Once or twice every generation, a game-changing investment opportunity comes along. Previously, it was the introduction and rise of the internet and internet-based commerce. Today, it's the ongoing legalization of marijuana.
How big could the weed industry grow? Although the answer really depends on your preferred Wall Street investment firm, some utopian estimates suggest that the pot industry could one day generate $130 billion to $166 billion in annual revenue. Perhaps it's not such a surprise, then, that we've witnessed investors flocking to pot stocks, or observed a flurry of marijuana stock acquisitions in recent months.
The Canopy-Acreage deal is unlike anything we've ever seen before
Of course, April brought something new to the table that the marijuana industry -- and most investors, for that matter -- had never seen before. Namely, a contingent rights acquisition.
On April 18, Canopy Growth (NYSE:CGC) announced that it would be acquiring U.S.-focused, vertically integrated dispensary operator Acreage Holdings (OTC:ACRG.F) for $3.4 billion in a cash-and-stock deal. This agreement would involve Canopy paying $300 million in cash upfront to Acreage's shareholders, with the remaining $3.1 billion being financed with Canopy Growth's stock. Most importantly, this deal doesn't go into effect until the United States federal government legalizes marijuana, or 90 months passes, at which point the agreement would no longer be valid.
Wall Street and investors viewed this deal announcement as a major win for Canopy Growth, which has stated that entering the U.S. market is a priority. Canopy had already been awarded a hemp production and processing license from New York state in mid-January, which was designed as a means to get processing infrastructure on U.S. soil. But the purchase of Acreage completely transcends the $100 million to $150 million Canopy plans to invest in its hemp processing facility in New York.
Assuming all of Acreage's announced acquisitions close, the company will have a production, processing, or retail presence in 20 states, which is more than any other vertically integrated dispensary. It'll also have licenses to more than 80 retail locations, placing it among the upper echelon of U.S. cannabis retailers, in terms of aggregate licenses held. If Congress changed its tune on marijuana, Canopy would be set from an infrastructure perspective, and Acreage would gain access to Canopy's leading brands and substantial cash balance.
A significant Acreage shareholder opposes the buyout
While this might seem like a pretty cut-and-dried deal where both parties come out as winners, the hurdles to its completion are mounting.
On Monday, activist hedge fund Marcato Capital Management, which owns about 2.7% of the outstanding subordinated voting shares of Acreage, issued a press release containing a letter that it had sent to Acreage's board that outlined why it plans to vote no on the proposed "value-destroying" transaction.
First, Marcato contends that the $3.4 billion value of the transaction substantially undervalues the present value of Acreage's future cash flows. Marcato points to the $6.9 billion increase in pro forma value to Canopy Growth's stock since the deal was announced, while noting that Acreage's share price has declined about 6% since April 18.
Second, Marcato feels that the deal is lopsided in favor of Canopy. The hedge fund notes that Acreage is valued at less than 21 times consensus 2020 EBITDA (earnings before interest, taxes, depreciation, and amortization), whereas Canopy Growth is valued at around 178 times calendar EBITDA in 2020. Since this is predominantly a stock-financed acquisition, Marcato argues that it'd be "asked to exchange an attractively valued security for a highly speculative one."
Third, the hedge fund argues that the sale process wasn't designed to maximize shareholder value since no other third parties were given the opportunity to make a bid on Acreage.
To tie everything together, Marcato would prefer that Acreage remain independent or, at worst, run a formal and competitive sale process that would allow shareholder value to be maximized.
There are big hurdles beyond Marcato, too
Understandably, Marcato's 2.7% share ownership in Acreage may not be enough to influence other shareholders to vote no on the deal. Then again, activist investors have influenced important votes with lesser stakes before, so nothing should be taken for granted.
The bigger hurdle for this deal is that marijuana legalization is not a given in the United States. Even with support for broad-based legalization hitting an all-time high with the American public in October, it doesn't mean that elected officials on Capitol Hill feel the same way about cannabis. Republicans have historically had a more negative view of marijuana than Democrats or Independents, and they currently control the Senate and Oval Office. Without a potentially significant political shift in the 2020 election, passing cannabis reform could prove difficult.
In addition, marijuana isn't the polarizing issue you'd think it to be. While legalization is popular among the public, very few Americans are going to change their vote if a candidate chooses not to support cannabis. With little fear about losing their elected seats, lawmakers have kept marijuana bills on the backburner.
And, as I've recounted before, legalizing marijuana creates a money problem for the federal government. Sure, it reduces law enforcement and court costs, but it also lowers taxable revenue collected from pot businesses. That's because marijuana companies are currently subjected to Section 280E of the U.S. tax code, which disallows any corporate deductions, save for cost of goods sold. Removing 280E would cost the federal government around $5 billion over the next decade.
Even with a long runway of 90 months to complete this deal, there's nothing that suggests its closure is imminent. That's something for investors in Canopy and/or Acreage Holdings to keep in mind.