November 18, 2019—Cannabis Boom Goes Bust as Economic Reality Bites and Pot Stock Prices Plummet. Why are Cannabis Stocks Crowding the 52-Week Low List?
Apollo Tees Up the Largest Leveraged Buyout of the Year with $5.4 Billion Tech Data Acquisition. Why is it Trading at a Premium?
Canada’s Open Text Continues its Consolidation Strategy with Acquisition of Data-Protection Firm Carbonite. What’s the Strategic Rationale?
Apartment REIT Continuum Scraps IPO and Sells to Starlight Instead for $1.7 Billion. Why Did They Sell to Private Equity?
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Transcript
Welcome investors to the Absolute Return Podcast. Your source for stock market analysis, global macro musings and hedge fund investment strategies. Your hosts Julian Klymochko and Michael Kesslering aim to bring you the knowledge and analysis you need to become a more intelligent and wealthier investor. This episode is brought to you by accelerate financial technologies. Accelerate because performance matters. Find out more at www.Accelerateshares.Com.
Julian: Welcome investors and podcast listeners to episode 40 of the Absolute Return Podcast. I’m your host Julian Klymochko
Mike: And I’m Mike Kesslering.
Julian: Today is Friday, November 15th, 2019. I have a few key topics to talk about this week in some market events that we were paying attention to starting with cannabis stocks really getting crushed here.
The cannabis boom basically went bust as economic reality bites and pot stocks plummet. Why are they crowding the 52-week low list?
Apollo tees up the largest LBO of the year with the five-point $4 billion acquisition of tech data. Why is this deal trading at a premium?
Canada’s Open Text continues its consolidation strategy with their acquisition of data protection from Carbonite. What’s this strategic rationale behind this deal?
Lastly, apartment REITread Continuum, they scrapped their IPO and instead sold to Starlight, a private investment firm at a big premium for one point $7 billion. Why do they end up selling to private equity?
Cannabis shares are stuffing the new 52-week low list on the stock exchange. Third quarter operating performance, the major producers comes in far below expectations. Really, these producers are just reporting horrible results. For example, Canopy Growth came out with their quarterly results. Their revenue dropped 15% last quarter. Their competitor, Aurora Cannabis, their revenue dropped a shocking 24% and these are supposed to be growth companies right. Now both of these companies lost a combined 2 billion in market cap on Thursday as investors are really just throwing in the towel on this sector, just disgusted by this horrific fundamental performance from these companies. The market not developing at all like they expected or forecasted. The main issue basically there’s not enough legal retail stores in Ontario. Basically only 24 have opened, which is shockingly low. I believe I read a stat that said one store per 600,000 in population. So clearly, they just aren’t able to get supply to market and they’re having massive buildup in inventory at each one of these cannabis producers. So, stores, wholesalers are placing fewer purchase orders. There’s all this unsold inventory that’s steadily building up and comparing to a market like Alberta, Ontario at 24 stores. Alberta, I believe has about tenfold that for a fraction of the population. So, it’s really a local issue in Ontario, which is the bulk of the Canadian population and there’s really no stores there. So massive inventory buildup and sales just plummeting at all these companies. And we’re seeing some interesting operational and capital expenditure adjustments at these companies.
For example, Aurora, they announced that they’re differing for the foreseeable future, the completion of a 1.6 million square foot growing facility in Medicine Hat. They’re also halting construction work on a greenhouse in Denmark. So, a lot of these cannabis producers are battening down the hatches, preparing for a very, very tough market.
Another one, Green organic Dutchman. They announced that they’re delaying indefinitely the completion of a 1.3 million square foot greenhouse in Quebec, basically looking to conserve cash. A lot of them are actually running low on cash. The capital markets have completely closed for these as opposed to last year. When you saw a ton of financing too at massive valuations, a lot of these stocks have just been crushed. If we look at the 52-week low list, there’s Canopy, Aurora, Cronos, Green Organic Dutchman, Hexo, Tilray and on and on. And so many have just seen their share prices plummet much to the happiness of short sellers. I mean it’s a pretty heavily shorted sector, but that proves to have some challenges with it, doesn’t it?
