Acreage Holdings: Canopy Growth Renews Its Vows
Opportunity Overview
Acreage Holdings (CNSX:ACRG.U disclosure long) is a beleaguered multi-state operator (“MSO”) in the US cannabis industry. Acreage was one of the most aggressive and least operationally focused players to participate in the US cannabis asset landgrab of 2018/2019. The Company rapidly assembled a large portfolio of licenses and assets to operate legal cannabis businesses (cultivation, processing, and dispensing) across 20 US states and went public via a Canadian RTO in November 2018.
There is a lot to be said about ACRG’s poorly run operations and about the challenges and opportunities in the US cannabis industry and MSO landscape, but that is not the focus of the current investment thesis in ACRG. The current thesis is driven by Canopy Growth’s (NYSE:CGC) recent restructuring of its agreement to acquire ACRG, that was originally struck in April 2019. The deal was designed to provide CGC, a Canadian operator, with the ability to plant a flag in the burgeoning US cannabis market without violating regulatory requirements prohibiting it from investing in US cannabis so long as cannabis is federally illegal. In a nutshell, the transaction provided CGC with the right to acquire ACRG when cannabis becomes “federally permissible” in the US and injected ACRG with a cash infusion through a clever merger arrangement and optionality. CGC itself received a similar investment/de-facto acquisition from US beer and wine company Constellation Brands (NYSE:STZ) in August 2018 after STZ dipped its toe in the water with a minority investment in CGC the year before. In May 2020, STZ reaffirmed its commitment to the CGC deal through the exercise of a portion of its warrants purchased in the agreement. The combination of both deals formed a sort of daisy chain between STZ, CGC, and ACRG, with CGC and ACRG each benefiting from the credibility and balance sheet of its bigger brother and de-facto parent company.
Original CGC/ACRG Deal (April 18, 2019):
Canopy Growth Announces Plan to Acquire Leading U.S. Multi-State Cannabis Operator, Acreage Holdings
STZ/CGC Deal (August 15, 2018):
CGC’s revised agreement to acquire ACRG reduces its effective purchase price from the 2019 agreement, and at the same time reaffirms CGC’s commitment to building a US presence through ACRG just as the market was approaching peak pessimism about CGC’s commitment to ACRG and the Company’s future as an independent company. The revised arrangement provides existing ACRG shareholders with a small up-front cash payment in consideration of modification of the agreement, and subsequently splits ACRG Existing Shares into two share classes that will trade independently. We believe that ACRG shares are currently undervalued relative to the fair value of post-split shares and have little downside risk. ACRG existing shares currently trade at $2.59 (closing price on June 26, 2020). Our Base Case scenario projects a 61% gross return and 122% annualized return to ACRG’s closing price on June 26, 2020 over an estimated 6 month holding period. Our Downside Case assessment of fair value is at breakeven with the June 26 price and we believe downside risk to be extremely limited.
The amended agreement is quite complex, and the details of the transaction should be read in detail in the ACRG company press release linked below. In summary, ACRG Existing Shares will split into Fixed Shares and Floating Shares. Fixed Shares will be pegged to CGC at an exchange ratio of 0.3048 CGC/ACRG, and the Floating Shares will be subject to a minimum call price (minimum bid to close complete the merger) by CGC of $6.41 per share.
Revised CGC/ACRG Deal (June 25, 2020):
The agreement outlines ACRG’s contracted future value when the merger with CGC closes. At the time of the deal announcement, the combined future value per ACRG share was $5.79, inclusive of an initial up-front cash payment to ACRG shareholders as consideration for modification of the agreement.
Base Case Scenario
Our Base Case price target is derived by discounting the contracted future value of each post-split share class (shown above and outlined in the agreement) to its present value. All signs point to a “Triggering Event” allowing the merger to close before year-end 2022, and we believe this is what the market should be discounting. We are allotting 3 months for the share split transaction to close, and 3 months post-share split for the market to digest the deal and reprice shares, for a 6-month projected total holding period. The amended agreement requires a 2/3 shareholder approval but ACRG insiders holding ~84.6% of the Company’s voting rights have already greenlighted the deal. Our Base Case gross return target is 61% for a 122% annualized return.
Stated another way, our Base Case price target would price in a 39% deal spread based on CGC’s closing price the day before the announcement of the revised deal.
As had been the case with the original deal struck last year, federal permissibility (in the form of either the STATES Act, or full federal de-scheduling) remains the triggering event. While CGC could execute the transaction at their discretion, waiting for a triggering event is necessary to maintain good compliance with listing agencies and financial institutions. The upcoming election coupled with the current macro and social backdrop in the US may serve to crystalize the triggering event, in particular given the revenue shortfalls that are expected at the state level, which cannabis tax revenue and job creation could offset. CGC’s management believes that we could see a change to U.S. federal cannabis status by 2022. ACRG’s management has recently reiterated their view for regulatory change in the next 12 months. We note that David Klein was appointed CEO of CGC in December 2019 to replace Bruce Linton. David Klein previously served as the CFO of STZ and we believe he is a credible choice to right-the-ship at CGC, and ultimately, the combined CGC + ACRG.
