Cannabis M&A proving a problem, says ATB Capital

ATB Capital Markets analyst Frederico Gomes is trying to weed out the source of an emerging problem within the Canadian cannabis industry, which has recently been rife with mergers and acquisitions. However, according to Gomes, gaining market share in the still-developing industry is made more difficult rather than easier through M&A, arguing instead for organic growth as the way forward for now.

“The expected outcome of this M&A activity would be an accelerated consolidation of the industry; however, we estimate that the three largest Canadian LPs have lost market share since the announcement of their transactions,” Gomes said. “These data indicate that M&A could be a distraction detrimental to acquirers’ core cannabis operations.”

In advocating for organic growth, Gomes notes it would be a better indicator of operational efficiency, as well as being conducive to lower capital allocation and integration risks.

“In our view, given the still nascent and volatile nature of the Canadian marketplace, LPs should pursue M&A selectively with a strategic rationale not solely based on acquiring market share or brands,” Gomes said.

Gomes pointed to the merger between Aphria and Tilray which when first announced in December 2020 spoke of a combined pro forma market share of 20 per cent. Since the merger, the company’s market share is still below 15 per cent, well off the expected mark, Gomes said.

“As these markets begin to re-open, Tilray is poised to strike and transform the industry with our highly scalable operational footprint, a curated portfolio of diverse medical and adult-use cannabis brands and products, a multi-continent distribution network, and a robust capital structure to fund our global expansion strategy and deliver sustained profitability and long-term value for our stakeholders,” said Irwin Simon, Chairman and Chief Executive Officer of Tilray in the company’s May 3 press release, in which he cited the COVID-19 pandemic as a challenge in multiple markets.

A similar story has transpired with Canopy Growth following its acquisition of Supreme Cannabis in June, as well as with HEXO after it completed its acquisition of Redecan, Canada’s largest privately-owned licensed producer, for $400 million in cash in August.

Despite the higher expectations from the merged entities, Gomes notes that the pro-forma market share of these companies declined 25 per cent on average from the date of the M&A announcement to September 2021.

“Through the addition of Supreme, we’re strengthening our leadership position by offering Canadian consumers a differentiated brand portfolio – including the addition of 7ACRES, which further bolsters our premium product segment,” said David Klein, Chief Executive Officer of Canopy in its June 23 press release announcing the completed acquisition. “Supreme has demonstrated the ability to cultivate premium quality flower at low cost and we’re excited to leverage these capabilities to further our leadership in the Canadian market as we scale these newly added brands and accelerate revenue growth.”

In contrast to the merged companies, particularly the aggressive M&A strategy deployed by HEXO (HEXO Stock Quote, Charts, News, Analysts, Financials TSX:HEXO), the most recent quarterly financial results for both Moncton-based Organigram Holdings (Organigram Holdings Stock Quote, Charts, News, Analysts, Financials TSX:OGI) and Toronto-based Auxly Cannabis (Auxly Cannabis Stock Quote, Charts, News, Analysts, Financials TSX:XLY) came in well ahead of both ATB and consensus projections.

Organigram’s most recent report, which arrived on July 13, showed net revenue of $20.3 million, which outstripped projections of $15.1 million from ATB and $17.2 million from the consensus, with ATB analyst David Kideckel calling the results encouraging, especially in light of headwinds like oversupply, price compression, and the ongoing pandemic impacting the Canadian cannabis market.

Despite the company’s EBITDA loss of $10.2 million compared to the ATB estimate of a $9.9 million loss and the consensus view of a $6.4 million loss, Kideckel believes Organigram has a strong long-term outlook given its robust capital position, cultivation/production expertise, partnership with British American Tobacco, and investment in Hyasynth Biologicals, one of the leading players in the biosynthetic cannabinoid market.

Gomes sees a similar story from Auxly’s most recent financial reports, which came on August 16, and were headlined by revenue of $20.9 million to beat the ATB projection of $16.8 million, as well as the consensus expectation of $15 million, with 108 per cent sequential growth in net sales boosting the company to sixth in terms of market share in the country at between seven and nine per cent.

Meanwhile, the company’s EBITDA loss came in at a modest $3.3 million compared to the ATB projection of a $6.3 million loss and the consensus expectation of a $5.2 million loss.

Overall, Gomes believes organic growth is the best play for aspiring cannabis producers looking to increase their market share.

“In our view, inorganic growth should be pursued selectively to acquire hard-to-build capabilities that significantly advance a company’s strategy (e.g. expanding geographical reach, entering a new category, incorporating an attractive asset base),” Gomes said. “In particular, we believe that M&A executed solely on the basis of buying market share or specific brands have a high capital allocation risk considering the significant market share volatility and the still fragile brand equity built in the Canadian market.”