Canopy Growth (CGC) made a major announcement last Thursday. If everything goes as planned, the Canadian cannabis giant will acquire Acreage Holdings (ACRGF) for an estimated value of $3.4 billion.
The entry into the U.S. cannabis market has been anticipated for quite a while, though the strategy for entering the U.S. market became better understood via the announced acquisition.
The announcement offers a constructive narrative for how Canopy could actually enter the U.S. Cannabis market, which is estimated to be a $50 billion+ market (inclusive of black market and legal sales) versus the much smaller Canadian market at $4.5 – $5.3 billion annual sales, according to Cowen analyst Vivien Azer. Canopy’s expansion beyond the Canadian market into the U.S. market suddenly expands the TAM (total addressable market) opportunity by upwards of 10x.
The U.S. cannabis market is more fragmented with domestic producers heavily concentrated in Northern California (or really all of California with a number of well-established brands and strains). The fragmentation of the market and the stiffened competition, along with a number of established strains (predominantly from California growers) makes entry into the U.S. market very difficult. Not to mention, much of the black-market activity is concentrated in various regions across California, where they not only don’t pay taxes, but price below wholesale rates anyway.
The acquisition of Acreage is an integral bridge to the U.S. market for Canopy. Acreage has managed services agreements in place for cannabis-related licenses across 20 states (giving it the right to develop), including 87 dispensaries and 22 cultivation and processing sites. Therefore, the expansion into the United States becomes a lot easier with those existing facilities and licenses, as it takes away a significant sum of the legwork involved with establishing recognizable strains or immediate channels to retail end-consumers that would pay the conventional retail rate. Also, getting licenses in the United States is a complicated legal process in a number of States where medical is legal whereas recreational is illegal, so the immediate impact from an acquisition would be more than material. Hence, it’s another reason why I anticipate the 41.7% acquisition premium to increase, and deal terms to be modified.
Legalization in the United States at the Federal level could happen, but it’s really conditional on the re-introduction of the STATES Act by Elizabeth Warren (D) Senator, and Cory Gardner (R) Senator from Colorado. Cory Gardner mentioned that Donald J. Trump would support the STATES Act, which diminishes the likelihood of a presidential veto, but it’s also worth noting that Cory Gardner comes from a more moderate (plus an already legalized state), hence there’s implicit bias in Cory’s stance despite being a Republican. Not to mention, conservatives have been slow on the issue, and it’s not yet clear whether they have mustered enough political capital from the Republican Party to sell their voter base on the STATES Act.
Historically, the Republican Party (especially in recent history) has polarized their voter base with the “War on Drugs,” and various drug policy enforcement initiatives tied to the southern border. Not to mention, the Republican Party base leans towards anti-drug, anti-crime, and touts investments along with statistics tied to various law enforcement initiatives. Sudden support for marijuana legalization could undermine the main narrative Republicans have been preaching for ages. The Speaker of the Senate, Mitch McConnell has yet to comment publicly on the STATES Act, and in recent weeks he has been more vocal in the support of raising the minimum age of tobacco consumption from 18 years to 21 years of age. I.e., he’s still sticking to his guns and getting more aggressive on regulating pre-existing drugs that are already legal, and now stock speculators expect him to rally his party base to legalize something illegal? Something doesn’t seem to add up here, quite yet.
“Top banking regulators from 24 states sent a letter to Congress to urge enactment of the SAFE Act, which would permit banks to service cannabis companies that comply with state law. Our View: We continue to expect the 116th Congress will enact cannabis-related legislation. Our view remains that this is more likely to be a narrow bill like the SAFE Act on banking rather than a broader bill like the STATES Act, which defers the issue of legalization to the states,” said Cowen’s Jaret Seiberg in a note to clients.
The SAFE Act could gain passage as it’s much easier to sell to conservatives, as it ties into banking, and economic policy, which would push the narrative towards deregulation. Something the conservative party does support. Referencing statistics on job creation, cutting back on burdensome regulation, and pro-banking regulation has been a staple of the Republican Party. So, getting the SAFE Act past congress and the senate seems more doable than federal legalization of marijuana in the immediate near-term.
Although, some of that might have factored into the decision making made by the board at Acreage whom are also composed of former Republican politicians, according to Seiberg: “As a leading multi-state operator (MSO) in the U.S., Acreage Holdings has differentiated itself given their political prowess. As a reminder, Acreage has seeded their board with heavyweights including John Boehner (former Speaker of the House (R)), Bill Weld (former Governor of Massachusetts (R), Republican candidate for President) and Brian Mulroney (former Prime Minister of Canada). With the state of cannabis policy changes in the U.S. inextricably linked to politics, these relationships can certainly be viewed as offering outsized value.”
Piper Jaffray analyst Michael Lavery stated, “The timing of potential legalization in the US is unknown, but we expect it in the next 2-5 years, possibly sooner, and we note that the terms of this deal expire after 7.5 years if legalization has not come by then. We estimate the total US cannabis market (including illicit trade) is $35-50B, with the largest seven publicly traded US cannabis operators combined capturing only 1.5% market share. Cannabis is still federally illegal in the US, but the lack of regulation has allowed products to evolve much more rapidly than in Canada.”
What’s unique? Lavery believes Federal legalization could happen within 2-5-years triggering the transaction between Canopy and Acreage . It’s certainly plausible that the political map, and the number of R-Senate seats could change hands in 8-years (given numerous election cycles), hence the political insiders/board of directors of Acreage recommended the deal given their political prowess and anticipation of legalization at a much later point. This seems plausible, but it also implies that virtually no analyst (not even me) anticipates that the STATES act will make it past the current 116th Congress, but perhaps the 117th or 118th Congress instead.
Lavery maintains an Outperform rating on Canopy stock, along with a $60 price target, which implies about 25% upside from current levels. (To watch Lavery’s track record, click here)
The deal terms look good for Canopy shareholders (because an acquisition later is better than never), but from the perspective of ACRGF shareholders, it wouldn’t be surprising to see terms negotiated again in the month of June, as the triggering of the transaction could happen way out into the future (as opposed to something near-term). Since that’s the most probable outcome, the lack of arbitrage adjustments in ACRGF stock will lead to some disapproval from shareholders as most M&A transactions lead to an immediate arbitrage adjustment with a slight market discount (virtually all cases).
This hasn’t occurred yet, which is why I’m expecting Canopy to pay even more to adjust the un-even dynamic of the transaction. Given the overwhelming dependence on this major acquisition to enter the U.S. market, I’m confident that Canopy will eventually find a path to both executing the transaction and gaining the necessary shareholder approval from ACRGF.
Expectations among Canopy shareholders should shift towards higher dilution to make the transaction work long-term, but with a call option to enter the U.S. markets at a point when production has ramped more meaningfully in its Canadian grow facilities. This is still a major catalyst for Canopy shareholders long-term and should be viewed positively. Just keep in mind, that ironing out the details will be an arduous process for the foreseeable 12-months.
Disclosure: The author has no position in Canopy Growth or Acreage Holdings stocks.
To read more on the nitty gritty of what’s going on in the rising cannabis industry, click here.
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