Is The MedReleaf IPO A Disaster Waiting To Happen?

by: Ted Ohashi

MedReleaf (LEAF) appears to be the second largest Canadian Licensed Producer (LP) of marijuana after Canopy Growth. However, reading LEAF's preliminary prospectus raises a number of red flags.

The underwriters are a Who's Who of cannabis financiers. They rate LEAF a "best efforts" issue. Recently, many smaller LPs have been rated "bought deals." Do they know something?

The issue is raising $100 million. $20 million is allocated to buy shares sold by shareholders, many of whom are senior management/directors of LEAF including the CEO. This is problematic.

Recently, LEAF issued shares at $2.96 per share. The proposed price is 300% higher while our LP stock index is down 5-10%. What is the justification?

MedReleaf is a Canadian marijuana market leader. If this issue is a fiasco, it could damage the entire cannabis stock group. The potential exists for this issue to flop.

Introduction: The announced MedReleaf Initial Public Offering (IPO) could be a spectacular "bomb." The company's stock is set up to trade on the Toronto Stock Exchange under the ticker symbol LEAF and is being underwritten by a who's who group of marijuana underwriters including: GMP Securities as book-runner and co-lead underwriter with Clarus Securities and including Canaccord Genuity, Cowen and Company Eight Capital and PI Financial.

However, as I go through the preliminary prospectus (read preliminary prospectus here) and see LEAF plans to raise approximately $100,000,000 at an expected price of $9.50 to $10.50 per share, I also see red flags all over the place. It raises the specter of this offering being a major flop, which could have a very negative effect on all public Canadian Licensed Producers, of which there are now 15 listed on the public markets and the marijuana stock market as well.

Let's take a closer look.

Fact #1: LEAF is one of the industry leaders in Canada. For the quarter ended December 2016, reported sales were C$10.4 million. By comparison, generally accepted leader Canopy Growth (TWMJF) reported sales of C$9.0 million for the same quarter. But WEED's acquisition of Mettrum Health closed in January 2017 so they probably retain the title of 'king of the hill'. But LEAF is a leader with a reported 19% market share in August 2016 and reports a monthly market share of 15% to 20%.

Problem #1: This offering by a leading group of underwriters is not a "bought deal." It is a "best efforts" financing. The preliminary prospectus says, "The obligations of the Underwriters under the Underwriting Agreement are conditional and may be terminated at their discretion on the basis of… "market out.""

In other words if the underwriters can't sell it, they can exercise the "market out" clause and not complete the offering. This has to be puzzling at a time when much smaller, less prominent Canadian Licensed Producers have been rated worthy of "bought deal" status. Bought deals are reserved for the very best underwriting candidates of which LEAF would appear to be one. Why isn't LEAF?

Fact #2: The planned pricing of the offering is $9.50 to $10.50 per share.

Problem #2: The preliminary prospectus discloses that on October 31, 2016 and November 3, 2016, LEAF sold shares at $2.96 per share. Between May 18, 2016 and as recently as February 2, 2017, LEAF issued shares at $.0001 per share. This means the current proposed pricing is over three times the price at which LEAF sold shares just over six months ago.

At the same time, the Let's Toke Business Licensed Producer Index and the Let's Toke Business Marijuana Composite Index are both down in the range of 5-10%. It isn't evident in the documentation what happened in the last six months to make LEAF shares increase 300% in value against the general trend in the market.

Fact #3: Of the $100 million to be raised, only $80 million is being raised to finance LEAF's growth potential. The other $20 million is being raised to buy shares from existing shareholders taking advantage of their first opportunity to get out.

Existing shareholders selling as part of an underwriting is called a secondary offering and is often interpreted to mean that "smart money" is selling shares they bought at a much lower price.

A secondary offering as part of an Initial Public Offering is almost always problematic. The optics are all wrong. The selling shareholders may not be bailing out but the best case is it looks wrong for insiders to be selling at three times the price they agreed to sell shares at just six months ago. It also puts those sellers, many of whom are insiders, in a position of encouraging investors to buy the shares some of which they, the insiders, are selling.

Problem #3: Would you invest in an offering where $1 out of every $5 raised is going to buy shares being sold by existing shareholders?

Fact #4: Many of the sellers are the leading executives and Directors of LEAF.

* Neil Closner, the Chief Executive Officer and a Director of MedReleaf is selling by participating in the secondary offering. Closner is not just an ordinary executive, he is the senior executive of LEAF.

* If we are correct that Theodore Wine is related to LEAF Director Annette Wine, it effectively means Annette Wine's family is also a seller or will benefit from selling as part of the secondary offering. This really means every member of the existing Board of Directors is selling.

* At least two of the individuals participating in the secondary offering is described as a 'foreign person or company' which means, according to the preliminary prospectus, "… it may not be possible for purchasers of Offered Shares to collect from any of the foregoing Selling Shareholders, or to enforce, judgments obtained in Canadian courts predicated upon the civil liability provisions of applicable Canadian securities laws against any of them…."

Problem #4: Many of the sellers are primarily senior people involved in LEAF as management or Directors and they do not provide a reason for selling. But it is probably their first chance get out.

Fact #5: The investment experience with newly public Licensed Producers of late has not been positive. Each of Abcann (TSXV: ACBN), Cannimed (OTC:CMMDF), Hydropothecary (HYYDF), Maricann (OTCQB:MRRCF) and WeedMD (TSXV: WMD) are currently trading below their initial pricing on the public markets.

Problem #5: One of the disadvantages of going public through an IPO is it is a prolonged process. When this LEAF offering was initially planned, these terms may have been more appropriate. But recently, the Canadian marijuana stocks have been weak and since the preliminary prospectus was published on May 8, 2017, conditions have changed. In my opinion, the offering is priced so far off the current market it now runs the risk of failure.

This would not be so bad except the marijuana stocks have been falling and MedReleaf is one of the leaders in the industry. If the offering has to be cancelled, delayed, restructured or re-priced, it would not only be bad for the Company, it could also trigger a further decline in the overall marijuana stock market.

Fact #6: You can't rewrite history. The insiders have tipped their hand and we know they want to sell. The underwriters did not rate this offering to be worthy of a "bought deal" status. You know a $9.50 to $10.50 per share pricing is expected. Investors now know what was intended and are set up for disappointment.

Problem #6: Unless market conditions improve in a hurry, MedReleaf and the underwriting group will be caught between a rock and a hard place. They can't go forward and they don't want to go back.

Conclusion: A higher profile catastrophe such as a MedReleaf IPO could have a severe negative impact on the entire cannabis Licensed Producer group. This is a disaster waiting to happen. The way it has been set up, it will be hard to avoid.

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.