Mike: Yeah, absolutely. And you know, just to go back to the sentiment, you know, really a lot of this sentiment, negative sentiment before some of these revenue declines and project delays. A lot of this is going back to the Canntrust situation where that’s really where the narrative turned very negative in cannabis. And so that’s been really interesting to follow. And just the after effects of something like that where, you know, even though, it’s really just involving one company, the sentiment across the industry, it was really just gotten down and kind of fell off a cliff. The other interesting aspect is that really like ultimately a lot of this is, you know, issues as you had mentioned with Ontario not having enough retail stores. So not really, it’s difficult to say whether this is strictly a demand issue or an issue with servicing that demand in with regards to not enough retail.
Julian: Much of it is also product quality. There’s a ton of returns where quality just isn’t there from these producers.
Mike: And producers not really knowing what exactly their end markets want. I believe it was, I think it might’ve been Canopy that where a bunch of their gel caps were returned back to them after not being sold at retail locations. And you know, some of that is just an industry being in its infancy is just trying to understand what actual consumers do want. But the other interesting aspect was some of the wholesaler and wholesalers in the inventory that they’re holding is because they’re not able to get this out to retail that they’re, and these provincial wholesalers holding about 52 weeks of inventory, which is just crazy. So, it really indicates that this isn’t going to be necessarily a short-term thing because ultimately you as a wholesaler, you can’t be holding that amount of inventory. So, you do have to eat through that, which is just going to progressively move forward.
Julian: Right. And you’ve got to think about how long does Canopy last on the shelf. Sorry, how long does cannabis last on the shelf before it goes bad. And so, there’s this massive buildup in inventory and I saw one estimate that to clear this inventory within a reasonable time, Ontario would have to start opening stores at 40 stores per month an exceptionally high rate starting January, which clearly is not going to happen. So, what are these producers supposed to do? And from an investor standpoint, I think it’s interesting to touch on valuation. Many investors are asking, have we hit a bottom here? Because some of these stocks have been absolutely crushed down 75-80% what are your thoughts on valuation here?
Mike: Yeah, the valuation is really interesting because a lot of these companies are really, we were discussing this the other day how they’re being valued as tech companies really where, you know, at that sort of price to revenue multiples and you know, say a tech company, a software company that has 80% gross margins and recurring revenue, you know, a very favorable business model as opposed to a commodity business model.
Julian: Right and we talk about growth because that’s why software companies, in addition to the high margins they are also valued based on their growth prospects, it’s hard to call these cannabis producers growth companies when their sales are dropping 24%. The other thing is, I don’t think I’ve seen one, maybe one with positive EBITDA, but the vast majority have massively negative margins as well. So, you’re getting the worst of it.
However, you look at valuations, most of these are still trading at five to 10 times revenue, which is really a software company multiple. You look at other commodity producers say an oil and gas, they tend to trade at one to two times revenue. So, under those basic valuation assumptions and just looking at negative margins, declining revenue, you take that all into account and be like, wow, there could be still 50, 60, 70% additional downside to the share prices here.
So, in my opinion, I think these are great shorts, if you’re long a great time to sell. However, with respect to short selling and why we are in fact not short any at this time, we were short previously, however borrow rates in order to short these, you need to borrow the stock in order to short sell them. Borrow rates are absolutely through the roof, prohibitively high, making it incredibly difficult to go short as a hedge fund or a short seller. For example, Tilray 55% is the rate you pay annually to short that stock. Hexo 39%, Aurora 59%, Aphria 35%, Canopy 17%. So, these are extremely pricey where some of them need to be cut in half just for you to justify the borrow rate and break even. So that makes it extremely difficult.
In addition, when borrower rates are so high, you are subject to the occasional short squeeze as well, which is not nice thing to go through, but we’re really not shorting any of these here, although I think there are great shorts outside from the notion of these incredibly high borrow rates, so it’s a real tough place to be if you’re looking to buy, my advice would be not to wait until perhaps there’s another 50-75% decline, but in my opinion is still some significant downside risk here.