David Klein, Canopy’s CEO on 2022 target on a recent appearance on CNBC (June 16, 2020):
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Canopy Growth CEO David Klein expects weed will be legalized federally by 2022
ACRG’s shares have priced in most but not all of the up-front cash payment from CGC. Beyond that, the shares do not reflect the value of CGC’s recommitment to a merger even if applying a large deal spread, the Company’s progress with its operational turnaround, or the $100M capital injection from CGC to ACRG’s hemp subsidiary.
Downside Case Scenario
Our downside case scenario conservatively assumes 4 years to the occurrence of a triggering event in mid-2024, and pegs CGC’s share price for conversion purposes at its 52-week low of $9.73 (closing price on March 18, 2020), representing a 49% decline to its deal announcement price and a 76% decline to its 52-week high. CGC’s 52-week low on March 18th was near the US market’s peak drawdown amid the COVID-19 market panic. Our Downside case estimate is breakeven from Friday’s close price.
In conjunction with the announcement of the amended agreement, CEO Kevin Murphy announced that he will step down from the role, and will be replaced on an interim basis by Director Bill Van Faasen (former Chairman, CEO and President of the Blue Cross Blue Shield of Massachusetts). ACRG is recruiting a CEO with broad CPG and regulatory and product & brand expertise. We see this as a welcome change and an indication that the Company is being proactive in refocusing its operations for an ultimate combination with CGC.
From an operational perspective, ACRG is a turnaround story and the Company has a lot of work to do to rationalize and improve its operations and capital structure. We view ACRG as the US MSO with the most built-in potential for improvement on an enviable asset base, backed by a merger commitment and vested interest from CGC, and by proxy, STZ. Despite recently taking on bridge financing with nauseating terms, we think ACRG is positioned to work through what was likely an operational trough and max pain in terms of liquidity constraint. We see far more certainty regarding ACRG’s future after its Q1’20 earnings release which came shortly after the announcement of the amended agreement with CGC, and detailed the Company’s progress with cost cutting efforts, its approach to non-core asset divestitures to raise cash, management change, $100M financing from CGC, and of course, the amended merger agreement. With near-term liquidity concerns now on the backburner, we think ACRG’s share price will ultimately be dictated by the CGC merger spread once the revised transaction is better understood by the market.
Our downside value is also underpinned by ACRG’s core assets which include licenses and operating assets in large markets with restrictive licensing regimes. We believe that in an orderly liquidation scenario, ACRG’s core operational licenses and assets could command an aggregate value in excess of the Company’s current enterprise value. For example, as recently as last year one of the ten New York licenses traded hands for over $100M. At the same price, just ACRG’s New York assets would trade for nearly a quarter of its current enterprise value. As ACRG’s turnaround and merger commitment from CGC unfold, we think the value of the whole will exceed the sum of the parts. In the meantime, we expect the loan proceeds from CGC to stave off any near-term liquidity concerns and limit downside risk in the equity.
Cresco Labs’ acquisition of NY license (August 8, 2019):
Cresco receives regulatory approval for New York marijuana license deal
Source: Q1’20 investor presentation
Catalysts
Shareholder approval of the amended agreement, listing of the dual-class shares, repayment of short-term bridge financing, hiring of a new CEO, regulatory developments at the state level in 2020 (New Jersey adult-use referendum)
Key Risks
Risk: Potential for illiquidity of new dual class share structure with limited institutional investor participation
Mitigant: We believe Acreage management understands the illiquidity risks associated with the dual class structure and will work to inform shareholders through their IR department. The Company has historically been proactive in their communication with retail shareholders across multiple media channels.
Risk: Incremental financing requirements
Mitigant: CGC provided a wholly owned subsidiary of ACRG with a $100M non-guaranteed secured loan to finance its US hemp division. In connection with the refocusing of its operations, ACRG has already initiated the divestiture of some non-core assets that management has stated will generate sizeable amounts of cash to refinance existing bridge loans and provide incremental capital. Furthermore, the agreement allows for ACRG to issue new equity for up to ~21% dilution. The Floating Shares which are not tied to a fixed exchange ratio eliminate any overhang on ACRG’s valuation from the exchange ratio peg to CGC and establish the possibility of future equity issuance at more favorable prices. We believe ACRG has substantial runway in the form of divestitures before an equity raise will be required.
Disclaimer
Nothing on this blog should be construed as investment advice. Everything on this blog is the opinion of the author and only the author. Investors should make their own decisions regarding the prospects of any company discussed herein. The author and the author’s affiliates may have long or short positions in the stocks mentioned on this blog, and there is no guarantee that such persons will maintain such positions. The author is not paid to produce research.
