KushCo Holdings (KSHB) – Merger Arbitrage – 10% Upside

Current Price: $1.14

Offer Price: $1.26

Upside: 10%

Expected Closing: late Q2/early Q3 2021

Presentation

This idea was shared by Ilja.

The cannabis industry is continuing consolidation aiming to capitalize on the recent industry tailwinds.

This is a merger between two ancillary cannabis product (mostly vaping equipment) companies – Greenlane is acquiring its peer KushCo Holdings at 0.2546 GNLN per each KSHB share, offering 10% spread at current prices. 170k shortable shares are available on IB for a 1.20% annual fee.

Conditions include approval of disinterested GNLN shareholders (management holds 56% economic interest and 83% of voting power) and the majority of KSHB shareholders. KSHB directors and certain shareholders with a combined interest of 12.5% have agreed to support the merger. KSHB shareholders will own 49.9% of the combined company. GNLN is getting a better performing peer at 1.12x EV/E2021 revenues which is similar to its own valuation at 1.08x. The combined company will trade on Nasdaq (GNLN current listing), which has been a goal of KSHB for a while now. Overall, I expect shareholders of both companies to approve the merger.

Given strong strategic rationale, the merger is likely to close successfully. Similarly to LHSIF and BMWLF and DRVD transactions, the majority of the remaining spread probably exists due to the risky industry aura. In the last 2 years, the number of canceled mergers in this industry has been somewhat elevated due to the 2019 Cannabis oversupply crisis and COVID-19 outbreak in 2020. To compare – 48 out of 375 transactions were canceled in 2018, while in 2019 terminations skyrocketed to 95 out of 368. 2020 statistics are not available yet, however, the pandemic strongly impacted the whole M&A sector (not only cannabis). In our view, these numbers do not reflect the riskiness of the current transaction. Similarly to what was explained in the BMWLF write-up (large-cap buyer Cresco terminated 3 major deals in 2019/2020, but recently successfully closed BMWLF), an elevated amount of terminations happened due to legitimate reasons (very difficult market environment), which are not present in the current situation. As illustrated in the “Strategic rationale” section below, the whole cannabis industry is currently facing significant legalization tailwinds. The consolidation ramped up right after the Nov’20 elections and is expected to continue further on. So far, I’ve been able to find only one failed transaction since Nov’20 – TBI.CN (C$7m market cap) acquisition of Franchise Cannabis (private), while multiple transactions have already closed.

Downside to pre-announcement price should be very limited and there is even some potential to make money on the hedged trade even if the transaction gets canceled. GNLN price currently stands 23% above pre-announcement price (peaked at +52% the next day after the announcement) – the market has clearly viewed the merger very positively for the buyer. KSHB currently trades at +4% (peaked at +18%) relative to pre-announcement levels. Some of the price action was due to New York’s adult-use cannabis legalization on the same day the merger was announced. However, clearly, most of the gains were due to the merger itself as cannabis ETFs (YOLO, CNBS) have remained relatively stable since. Thus, if the transaction were to get canceled, it seems very likely that profit from the short side would outshine the losses of the long side of the trade.

Worth noting that the exchange ratio is subject to adjustments if Greenlane issues additional shares prior to closing the transaction, however, KSHB interest in the combined company will remain between 49.9% and 48.9%.

KushCo

The company markets and sells a variety of ancillary products and services to customers operating in the recreational cannabis and CBD industries. KSHB focuses on the B2B segment including retail customers and cannabis growers/processors. KushCo products include bottles, jars, bags, tubes, containers, various vaping equipment, etc. The company also offers labeling customization services for the industry.

