Tilray-Aphria Merger Is Positive, But the Outlook Remains Cloudy

Stock Market

The times are changing in the marijuana industry. Three years ago, traders were excited for the Canadian cannabis stocks. That country was about to open up its retail marijuana market and it seemed like the possibilities were endless. Fast-forward to now, however, and the Canadian pot companies have crashed and burned while American players have become strongly profitable. Canadian leader Tilray (NASDAQ:TLRY) stock has not fared well in this new paradigm.

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However, a game-changing merger may finally get Tilray back on track. The company is set to join forces with Aphria (NASDAQ:APHA). Both of these have been long-time leaders in the Canadian marijuana space. But given the problems that market has had, both companies have run up large operating losses, historically.

Merger Details

The deal, should it be approved, will go as follows. Tilray will issue shares to acquire Aphria. As a result, people owning TLRY stock will see no change in their ownership. Meanwhile, folks that own APHA stock will receive .8381 shares of Tilray for every share of Aphria that they owned.

As of this writing, Aphria stock is 2% underpriced compared to its value in TLRY stock based on that .8381 share exchange ratio. Thus, in theory, you could make a free 2% profit by swapping TLRY stock for Aphria stock. However, after potential transaction costs and tax consequences, there may not be much arbitrage benefit here if you already own Tilray.

Still, if you are considering starting a new position in either Tilray or Aphria stock right now, APHA stock gives you a little bit of extra upside from the upcoming merger.

Gaining Operating Scale

Let’s zoom back out though: What’s this deal going to accomplish? According to the informational page that the companies made for their merger, Tilray plus Aphria will make up the world’s largest marijuana company. With trailing revenues of 874 million Canadian dollars, it will narrowly edge out Curaleaf (OTCMKTS:CURLF) for the top spot based on sales.

Notably, nearly all the other closest rivals are the U.S.-based marijuana companies that operate in individual states. Thus, among the companies primarily involved in the Canadian market, Tilray and Aphria, combined, should be the No. 1 player by a wide margin. Canopy Growth (NYSE:CGC), by comparison, will have just half the revenues of the post-merger Tilray.

That said, Tilray/Aphria is unlikely to hold the top spot for long. The U.S. players such as Curaleaf are growing at huge rates while the Canadian market remains in the doldrums. So, while Tilray will be the largest marijuana company for the moment, don’t count on it holding that title forever.

Regardless, the merger should save a lot of money. And that’s crucial, given past results. Over the past 12 months, Aphria lost $163 million. Meanwhile, Tilray had $271 million loss.

Overhead is the obvious place to cut. Put together, Aphria and Tilray spent more than $270 million on sales, general and administrative costs last year. If a post-merged company can cut its overhead by a third as it eliminates redundant costs, that would save roughly $100 million per year. Pre-merger, Tilray and Aphria lose more than $400 million annually, so this savings will hardly get them to breakeven, but it’d be a significant push in the right direction.

TLRY Stock Verdict

The Canadian marijuana industry is long overdue for consolidation. Everyone came flying into the space a few years ago, thinking it was a gold rush. Instead, the quantity of cultivated cannabis far exceeded actual recreational demand. Thus, operators ended up with huge inventory levels they couldn’t sell and nearly everyone lost money.

As Economics 101 dictates, you have to find an equilibrium between supply and demand to reach optimum efficiency. A key part of that will be reducing supply to match demand. By consolidating a ton of small marijuana companies into a few powerful players, the industry should be able to right-size its cost structures and finally start earning money.

So, Tilray and Aphria deserve a lot of credit for taking a tough but necessary step here. This sort of move will eventually lead the Canadian marijuana industry toward profitability. However, the road ahead remains long. Even with merger synergies, expect the combined firm to continue losing large sums of money in coming quarters. This deal is a major stepping stone for the Canadian marijuana industry, but there won’t be a windfall of profits overnight.

As such, there’s no real need to own TLRY stock yet. Shares will likely dip after this pending business combination is completed. The merger is a positive, but it’s hardly a silver bullet. For the time being, the American marijuana operators such as the aforementioned Curaleaf are much more promising as investment candidates.

On the date of publication, Ian Bezek did not have (either directly or indirectly) any positions in the securities mentioned in this article.

Ian Bezek has written more than 1,000 articles for InvestorPlace.com and Seeking Alpha. He also worked as a Junior Analyst for Kerrisdale Capital, a $300 million New York City-based hedge fund. You can reach him on Twitter at @irbezek.

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