Insights

The Problem with Cannabis Company Acquisitions

Last week, shares of Canadian cannabis company Aphria (APHA) fell by more than 20% in a single day of trading. While the burgeoning legal marijuana market has seen its fair share of turbulence, the massive drop in stock price still stood out. Why the sudden change in price? Earlier that afternoon, short-seller Hindenburg Research alleged that insiders at Aphria had engaged in overvalued acquisitions and fraudulent financial reporting.

Aphria released a statement calling the short-seller report a "malicious and self-serving attempt to profit by manipulating [the company's] stock price," but the damage had already been done. As of market close Dec. 14, 2018, the stock price had begun to recover from its Dec. 4 low of $4.51 per share. However, even while trading up at $5.60 per share, Aphria remains well below the $8 to $10 range it enjoyed through much of November.

What's the Problem with Cannabis Acquisitions?

For investors entering the legal cannabis scene, Aphria is an important cautionary tale. Regardless of whether the short-seller's accusations are true or false, they speak to a larger trend emerging among small companies in the cannabis market. As the legal cannabis space has taken off, companies eager to distinguish themselves have taken to various means of expanding their reach as quickly as possible.

For some operations, such as Aurora Cannabis (ACB), that means investing millions of dollars into new facilities, entering new markets and more. For others, like Aphria, the means of expansion have involved a somewhat more cutthroat approach: some companies have grown by aggressively acquiring potential competitors. Aphria isn't alone, either. Canadian marijuana companies Aurora (ACB) and Canopy Growth Corp. (CGC) have spent hundreds of millions of dollars to buy up other marijuana outfits in the past year alone.

While fast-paced acquisitions are not problematic in and of themselves, companies run into trouble when they pay for acquisitions in stock, rather than cash. By some estimates, more than two-thirds of all cannabis sector deals involving a change of company control have been financed entirely with stock. In the global mergers and acquisitions space, by comparison, about half of all such deals in 2018 were financed that way.

When a cannabis company utilizes stock to buy up a competitor, its total share count increases. So what's the problem? As a company increases their shares, they dilute the amount of money that each of those shares earns, called price-to-earnings ratios. That means two things for acquisitions: one, acquisitions make it more difficult for companies to report strong price-to-earning ratios unless the acquisition proportionally increases the amount of money they make; and two, acquisitions made using company stock are inherently risky, especially in a space as volatile as the legal cannabis industry.

Why is the Cannabis Industry So Volatile?

Legal cannabis is, by and large, untested as an industry. There are dozens of companies aiming for dominance, but few clear victors have emerged at this point. Many prominent companies, such as Aurora, have been buffeted by the stock market downturn — and many more are likely to be beleaguered by ill-advised acquisitions in the race to the top. What does this all mean for investors? Beware of companies that are expanding too aggressively and keep a close eye on the major acquisitions and sales of growing marijuana outfits. Investors, market analysts, and even cannabis companies themselves aren't yet sure who will come out on top in the race to grow.

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