Financial performance (FY ends in August):

Since Q1 FY20 (Nov’19) KSHB performance was impacted by several headwinds including general oversupply crisis in the whole Cannabis industry, illicit vape market crisis resulting in a temporal ban of vape products by several states in 2020 (due to numerous deaths and illnesses caused mostly by the black market products), and COVID-19 outbreak (shipping delays, higher freight costs, etc). Revenues were further impacted by the 2020 transformation plan aiming to focus on higher-margin customers and longer-term contracts as well as tightening the credit terms for smaller and less creditworthy customers. It seems that the transformation was somewhat successful as in Q4 FY20 adj. EBITDA turned positive for the first time in several years. Before the merger, KSHB was projecting $130-$160m revenues in FY21 vs. $113m in FY20. The guidance was raised in Q1 FY21 up from the initial $120-$150m. EBITDA guidance was $5-$7m.

The only other major shareholder aside from management is a $46bn hedge fund Adage Capital (owns 7.1% stake, which was increased from 5.2% in Feb’21).

Greenlane

Similar to KSHB, the company sells various cannabis accessories and liquid nicotine products. Aside from the B2B segment, the company has exposure to the B2C segment through its owned and operated e-commerce platforms including Vapor.com, higherstandards.com, etc.

Financial performance (FY ends in Dec):

At the end of 2019 GNLN performance was impacted by mostly the same headwinds as KSHB (Cannabis industry crisis, illicit vape market crisis, and COVID). The company is also in the process of transformation, however, it doesn’t seem very successful so far.

GNLN has 3 different common share classes (see below):

Before the transaction closes, GNLN will eliminate its voting shares – class C will be exchanged into class B at a 3 for 1 ratio.

Class B shares were issued pre-IPO, which the company did in April’19 at $17/share. The IPO timing was terrible as promptly after that the whole cannabis industry experienced a major crisis due to oversupply (GNLN shares fell to $3/share in Sept’19).

Valuation

The combined company is expected to generate $310-$330m revenues in 2021. KSHB stand-alone forecast used to be $130-$160m, which leaves around $175m for GNLN (stand-alone):

Thus, at current prices the offer values KSHB at 1.12x E2021 revenue, which is only slightly above GNLN 1.08x valuation. This seems quite attractive to GNLN as the takeover premium seems to be minuscule even though KSHB has superior adj. EBITDA performance and higher gross margins. This explains the significantly stronger price action of GNLN vs KSHB after the merger announcement.

Strategic rationale

As with multiple other recent mergers in the cannabis industry, this transaction is straightforwardly aimed to capitalize on the recent industry tailwinds, primarily, the continuing state-level legalizations and the increased chance of federal-level legalization later on this year. Both CEOs were clearly very excited and couldn’t keep from repeating these potential catalysts on the call. A few quotes from KSHB CEO:

And as I touched on earlier, the transaction comes at a pivotal time in our industry where multiple tailwinds are converging, from customers rapidly gaining scale to new states legalizing cannabis, and even the potential of full-blown federal legalization, which has never looked more likely to materialize than it does today.

[…]

there has been increasing momentum at the federal level for real and meaningful cannabis reform, including full federal legalization, which would undoubtedly open the floodgates for our industry.

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it’s important to emphasize that this transaction is being done in a catalyst-rich macro environment that is amplifying the strategic benefits of the merger

The combination and increased scale will allow the combined company to better capitalize on these tailwinds. The businesses are complementary with KSHB focusing more on the packaging segment and B2B sector and GNLN having exposure to B2C. Both firms also expect substantial cross-selling opportunities:

KushCo has traditionally been more of an enterprise play, dealing with businesses in the cannabis industry, whereas Greenlane has exposure directly to the consumers, buying CBD product from them, and even through e-commerce platforms like paper.com. So it just makes a lot of sense.

[…]

highly complementary businesses as well as the high-quality customer bases we each serve, there is potential for rapid organic growth through extensive cross-selling.

 

The merger is expected to result in $15-$20m cost synergies (current combined SG&A is $100m) within 2 years. The combined company is estimated to immediately start generating positive EBITDA. Gross margins are also expected to improve to 22%-24% levels.