Current Price: C$0.125
Offer Price: C$0.157
Expiration Date: TBD
This idea was shared by Axel.
On the 16th of February, Canadian cannabis operator Zenabis announced that it will be acquired by its larger peer Hexo. Consideration stands at 0.01772 HEXO shares per each Zenabis share (total value around C$200m), which at the moment offers a 25% spread. Both companies have listings in USD and CAD. IB shows 300k+ shortable HEXO shares available at a 10% annual fee, which makes a minor impact to the upside assuming the merger closes in 2-3 months – a similar-sized (C$263m) previous acquisition by Hexo closed in this timeframe.
This is a strategic merger and the buyer has already done similar size mergers before. Shareholder approval seems likely, however, there is some uncertainty regarding the Bevo Farm sale condition (more below). Further information on the transaction should be provided in the circular (to be filed this/next month). The meeting date has not set yet.
The downside is limited due to all Cannabis industry stocks currently trading elevated at elevated due to prospects of US federal approval later this year. Pre-announcement price stands at C$0.16/share, which is above the current price.
Conditions include approval from te 2/3rds of Zenabis shareholders. Management owns 28% of the company. In the past few years, Zenabis has been a cash-burning dilution machine. Since Q1’19 the number of outstanding shares increased 7x. In 9M’20 ZENA burned C$22m cash and at the end of Q3 only had $5m of cash left. Another C$15m dillutive equity issuance was announced recently. Zenabis is also being pressured by its high debt load, with competitors aiming to take advantage of the situation – at the end of last year, the company had a conflict with one of its peers Sundial, which made a strategic investment in one of Zenabis’ lenders and tried to pressure the company into an exclusivity agreement in case of sale. At the time Zenabis had already been in talks with Hexo. Aside from the prospects of U.S. federal legalization, the whole Canadian cannabis industry is still under significant pressure due to demand/supply imbalance – Zenabis sells only 30%-50% of its quarterly production, while the newly started European operations through JV are in still in very early stages and limited in size. In light of this and with management’s support shareholders are likely to agree to the merger.
Further conditions include a successful sale of the Zenabis propagation and flower business (vegetable and pepper plants) Bevo Farms and “the termination and unconditional release of the guarantee provided by Zenabis in favor of Bank of Montreal in connection with the disposition of Bevo Farms”. More details were not provided, but should be included in the upcoming circular. Bevo Farms sale was announced in January and should result in Zenabis debt reduction by C$42.5m (was C$112m as of Q3) and includes a deferred consideration of C$25m cash. The company has also agreed on better rent terms for one of its British Columbia facility, owned by Bevo Farms. The buyer is Langley Propagation and Floral (limited information available online). Overall, this condition and lack of more information adds some uncertainty to the situation.
The strategic rationalle is clear. Hexo is getting close to its production limits – TTM production was 75k kg, while in Q3 it sold 90%+ of its production. In mid-2019, the company has already tried to expand its production capacity via the Newstrike acquisition ($263m), however, it ended up as a fiasco – when after the merger was completed HEXO found out that Newstrike was selling cannabis without a license and had to shut down the facility accounting for 90% of Newstrike production. Merger with Zenabis will add an additional 111k+ kg of capacity, more than doubling the current limits of the buyer. Hexo strategy is to partner with leading customer packaged goods companies through JVs and sell the products through existing distribution networks of JV partners. Recently Hexo has partnered with Molson Coors and aims to enter the Colorado CBD beverage market while preparing for the potential US federal-level legalization later on this year. The merger also offers expansion opportunities in the European and Australian markets through Zenabis’ JV with ZenaPharma. Just recently, HEXO received an EU trademark for their CBD beverage brand ‘Powered by Hexo’.
Finally, although both companies are still unprofitable, the numbers have been improving with the COVID-19 outbreak. Zenabis adj. EBITDA has even turned positive over the last two quarters (Hexo is still negative). The merger should catalyze a faster approach to profitability. The companies expect C$20m synergies through the gross margin improvements, additional capacity utilization, and overhead cuts (combined TTM SG&A was C$66m).
Hexo grows and sells cannabis throughout Canada (covers 90%+ of the population). The company operates 4 facilities with a combined annual capacity of 90k kg production.
The company operates 3 facilities with 111k kg production capacity. It also has EU export license and operates a JV with ZenPharm for import/export into Germany, Malta, Israel, and Australia. The first product shipment to Malta was done in Dec’20.