Switching to LBO land, what happened here was private equity firm, Apollo Global Management, they announced the friendly acquisition of tech distributor Tech Data for $130 per share in cash representing a deal value of 5.4 billion and a premium of about 17%. The way that this deal went down is last month Reuters came out with a story, speculating on basically that this company was in play. They had received an offer at $130 per share, so a bunch of pre arbs got involved, pushed the deal price up.
However, in this situation they were successful because the deal ended up getting done to a premium of the stock’s most recent price prior to the deal going definitive. So, a nice win for a pre arbitrageurs on this one. What’s interesting about this deal specifically is it represents the largest leverage buyout of the year so far. It’s a $5.4 billion deal and Apollo is underwriting it with $3.2 billion equity check. So, they’re funding about 60% of the deal and equity. So not a ton of leverage on this deal. And if we compare that to their latest fund that will represent about an 18% position in that leveraged buyout fund of Apollo. So, a pretty concentrated portfolio. And this is really just a mid-cap value stock. You look at the valuation of the LBO, it’s at 6.8 times EBITDA. So real old school leverage buyout where they used to do them at reasonable multiples, IE sub eight times EBITDA. This one clocking in at 6.8 times. So, I believe that’s a pretty reasonable multiple in my opinion. What are your thoughts on this deal here?
Mike: Yeah, first one with regards to valuation, I mean 6.8 times EBITDA. Investors, you know, they likely aren’t, you know ecstatic about the valuation. You know, it’s really not that much of a bump since when the rumors first started leaking. But Apollo likely got this reduced price by offering, the 30 day go shop period. And so that, where we’re seeing it trade right now is that at a slight premium. So, it does seem like investors do believe that there will be a competing bid as their shareholder base does turn over.
Julian: Or at least they are pricing and optionality of that happening. So basically, the consideration is 130 bucks’ cash and it’s trading at $0.25 cents through that. So that basically if you just for the risk of the deal, which has maybe perhaps a dollar, so that call option would be $1.25 speculating on a perhaps an overbid here through the go shop process. However interesting you should bring up this go shop, as it relates to a small premium because I’ve read studies where they’ve analyzed deals with go shop provisions and they tend on average to have lower premia with respect to the control and takeover of the company. So, I think board of directors believe that they tend to be positive for shareholders, but they really allow, well at least empirical data shows that that allows the acquiror to buy the company at a lower premium. So ultimately, I think shareholders get short changed with the existence of this go shop process just because it’s really reflected in the net result for shareholders. I mean how often is a go shop actually successful? I believe its way below 5%.
Mike: Yeah. And just further to that, I mean in these types of situations, the companies or the bidders most likely to offer a go shop are typically private equity firms. And so those are those, these buyers are coming in and sophisticated buyers, they’re typically, you know, private equity firms are made up of former investment bankers for the most part. So, they’re very familiar with M&A transaction process. So, in this situation you’re getting something from a very intelligent buyer. You know, as you had mentioned, usually you’re not really getting full value for that Go shop.
Julian: More M&A news this week with software consolidator Open Text announcing the acquisition of Boston based data protection company Carbonite for $23 per share in cash representing a deal value of $1.4 billion and a pretty high premium of this one 78%, although Carbonite shares were really beaten down over the past year, down 38%. This was another deal where a media story broke the news or at least rumors, speculation that a potential deal was in the mix. I believe the stock was around $12 and change back in September when a speculation started brewing that Carbonite could be in play, it could be up for sale. At that day that the story broke it rallied about 20%, continued to rally over the next couple of months, up to about 18 and change and ultimately speculators being rewarded big time on this one because they got a deal at $23 per share. This spread has a positive return, 1.7% annualized, quite skinny, obviously reflective of the low risk. Obviously Open Text is a very credible acquiror. That really is their modus operandi here is to roll up the software space. They’re a serial acquiror, so this deal is pricing in a 99% chance of success. Touching on valuation, a reasonable valuation, roughly nine times EBITDA. So Open Text’s getting a pretty good deal here. Carbonite had been going through some problems, but some interesting history, we actually owned the stock in 2014 because it was subject to a hostile takeover bid from J com at $15 a share, which Carbonite ultimately rejected. And that deal ended up being dropped, that hostile offer being dropped by J com. So obviously a $23 friendly deal, significantly higher than the $15 proposed by another potential acquiror five years ago. What are your thoughts on this one here?
