The Canopy-Acreage Merger Opportunity

Summary

• Canopy Growth and Acreage Holdings announced an important merger between the biggest pot company in the US and the biggest pot company in the world.
• For now, a 40-50%+ merger spread opportunity continues to persist.
• I review the benefits and challenges likely to affect consummation of the deal, as well as the potential opportunity it presents.
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Macro

In the 2018 Gallup poll, 62% of Americans favored marijuana legalization. It's very likely that % has increased since.

Among the young, swing voters (Libertarians, Independents, etc.) and various other social groups, the number who favor marijuana legalization is currently in the mid-70%'s and climbing sharply. Illinois just became the 11th state to legalize recreational adult use. Indeed, any US political candidate against marijuana legalization may find themselves unelectable.

Meanwhile, the latest estimates indicate the US cannabis market is likely to exceed $50 billion+. Globally, including hemp products and all cannabinoid uses, we've heard estimates as high as $150 billion.

The truth is no one really knows how big the market will be. Estimates could easily be off by orders of magnitude either way. Such key aspects as whether cannabis and products derived from cannabis will partially supplant beer and cigarettes, for instance, are still up in the air. Additionally, it is widely thought certain important drug categories worth tens to hundreds of billions - opioids, epileptic drugs, anti-inflammatories, sleep-agents, etc. - will be disrupted by cannabinoids, but the FDA isn't even reviewing such claims yet.

Nevertheless, there are many such as myself who think:

1. Cannabis-related product sales are undergoing strong worldwide secular growth that is likely to continue for the next decade.
2. The US will continue to move towards legalization of cannabis over the next few years, either through the States Act or something similar.
3. Canopy Growth (NASDAQ:CGC) is at the forefront of this cannabis paradigm shift - one of the companies most likely to succeed long term.

If these three things also describe your opinion, then I contend you should at least consider buying Acreage (OTCQX:ACRGF, ACRG-U). Yep, Darren McCammon, the guy who called Canopy "The Cisco Of Pot" and wrote "Canopy's Moat: Powered By ebbu," is now suggesting you buy another stock.

Well, sort of.

Merger Terms

The basic Acreage-Canopy merger terms are:

1. Canopy pays Acreage shareholders $2.55 per share in cash, plus
2. .5818 shares of CGC for each share of ACRG-U.

However, I’ve heard all sorts of misinterpretations of this deal. Many stem from a mistaken belief the terms were set as a fixed dollar amount instead of the fixed share exchange it primarily is. Each ACRG-U share is worth .5818 CGC shares (+$2.55). So, as the price of CGC goes up or down, so too will the value of the deal for Acreage shareholders. Additionally, this .5818 share exchange doesn’t occur until it's legally permissible to do so (with a 7.5-year time limit). So, one doesn't really know when the deal will actually close.

Thus, there are uncertainties, and the market hates uncertainties. However, a long-term investor can also switch from CGC to ACRG-U and hope to capture not just the future returns of CGC but also a 40-50%+ spread on top of it.

As of this writing, the merger spread looked like this:

(Source: Author's calculations)

It’s one of the largest persistent merger spreads this analyst has ever experienced - one which continues weeks after the merger was announced, even though 91% of Acreage shareholders and 38% of non-insider shareholders have already confirmed they will vote for the deal. This large spread exists for both some valid and invalid reasons.

Misconceptions

• It’s been reported that this merger only goes through once marijuana is legal in the US. That is incorrect. Cannabis becoming federally legal in the US is the point when Canopy and Acreage have to contractually complete the deal. However, they can choose to complete it well before then. In fact, both CEOs have publicly stated their intention to close this deal as soon as cannabis becomes federally permissible in the US.
• It's been reported Acreage has the right to use Tokyo Smoke and Tweed brands. While this is correct, it greatly underestimates the situation. Acreage has the right and is actively encouraged to fully utilize all Canopy IP, brands, and know-how as much as possible - for free! This IP, brands, and know-how would, for instance, include ebbu patents, Canopy Health formulations, Canopy Innovations technology, and Canopy product look-alikes. In fact, I would also expect products in the US and Canada to be made to closely resemble each other as much as possible so as to help establish trusted brands across North America. I would also expect storefronts in states where Slang (OTCQB:SLGWF) products were available to carry those products (Canopy has warrants in Slang). In case it's not already clear, the idea here isn't just to open Tokyo Smoke and Tweed stores but to help establish dominant brands across the North American continent. While Canopy can’t legally flood America with its products and brands yet, Acreage can with very similar offerings. Acreage can utilize Canopy knowledge and IP to copy-cat branded products in each state and sell them. This is a very smart, inventive way to move forward where competitors can't and while lawmakers take their own sweet time passing legislation.

