The Canadian cannabis market has long been over supplied and under stored. The public companies have needed to consolidate in order to reduce supplies and brands to eliminate stiff competition.
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A recent merger discussion between two of the three leading Canadian cannabis companies could provide substantial synergies and plenty of upside to the shareholders of Aurora Cannabis (ACB) and Aphria (APHA). A deal might not happen between these two companies, but the consolidation in the cannabis sector will ultimately help Aurora Cannabis.
Mega Merger
For most sectors, a merger between Aurora Cannabis and Aphria wouldn’t be considering a mega merger. The stocks both have market valuations below $1.5 billion, but these companies are now the leading cannabis sellers in Canada.
These stocks only trail the behemoth Canopy Growth in total sales for Canadian cannabis companies, but the later obtains substantial sales outside the Canadian cannabis market. While Aurora Cannabis and Aphria reported mostly Canadian cannabis sales in the last quarter with Aurora at C$70 million and Aphria at C$57 million, Aphria does have a large German medical distribution business not generally included in valuation discussions due to the low value and growth potential of the business.
The merger talks have supposedly broken down, but investors should prepare for a deal in the sector involving these companies. The suggested C$200 million in synergies and the appointment of Aphria CEO Irwin Simon would place the combined entity in a very enviable position.
With Canopy Growth still reporting large EBITDA losses into the future and the general Canadian cannabis sector all losing money, a strong CEO in charge that has turned Aphria into an EBITDA positive business would be a huge positive. The combined entity could demand a premium price.
Deal Upside
The combined company only has a market value of $2.7 billion while Canopy Growth is up at $6.4 billion. The new company would match the leading Canadian cannabis company with sales while far out pacing Canopy Growth on EBITDA profits.
At this point, cannabis investors should be done with focusing on sales growth potential. The key to this deal is the ability to take the scale of this entity and generate massive profits.
Aphria has targeted EBITDA profits of C$40 million for the fiscal year ended in May while Aurora Cannabis recently cut SG&A costs to below C$45 million quarterly and plans EBITDA profits in the current quarter. The C$200 million in cost savings could leave a combined business with up to C$750 million in 2021 cannabis sales. If EBITDA margins reached 20%, the new entity would reach C$150 million with potential upside.
In addition, these companies both lack CPG partners making a large deal very possible in the future. Even EBITDA targets of C$250 million, a stock trading at 20x EBITDA would produce a near double for shareholders agreeing to a merger of equals. A new entity has plenty of revenue upside from growth in Canadian cannabis sales from retail store growth, expected German medical sales growth and the entry of Aurora Cannabis into the U.S. CBD market.
Analyst Commentary
In a recent research note, CIBC analyst John Zamparo discussed the aspects of the potential merger and its implications on the cannabis sector:
“Such an arrangement would create a clear industry leader, with national market share likely above 30%. We believe anti-trust concerns would likely be non-existent, as consumers can choose from dozens of different brands, and neither company has a retail component,” the analyst wrote. “Generally speaking, we believe the industry requires consolidation and also some dissolution. For a domestic industry with just $2.2B of retail sales, we believe it is difficult to justify the ~$17B in combined enterprise value. It may take time for this to play out, however.”
To this end, Zamparo rates Aurora shares a Hold. But the analyst might as well have said “buy” — because he thinks the stock, currently at C$14.50, could zoom ahead to C$24 within a year, delivering 65% profits to new investors. (To watch Zamparo’s track record, click here)
Takeaway
The key investor takeaway is that Aurora Cannabis was already a more appealing stock with the improving financials from cutting SG&A costs. A merger of equals with Aphria or any synergistic partner in the Canadian space would make the stock far more appealing as reduced competition improves the profit profile in the sector.
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Disclosure: No position.