Mike: Yeah, so specific to open text. Now they’re a Waterloo based company that Canadian investors would be quite knowledgeable about. But they’ve had a really, as you had mentioned, a very successful roll-up strategy in the technology sector, really focusing on the SAS and enterprise SAS business lines. And so Open Text’s share price has compounded at over 20% annualized for the last 10 years. So, it’s been a very, very good returning stock.
But you know how they’ve done that with the roll up strategy. So, they have actually deployed almost $6 billion over 30 acquisitions over the last 10 years. So very acquisitive. And you know, with that 20% compounding in the share price, there are free cash flow per share has actually compounded at a slightly lower rate at around 17% compounded. But you know, this is this, they’ve really unlocked a lot of value for shareholders over the last decade. But you know, going specifically to this transaction is as you had mentioned that Carbonite, they acquired them for nine times. Open text is trading at 12 times EBITDA. So, it is accretive right off the bat. And this is just kind of a classic deal within their, within their wheelhouse, although a bit larger than their typical deal.
Julian: Yeah. Acquiring a company at nine times EBITDA when financing costs are near rock bottom makes sense here for sure. And it’s interesting Open Text following an acquisition strategy of Constellation. However, Constellation software typically focuses on smaller private companies. Open Text is not afraid to go for the public ones. They do a number of public acquisitions here. So, in our opinion, fairly low risk deal, 1.7% annualized spread for arbs on this one. So relatively safe return on Carbonite arbitrage spread if you’re into that sort of thing.
So those last two deals were at relatively low valuations, but we’re going to look at a deal that had an incredibly and shockingly high valuation and this is to do with a REIT. So, despite heavy investor demand, apartment REIT Continuum, they decided to scrap their IPO, which was in the midst of being priced and almost done. And they were approached at the last minute to sell to private investment firm Starlight for 1.7 billion. It was basically a deal that was too good not to take. So, they took it.
As some background on Continuum, they own 44 apartment buildings, a majority of which are in Toronto and Mississauga. So, they were planning on going public on the TSX at between 1550 and 1650 per unit. This was the marketing range, I believe they’re going to offer about $300 to $400 million of stock. They had demand of about a billion. So clearly this was going to price at the top of the range. But Starlight came in with an offer of $20 and 10 cents, which represented a premium to that range of 22% to 30%, which is a sizable, what you have here is a private buyer paying a substantial premium to what public market investors were willing to pay. And if you look at the valuation, not only was that premium surprising, but the buyer here paid a shockingly low 3.5% capitalization rate, which is basically the lowest cap rate I’ve ever seen in Canadian read space. And capitalization rate and valuation are, you know inverses of each other. So as cap rate goes lower, valuation goes higher.
So, this is representing really just a record high valuation for Canadian real estate assets.
A quote here from the CEO of the read on why they instead decided to sell to a private equity buyer as opposed to going public. He said they gave us an offer that was so superior that we had to say yes.
So, some strategic rationale of the buyer. Basically, more rental buildings are now being constructed in Ontario, specifically Toronto. There’s been crazy population growth. It’s outstripping new supply and has been for a while, Continuum had a 97% occupancy rate. So very good cash flows there. And because of this tight supply, apartment building owners have seen rent jump as high as 25% when a tenant turns over and you’ve had a wicked bull market in Toronto housing for the past decade. So that’s really having knock on effects into the, into the rental market as well. What are your thoughts on this crazy price that Starlight ended up paying here and then Continuum deciding pretty much at the 11th hour deciding to scrap their IPO?