Truth

This deal is good for both Acreage and Canopy shareholders. It effectively combines the largest cannabis licensee in the US with the largest worldwide cannabis company to form an even more powerful juggernaut. Legally they remain two separate companies, effectively they will not be.

However, Acreage shareholders should also be aware of the downside. Canopy is very likely to move forward with or without them. Canopy has an established history and culture of breaking open the cannabis space, of leading the sector. In fact, Canopy's structure (co-CEOs) and management incentives are all keyed towards growth and expansion. Thus, if not Acreage, they will establish North American brands with Harvest Health & Recreation (OTCQX:HRVSF) or another MSO. What Acreage shareholders are really deciding here is not just whether they want to partner with the juggernaut of the industry but also, if they don't approve the deal, whether they want to risk ultimately being run over by it.

• Shareholders on both sides who hope for as much worldwide domination of everything cannabis as possible have a lot of incentive to vote for the combination. (I, for instance, own shares in both companies and have voted "yes" to the merger with both.)
• As a former ebbu shareholder, I can also say the picture changes once your company decides to sell to Canopy. For one, the surety of long-term success increases significantly. You know Canopy-Acreage will make mistakes, but you no longer worry those mistakes are likely to kill them. You also gain confidence that the successes are likely to outweigh the mistakes. Thus, keeping a major portion of one's net worth tied up in Canopy becomes an entirely different picture than keeping it in a smaller and more uncertain US-based MSO. This is the reason insiders are willing to voluntarily extend their lockups if the Acreage-Canopy deal is approved, but will not do so if it isn't. Maintaining wealth in Acreage is a much riskier proposition than doing so in Acreage-Canopy.

Indeed, ACRG-U shareholders should ask themselves what happens if the deal isn't approved.

1. Exactly how much are their shares likely to be worth if this deal doesn't go through now that insiders are free to sell tens of millions of shares which have been locked up for years?
2. Where is Acreage going to get the access to capital to build out its 87 dispensary licenses unless it can share in some of Canopy's heft and superior access to capital?
3. Is Acreage going to also try to raise enough funds to establish its own brands, or is it going to let that opportunity pass it by?
4. At what dilutive cost would such non-Canopy supported funding come?
   • Side Note: Constellation is also clearly behind the deal and willing to offer support. It for instance agreed to 25% of the cash from any future Canopy warrant exercises going to Acreage.

Thus, although an ill-conceived letter from Marcato Capital made approval by ACRG-U shareholders seem more questionable, both groups are clearly better off if the merger is approved: ACRG-U shareholders because they want the $2.55 in cash, the access to Canopy IP and know-how, the ability to buy and sell shares in volume without affecting price, and the access to capital and resources to take the business to the next step. CGC shareholders because they want to expand brands into the US with as much head start against serious competitors like Altria (MO) / Cronos (CRON) as possible.

Indeed, I think it quite telling that the day after Marcato released its letter saying it would vote against the deal, ACRG-U traded down almost 6%, while CGC was actually up slightly. This was basically Mr. Market's way of saying ACRG-U shareholders need Canopy more than Canopy shareholders need Acreage. Though I am a shareholder in both, I have to agree.

No deal and CGC moves on to Harvest Health & Recreation or another MSO. No deal and ACRG-U likely sees tens of millions of insider shares sold into a relatively thinly traded share base, has the ongoing problem of trying to access the capital to build out its base in an illegal market, needs to spend further funds to develop its out products and brands or give up on that idea altogether, and ultimately has to compete against whomever Canopy does lend its heft and know-how to. Acreage shareholders should pay close attention, and consider that 6% drop may be a small precursor of what is likely to happen were this merger not to close.

