Debt for Equity Swaps Can Create an Opportunity for Cannabis Investors

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Friends,

In early May, we highlighted how Aphria had been proactive in addressing a balance sheet issue by buying back some of its convertible debt at a big discount, issuing shares to the debt holders. We suggested that Aphria’s actions could serve as a model for Canadian and American operators that took on too much debt. Earlier this month, Supreme Cannabis was able to restructure its C$100 million convertible debt, and VIVO Cannabis did so as well last week on a smaller amount.

Whether it’s through convertible debt that is underwater or straight debt, many companies are burdened by too much debt, and the stock prices reflect the risk of the company going into bankruptcy. We have already seen several bankruptcies in both Canada and the United States among publicly traded companies, and there have been some restructurings, like the one iAnthus shareholders just approved, that fall short of bankruptcy but are effectively the same thing, as equity holders are pretty much wiped out.

We think investors should be paying close attention to these transactions, as a debt-for-equity swap has the potential to create gains for equity investors. First, if the restructuring of the balance sheet leaves the company with plenty of runway, equity investors will be more confident given the lower probability of bankruptcy. Second, and perhaps more important, the actual process can have a very negative short-term impact. Recall the awkward transaction done by Aurora Cannabis in November, which crushed its stock. More recently, many of the shares issued by Supreme apparently hit the market, pushing the stock to a new multi-year low. The Canadian chart below illustrates the high volume (9.0 million shares), and there were also 9.5 million shares traded in the U.S):

The negative headline of dilution due to the shares being issued and the technical impact of some or all of those shares hitting the market happen ahead of the financial statements that reflect the better balance sheet due to the elimination of debt. In the case of Supreme, the company issued 116.6 million shares (50% free-trading, 50% locked up for 4 months), which boosted the share count by 30%. Investors won’t see the substantial debt reduction on the balance sheet until the company reports in November, but the tangible equity will go up by about 50%. By our calculations, the stock is trading at about 40% of the adjusted tangible book value.

It will be interesting to see if the short-term pain inflicted on the stock of Supreme Cannabis by the transaction will yield upside to investors. In general, with the risk of bankruptcy reduced, investors should be more inclined to invest if this is what was weighing down the stock. While Aphria’s transaction was smaller relative to the entire capital structure and the company wasn’t in as precarious of a position as Supreme appeared to be, we note that it has performed far better than its peers since it announced its transaction on May 8th. There are many factors at play most likely, but we believe that the balance sheet improvement was certainly one:

Many other cannabis companies are struggling with near-term debt maturities, and we continue to expect debt for equity swaps to help address the challenges for some of them. Investors may be able to take advantage of stocks that have been overly discounted for worst-case scenarios and that then suffer in the short-term from selling of the shares issued to debt holders.


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Sincerely,

Alan & Joel

Exclusive article by Alan Brochstein, CFA
Alan Brochstein, CFA
Based in Houston, Alan leverages his experience as founder of online communities 420 Investor, the first and still largest due diligence platform focused on the publicly-traded stocks in the cannabis industry. With his extensive network in the cannabis community, Alan continues to find new ways to connect the industry and facilitate its sustainable growth. At New Cannabis Ventures, he is responsible for content development and strategic alliances. Before shifting his focus to the cannabis industry in early 2013, Alan, who began his career on Wall Street in 1986, worked as an independent research analyst following over two decades in research and portfolio management. A prolific writer, with over 650 articles published since 2007 at Seeking Alpha, where he has 70,000 followers, Alan is a frequent speaker at industry conferences and a frequent source to the media, including the NY Times, the Wall Street Journal, Fox Business, and Bloomberg TV. Contact Alan: Twitter | Facebook | LinkedIn | Email

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