Tilray: An Irrational Reaction

Summary

• Tilray surprised investors in a positive way when management announced plans to create an extended lock-up period for the firm's original investors.
• This move seems to be reinforcing the idea in the market's eyes that stability has been instilled in the firm for now.
• While this may be true, the transaction, which created significant upside in the stock, really meant nothing and investors should expect a reversal.
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Financial engineering can be a wonderful tool used by the management teams of firms in order to create value. In the past, for instance, I have talked about some of the innovative financing transactions of cannabis giant Aurora Cannabis (ACB) that allowed the company to grow on terms it might not otherwise have received. However, not all financial engineering is accretive, but in an industry where any news that’s not bad news is considered bullish, even transactions that don’t create value for investors more broadly can be given a high-five by the market. Such is the case with a recent move made by the management firm at Tilray (NASDAQ:TLRY), a rival to Aurora in the cannabis space. This latest transaction, while proving to be good for the investors immediately affected, received significant applause by the market, but the end result, likely, will be a correction of sorts, all things being equal, because for the company as a whole, the move means little, if anything.

A look at the transaction

Prior to being the standalone cannabis business that it is today, Tilray operated as a wholly-owned subsidiary under the control of Privateer Holdings, a private equity company. Seeing the opportunity in this space, Privateer was responsible for Tilray’s earliest growth, but then in 2018 it sought out external funding and this, in turn, eventually led to a listing of Tilray through an IPO later that year. Since then, the business has continued to focus on opportunities in this space, but one downside is that, because of the structure of the arrangement and due to the fact that Privateer owns a 77% piece of Tilray, this works out to around 75 million shares.

The problem with such a large ownership, fundamentally, is that it’s difficult to cash in. If investors begin selling their shares in an uncoordinated manner, it can spook the market into thinking there’s something wrong, or even if it is coordinated it can lead to the price tanking because volume is simply too high to be absorbed by counterparties. Add to this the fact that Privateer’s investors, earlier this year, received ownership over three of Privateer’s subsidiaries as it worked to uncoil its business (leaving only the 75 million shares of Tilray under the company’s name) and you can understand how difficult the situation has become.

To fix this issue, management and Privateer appear to have worked out an arrangement that can be beneficial for all parties involved. In short, Privateer is going to be merging in an all-stock transaction with a subsidiary belonging to Tilray, with the subsidiary of Tilray surviving the transaction. For each share of Tilray’s own common stock absorbed, the company will be issuing a share of its common stock back out to the investors in Privateer.

In order to prevent any sort of rapid selling or anything of that sort, the investors affected will be subject to a rather flexible lock-up provision. During the first year following the completion of the transaction, they may only sell their shares in Tilray under specified circumstances. These include marketed offerings, block trades, or trades related to strategic investors, and all of these maneuvers, it looks like, will be subject to the discretion of Tilray’s management. After the first year, and through the second, the cannabis firm’s investors can see their shares be "released" from the lock-up in staggered tranches, with the lock-up in its entirely being released at the end of two years.

The market’s reaction makes no sense

One positive light to this, from the market’s perspective, is that it suggests that Tilray’s original investors are here for the ride for the foreseeable future. Growing a company only to sell off ownership in it can make the market worry that something might be wrong, while in this case, unless Tilray does engage in one of the specified transaction types (which is entirely possible), the original investors are going to be on board for the better part of two years.

This level of commitment is a positive, but beyond that assurance of sorts, there’s nothing of significance to this transaction. In fact, had the market reacted normally to this move, I would have made the case that it’s barely newsworthy, but this was not what happened. In response to this development, shares of Tilray soared, rising as much as 20.2% during the day, only to close the day up 11.2%. This increase in price, through close, works out to an increased market value for the business of about $422 million, while at the peak of the day the increase amounted to more than $763 million.

Seeing these kinds of moves for a company, when the underlying cause is not accretive to the company in any way, shape, of form, and only serves to suggest that original investors are selling, only not today, does not warrant a move of this magnitude. Not by a long shot. Keeping all else the same, it wouldn’t be unreasonable for investors to expect this tide to reverse, as the market recognizes the general move higher was driven more by the hype permeating through the space than it was by a real value-accretive transaction.

Takeaway

Based on the data provided, it seems clear to me that his push higher in Tilray’s share price was very likely unwarranted. The jump worth hundreds of millions of dollars was not done in response to any fundamental change in the business, nor was it due to a transaction that will go on to create value for shareholders. Because of this, investors should not be surprised if, keeping all else the same, we see a pullback for the firm in the not-too-distant future.

Analyst’s 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.