Primary Risks

• The main risk is the risk of investing in any cannabis company at all. Will the US and the rest of the world be legalizing cannabis, and if so, just how big it will be? In the macro section above, we already saw that trends are clearly moving towards legalization, with even 56% of Republicans now favoring it. We also saw revenue in the US has been forecasted to exceed $50 billion, and $150 billion worldwide. However, ultimately the sector is just too new. Any forecast is more likely to be off by an order of magnitude than correct. The investor is left to decide if worldwide cannabis legalization is a paradigm shift they want a piece of or not. Fundamental analysis simply isn't going to work.
• Another risk specific to the deal is cannabis has to become federally permissible in the US for it to close. While true, I don't understand why this is considered an impediment to taking advantage of the spread. Put simply, if something which makes the deal federally permissible (such as the States Act) does not pass, both stocks will likely tank. At least with the spread, you may have an additional buffer.
• This merger also gives Canopy shareholders an opportunity to reduce their capital at risk, while maintaining the same upside if they so choose. Currently, to own 1,000 shares of Canopy directly, you need to put $40,260 at risk. However, to own 1,000 shares of Canopy indirectly through ARCG-U, you need risk only risk $31,368 (1,719 shares of ACRG-U * .5818 = 1,000 shares of CGC). Thus, by owning 1,719 shares of ACRG-U, you can get the same benefit as 1,000 shares of Canopy but you put $8,892 less capital at risk.
  
  
  (Source: Author's calculations)

The current high spread in the Acreage-Canopy merger exists in part due to do fear. Fear that shareholders may not approve the deal despite it being in their own best interests. Fear that cannabis won’t become legally permissible in the US within the next 7.5 years. These fears and misconceptions should dissipate with management further clarifying the deal, shareholders approving the merger in June, and ongoing progress on the legislative front.

Ongoing Challenges

Even assuming some of this is resolved, however, there will continue to be ongoing practical issues affecting the spread:

1. First, there will almost certainly need to be more Acreage share issuances. With the merger approved and Canopy's help, plus passage of the SAFE banking act, Acreage should be able to access funding similar to Canopy. However, they also have a lot of growth in front of them. They will need to continue to obtain new licenses, build out existing ones, establish product manufacturing and distribution platforms, buy other companies with key assets, etc. Bank loans by themselves are unlikely to provide enough capital for all that. Thus, Acreage is likely to periodically be issuing shares, issuances which may temporarily affect the spread.
2. The spread will also continue to some extent because arbitrage is difficult and costly for this merger. ACRG-U is fairly thinly traded on a second-tier Canadian exchange (165k share average daily volume). CGC currently costs 13% to borrow. So, doing a classic arbitrage trade is more difficult and carries more risk than normal for professional arbitrageurs. They need to have access to both exchanges. They need to be able to trade ACRG in volume without moving the price (not easy). The borrow cost is high (13% via Interactive Brokers) and has a nebulous end date, thus making the total cost unknown and concerning. This is part of why Wall Street hasn't been heavy arbitrageurs so far, and may never be. That, however, doesn’t mean we individual investors can’t, or shouldn't, take advantage of the situation.

Conclusion

I personally chose not to do the classic long Acreage, short Canopy arbitrage. In part, I don’t want to pay the borrow fee on Canopy with the uncertain time frame for the deal to close. However, even more important to me is that I am unwilling to short Canopy, the leading company in a very high-growth sector. To me shorting Canopy, even as a hedge, is like shorting an internet firm in the mid-'90s. No thanks. Instead, I want to stay long only, in order to take advantage as this high-growth, worldwide paradigm shift continues with Canopy Growth at its lead.

To me, long cannabis and Canopy is what makes the most sense - the horse I have been on and want to continue to ride. It just so happens that currently the best way to ride CGC is probably to own Acreage shares. So, I sold some of my Canopy holdings and replaced them with ARCG-U shares.

If both shareholder groups approve the deal, the spread should shrink. It should further shrink as we get closer to the States Act passing. Ultimately, I plan to once again own CGC shares, only I will have gotten them at a 40-50%+ discount by taking advantage of the spread. After all, if one bought Acreage today at a 45% discount to the merger premium, the deal closed, and Canopy ultimately went on to double, the return for Acreage shareholders isn't 100%, it's over 350%! (=(($40.47*2)+$2.55)/$18)

Disclosure: I am/we are long CGC, ACRGF. 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.