its’ worst.

I’ve gone into this sausage making because I’d like to educate about how fluid valuations can be (especially if people are doing them for the first time). As well, no reader of these financial statements would have seen the magnitude of this coming per se. I did spend the time on contingent consideration in the initial structure I performed on $AYR.B – and alluded to the warrant valuation….but didn’t finish the math. If I had – I would have.

As it is, the effervescence of MSO share prices and the market caps right now….these numbers are mosquito sized. That will change if asset valuations in the US take a regulatory meteor – or worse – if they are crystallized into a capital structure just before it happens.

It’ll have the same impact as goodwill and intangibles having the bad luck of not having been written off before the playing field gets changed.

Either or, there does exist a moat for MSOs – and general consensus is that those moats will disappear….it’s simply a function of ‘when’.

I’ll keep trying to identify where the biggest risks lie (as an independent analyst……I am way too excited in seeing Jushi’s financials regarding this), and hopefully this illustrates some of the risks in financial statements you won’t find by reading sell-side information.

As it is, I think the warrant liability as $AYR.B is reporting is about $30-50MM too low right now. Look for a true up next financials, and also look for another whack of them to be exercised. $AYR.B doesn’t disclose the tenors of the warrants, but despite valuing them as a linear instrument (very roughly), the liability is behaving non-linearly. That’s a red flag to myself. And the point of this post.

In Part II, we’ll examine $AYR.B’s ‘contingent consideration’ in detail.

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 holds no position in $AYR.B