If you think the stock market has had a wild year, take a peek at cannabis stocks, which over the past three years have skyrocketed and imploded.
Back in 2017 and 2018, you could have been blindfolded and chosen a pot stock from a list of publicly traded companies and landed yourself a winner. Prior to the legalization of adult-use weed in Canada on Oct. 17, 2018, promises of capacity expansion, international sales, and acquisitions were often more than enough to send marijuana stock valuations into the stratosphere.
However, that's not been the case since the end of March 2019. The vast majority of pot stocks have seen their valuations decline by 50% (or more) as supply issues in Canada, high tax rates in the U.S., and financing concerns throughout North America, have burst the industry's bubble. All next-big-thing investments undergo growing pains, and the cannabis industry is working its way through a rough patch of its own at the moment.
The Canadian cannabis industry was apparently on the verge of a megamerger
With a number of well-known cannabis stocks struggling, the expectation from Wall Street has been that bankruptcies or mergers would thin out the field a bit and allow the survivors to thrive. Little did investors know that, according to BNNBloomberg, a megamerger discussion was in the works to our north as recently as last week.
Based on reports from two people familiar with the matter, Aphria (APHA) and Aurora Cannabis (ACB -6.20%) were engaged in merger discussions whereby Aphria shareholders would own 51% of the new entity, with Aurora Cannabis' shareholders making up the remaining 49%. The combined company would have a market cap of close to $3 billion, control around 30% of Canada's legal cannabis sales, and have the potential to generate 800 million Canadian dollars ($592.3 million U.S.) in yearly sales.
Additionally, the combined company would have a production, import/export, or research presence in 25 total countries, with the potential to save in the neighborhood of CA$200 million annually in cost synergies. These overseas markets are viewed as critical to the success of Canadian licensed producers since the ability to export can ensure that oversupply and declining domestic prices don't become a drag on margins.
Although neither company would comment on whether they'd entered into discussions about merging their operations, BNNBloomberg noted that disagreements ultimately arose over the makeup of the board of directors and compensation for senior executives. While future negotiations are possible, it would appear that both companies are going it alone for now.
An Aurora Cannabis-Aphria tie-up would have been a terrible idea
If you ask me, it's probably a good thing that negotiations fell apart. Putting aside the almost laughable fact that this deal may have fallen apart because of disagreements on senior executive compensation -- over the trailing two-year period, Aphria's and Aurora's stock are down 43% and 84%, respectively -- a combination of these two businesses really wouldn't make a lot of sense.
For instance, the report suggests that the combined entity would recognize around CA$200 million in cost synergies. Much of this would likely be realized by closing smaller production facilities and relying on economies of scale in larger grow farms. But Aurora Cannabis is already doing this.
It's shuttered five of its smaller facilities, halted construction on two major projects, and sold a 1 million-square-foot greenhouse. Combining these two businesses would just create a company with far too much production for what's demanded today, ultimately forcing the new entity to shutter more facilities.
Another head-scratcher is that the deal would emphasize their global appeal. The thing is, Aurora Cannabis already has a presence in two dozen countries outside of Canada, and Aphria has a presence in nearly one dozen of these same markets. Neither company has been generating much in the way of marijuana sales outside of Canada. Thus, I fail to see how combining two companies with similar struggling international operations would make for a successful overseas segment.
The combination doesn't seem to make a lot of sense for Aurora Cannabis from an operating margin standpoint because Aphria is generating a lot of its revenue at the moment from its pharmaceutical distribution business (CC Pharma) in Germany. Pharmaceutical distribution can lead to a lot of sales and somewhat predictable cash flow, but it's a very low-margin operating segment. Therefore, putting Aurora and Aphria together would probably reduce margins, not expand them.
Don't even get me started on how ugly the combined balance sheet of these two companies would be. Aurora Cannabis is lugging around CA$2.42 billion in goodwill, most of which is tied to grossly overpaying for MedReleaf in July 2018. Meanwhile, Aphria had almost CA$670 million in goodwill on its balance sheet, which is primarily from its purchase of Nuuvera in March 2018.
This combined company would have almost CA$3.1 billion in goodwill and roughly CA$845 million in intangible assets. Not even taking into account the strong likelihood of impairment charges tied to facility closures and layoffs, it would be a massive writedown waiting to happen.
Aurora Cannabis and Aphria have a lot of work to do to rebuild shareholder trust and get production in line with current demand. Until these basic goals are tackled, the idea of combining these two companies should be off the table.