If You Like the Tilray Merger, Don’t Buy Tilray Stock

Assuming all goes well, investors in Tilray (NASDAQ:TLRY) stock and Aphria (NASDAQ:APHA) stock will both own shares of the same company in the end. But the two stocks don’t seem priced as such.

a marijuana leaf displayed among other numbers related to stock performanceSource: Shutterstock

It’s an interesting, and odd, situation. And it leads to a relatively simple conclusion.

There are reasons to see the Aphria-Tilray tie-up as attractive. The combined company will be the largest cannabis company in the world in terms of revenue. Cost savings look material. Aphria’s respected chief executive officer will lead the new company. This looks like an intriguing play for cannabis bulls.

But the way to get exposure to the play is through Aphria, not Tilray.

A Surprisingly Wide Spread

In the all-stock merger, Aphria shareholders will receive 0.8381 shares of TLRY stock for each share of APHA they own. TLRY closed Wednesday at $25.29. That in turn suggests that each Aphria share should be worth $21.71.

But that’s not where APHA is trading; it closed Tuesday at just $18.18.

The existence of a “spread” between the merger value and the current price isn’t unusual. Nearly every deal has a spread for two reasons.

First, and most notably, there’s a risk of a deal breaking. If a company agrees to be bought out for $35 per share in cash, that price isn’t guaranteed. Something can go wrong. For instance, antitrust regulators may block the deal.

Second, the time value of money matters. $35 per share at merger close — which might be six or even 12 months after the announcement — is not worth $35 today.

We can see this effect with Salesforce.com (NYSE:CRM) and Slack Technologies (NYSE:WORK). That cash-and-stock deal should value WORK stock at $43.36. It instead closed yesterday at $40.25.

The fact that there is a spread between TLRY and APHA thus isn’t unusual. But the size of the spread is. APHA’s merger value, based on the current TLRY stock price, is around 15% above is trading price. WORK’s spread is around 6%, and even that’s considered somewhat wide (perhaps due to potential antitrust concerns).

Why TLRY Stock Trades At a Premium

Why does this spread exist? The answer appears to be the same wave of retail buying that lifted names like GameStop (NYSE:GME) and AMC Entertainment (NYSE:AMC) is late January. TLRY stock too was caught up in the buying, while APHA was to a lesser extent.

After the merger was announced on Dec. 16, TLRY stock gained 18.6% to close at $9.33. APHA was relatively unchanged, and closed at $8.06. The 0.8381 ratio actually suggested that APHA was trading above the merger value, possibly because investors thought a second bidder might arrive. (In fact, there was another cannabis company interested in merging with Aphria, according to the proxy statement.)

But, over time, the APHA spread expanded rapidly, from -5% to as high as 35% on Feb. 11. This was not a logical move. Rather, TLRY saw more buying and more trading (its volume was significantly higher).

The irony is that TLRY appears to have been targeted in part because its short interest spiked. But its short interest spiked due to merger arbitrageurs, who looked to capture precisely this spread by owning APHA stock and shorting TLRY stock. There wasn’t much chance of a supposed “short squeeze” in that scenario (though a widening spread could cause some potential short-term pain). Yet traders tried anyhow.

Why APHA Stock Is the Choice for Merger Bulls

With the spread still in the double-digits on a percentage basis, the choice remains clear. APHA stock is the play. The same amount of money will buy roughly 11% more shares in the combined company.

Obviously, there is some downside risk to that trade. Since the day the merger was announced, APHA has rallied a sharp 123%. The catalyst at least in part has been a broader rally in cannabis stocks. The ETFMG Alternative Harvest ETF (NYSEARCA:MJ) has gained around 43.5% over the same stretch. That sector rally could reverse and bring APHA down with it.

But, of course, TLRY stock would fall as well. It bears repeating: this is an all-stock merger. TLRY and APHA, assuming the merger closes, are going to end up at the same place, and will provide ownership in the same combined company. APHA simply offers a cheaper way to do so.

And if the merger does fall through, it seems like worse news for TLRY than for APHA. It’s Aphria shareholders that are getting the majority of the company (about 62%). It’s Aphria that has been EBITDA (earnings before interest, taxes, depreciation and amortization) positive for six straight quarters.

Aphria’s chief executive officer, Irwin Simon, is taking over the combined company, which says something about how he’s viewed. And, again, Aphria presumably has another merger partner to turn to.

Between an estimated $78 million in merger synergies, an impressive brand portfolio, and global leadership, this merger makes some sense. Buying more TLRY as a way to own the combined company does not.

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

After spending time at a retail brokerage, Vince Martin has covered the financial industry for close to a decade for InvestorPlace.com and other outlets. 

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