The High Price of Cannabis Stock Acquisitions
The process of investing can be as complex or as simple as you want. While a Dividend Growth Investing (DGI) strategy is easily explained to your average Joe retail investor, more complex topics like Modern Portfolio Theory (MPT) aren’t so easy to explain. Basically, MPT is all about maximizing return and minimizing risk by owning assets that don’t behave in a similar way. In other words, you don’t want all your stock returns to be highly correlated. Stocks that fall within the same industry – like cannabis stocks – will tend to have more correlated returns. That’s why when there’s bad news for one cannabis stock, it affects all cannabis stocks.
A few weeks ago we penned a piece titled “MedMen Stock Slides Amid Rapid Expansion,” which talked about the dangers of becoming overextended in an era of cheap capital. That time is nigh according to an article by CNN yesterday which talked about how MedMen’s acquisition of PharmaCann fell through stating:
Public cannabis companies are facing a capital crunch as investors are recognizing that some firms were vastly overvalued and sweeping regulatory changes may come later than previously hoped. “You’re going to see a lot of public companies that are cash-strapped that need a round of financing that likely can’t get that done in this current climate,” Hawkins said.
When acquiring another company, the transaction can be described in basic terms. The acquiring company’s shareholders would expect that to give up cash or equity in exchange for something of equal or greater value. Oftentimes, this extra value comes in the form of “synergies” where “2 + 2 = 5” and the combined entity is worth more than the sum of the parts. In the case of cash acquisitions, it’s pretty straightforward, but issuing stock to acquire another company creates new complications. Says the CNN piece, “the precipitous drop of MedMen’s stock — shares are $1.42 now versus $4.46 last year when the deal was announced — sunk the value of the all-stock PharmaCann acquisition.” That’s what happens in a highly volatile, highly regulated industry. In order to better understand what an acquisition looks like, we’ll turn to a multi-state operator called Green Thumb Industries (GTII:CN).
Green Thumb Industries (GTI)
Founded in 2014, GTI is a $1.7 billion company which operates across 12 states with more than 1,200 employees. Like many of the multi-state operators we’ve looked at, GTI uses basic metrics to measure their progress such as number of states, number of stores, and number of retail licenses.
Revenues are growing as expected alongside acquisitions of which we’re going to look at a bit closer. In the latest interim financial statement filings from GTI, they detail the acquisitions that took place in the first six months of this year. The below table shows what was offered by the company (consideration) and what was acquired (net assets). Here’s the breakdown provided (all numbers in USD):
The key numbers in the “consideration” piece are cash at $67.5 million and $457 million worth of stock issued at a price that isn’t disclosed. (Share capital is the money a company raises by issuing common or preferred stock.) At the beginning of this year, share capital stood at just over $401 million and now exceeds $921 million. For a total consideration of $610 million, shareholders received net assets which can also be seen above. The first few line items aren’t meaningful – $2.6 million in cash, $10 million in product inventory, some cannabis plants worth $5.6 million and property & equipment totaling $14.8 million. It’s the intangible assets that might raise some eyebrows.
One metric we see multi-state operators throw around is the number of “retail licenses” they possess. For example, GTI has 95 retail licenses but only 32 stores open. Consequently, retail licenses reflect the potential size of the company based on legal permissions. In order to use the licenses, they need capital to build out their operations. GTI has lots of licenses that need to be built out already, so you might think that spending nearly $160 million on more licenses would be a bit excessive.
GTI doesn’t provide us with much detail here, but under Intangible Assets, they list “Licenses and Permits” that were acquired during the first half of this year at nearly $160 million. We understand the whole “land-grab at all costs” strategy that most MSOs are employing, but why not put that capital towards growing out retail locations for existing licenses?
The next two line items under Intangible Assets are “Tradename” and “Customer Relationships” which are valued at $20.9 million and $62.9 million, respectively. That’s a pretty hefty price to put on a handful of brands and some CRM records but this might be justified considering that the cannabis industry has shown to have particularly loyal consumers. Again, we’re not given much information to work with here.
The biggest item of interest in the “Net Assets Acquired” section is something called “Goodwill.” The Corporate Finance Institute describes how “the concept of goodwill comes into play when a company looking to acquire another company is willing to pay a price significantly higher than the fair market value of the company’s net assets.” In this case, more than half the “value” that’s been acquired by GTI isn’t something that can actually be accounted for.
If we combine both Intangible Assets and Goodwill we get $582,192,003. Roughly 95% of the value acquired by GTI in the first half of this year is based on perceived value as opposed to market value.
The Value of Licenses
In our original piece on The Biggest Cannabis “Multi-State Operator” Stocks, we described the “biggest” operators based on the number of retail licenses owned. That’s probably not creating the right incentives for MSOs who seem hell-bent on acquiring every license that isn’t bolted down. With all the acquisition dust having settled, The Motley Fool tallied up the biggest holders of retail licenses which – as of July 20th, 2019 – to be:
- Harvest Health (HARV:CN) – 142 licenses
- Curaleaf (CURA:CN) – 131 licenses
- Green Thumb Industries, Acreage Holdings (ACRG:CN), and MedMen Enterprises (MMNFF) all have close to 90 retail licenses (on a pro forma basis).
In the case of GTI, their last investor deck shows 32 open stores and 95 retail licenses. Going back to GTI’s investor deck that was published in January of 2019 and we see 83 retail licenses listed which means that they now have 12 more retail licenses for consideration of $159 million. While this amount might include other licenses and permits that aren’t related to retail, shareholders need to question the sensibility in purchasing something that can’t actually be valued. An article by Marijuana Business Daily talks about how volatile marijuana licenses are with the number of active licenses plummeting.
Why not wait until the industry undergoes consolidation and then pick up these same licenses for pennies on the dollar? Not to mention, things can change, with each state handling licenses differently with its own regulatory risks to consider.
This propensity to splash cash around isn’t limited to acquisitions. GTI’s General and Administrative expense breakdown reads like something out of the dot-com days. For the first six months of this year, GTI gave $55,000 a month to charities, paid over $59,000 a month in bank fees, and spent more than $244,000 a month on travel. If the pundits correctly predict a coming cash crunch, cannabis investors should be looking for companies that have a path to profitability and a focus on operating lean to increase margins.
A study by KPMG found that more often than not, acquisition “synergies” aren’t realized. In a study on blue chip mergers and acquisitions across a two-year time frame, “only 17% of deals had added value to the combined company, 30% produced no discernible difference, and as many as 53% actually destroyed value.” Then, there’s the cannabis market which is flooded with fly-by-night operators across the entire supply chain. Why not save all that dry powder and bargain shop down the road instead of spending hundreds of millions of dollars today on assets you can’t actually value?
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