Mike: Yeah, for sure. And just going back to your point on the cap rate really can just be thought of as earnings yield on in terms of valuation. You had mentioned the 3.5% cap rate that this deal values them at. To put that into perspective, their public market comparable are kind of in the 4% range. So that is you know, quite a substantial premium and typical, you don’t see premiums like that on a rate that’s so concentrated, that’s so focused on one geographical area. As well as, you know, even if it is focused on one type of real estate properties that’s one thing, never mind just focused literally on the GTA. In terms of Continuum’s main investors, they’ve obviously done quite well on this. Those were CI investments and 1832 asset management. So, this is obviously a win for them. Although they weren’t likely seeing a liquidity scenario got by going public, you know, this is just at a very nice premium for them. And then you know, other stakeholders in this transaction there was the investment banks that were, the lead investment banks that were set to make money on the IPO issuance. Well instead of that, they just, you know, exchange those fees for advising on this transaction. So, it’s kind of, the investment banks are somewhat indifferent to what happened in this scenario.
Julian: Right. Unfortunately, the merger arbs are missing out on this acquisition here because it’s not public at this point. And so, you can’t go in and buy the shares and earn that spread unfortunately.
One thing I wanted to touch on is the notion that a private buyer coming through and paying a significantly higher price than what the public investor is willing to pay. Now, in my opinion this really just reflects the current state of private equity where they’ve raised so much money. There’s been such an insatiable demand for private market assets that there’s now 2.5 trillion of dry powder in private equity.
Now that’s 2.5 trillion of future forced buying because these private investment firms, private equity, they can’t earn their fees until they put that money to work.
So, they’re really putting pedal to the metal, just trying to get this money to work as fast as they can. And the way they’re doing that is by paying premium valuations.
Historically, how private equity investors have earned above market returns is by buying assets at a discount. I have a chart here that shows historical EBITDA multiples of leverage buyouts or private equity firms versus the Russell 2000 index. And historically that has actually been a two-turn discount, IE if the Russell 2000 was at 10 times EBITDA, private equity was making acquisitions at eight times.
However, something unprecedented has happened with this massive flood of capital is that, that historical relationship has actually flipped flop such that private equity is now paying premium valuations to public assets. Now that discount that they used to pay, it would manifest itself into higher returns known as the illiquidity premium.
But now that private market assets are trading at a premium to public market assets, that illiquidity premium has actually turned into a discount. And in my opinion, that means that private market investors are actually going to see lower returns than public market investors just based on the relative valuations which have flip flopped. And now you’re seeing private market valuations to be well in excess over two turns higher than public market valuation multiples, which is really just crazy. And a reflection of this ravenous demand for private asset investments by institutional investors, in my opinion, partially driven by the fact that their mark-to-model. So, you don’t have to live with that mark-to-market volatility. They get to mark these assets to model whatever they want. And so that relieves a lot of stress from allocators where they don’t freak out over some big mark-to-market drawdown.
Mike: And ultimately, it’s marked to model until there is a liquidity event because ultimately these funds do have a limited life. So, you know that 10-year range, ultimately, they have to end up selling it or do an IPO as we had mentioned last episode. So eventually you know what matters is cash on cash returns, but just because of the nature of these fund structures is you’re having a ton of asset inflow into the industry. You know, by the time returns start going lower that will be years into the future. So, this isn’t a dynamic that is going to turn around and flip on its head very quickly. This will evolve over the next number of years.
Julian: Yeah, you’re right about that. So, our analysis today, it won’t be reflected for another 7 to 10 years in terms of the results. So, it’ll take a long time to play out. But if you’re playing in the private asset sector that it’s just something to keep in mind, the massive valuations and I think as a public market guy that you should be, you know, excited to see a higher return.
We’re seeing a ton of cheap stocks and four to five times EBITDA range that can, you can get for a fraction of these private asset multiple. So that’s something, a really interesting dynamic to keep an eye on here.
And that wraps it up Ladies and gents for episode 40 of the Absolute Return Podcast. If you liked it, you can always check out more www.absolutereturnpodcast.com. If you liked it or loved it, please tell your friends, colleagues, family members scream off the top of your building whatever it takes. Until next week, wish you luck in investing and we will chat with you soon.
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