Aurora Cannabis Inc, MedReleaf Corp Spread Remains Elevated As Shareholder Vote Approaches

Benjamin A. Smith
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As Aurora Cannabis Inc (TSX:ACB) (OTCQB:ACBFF) (FRA:21P) and MedReleaf Corp (TSE:LEAF) (OTCMKTS:MEDFF) (FRA:MEW) merger plans head towards the late innings (July 18 dual shareholder votes scheduled), spreads between acquirer and acquiree continue to flirt with double-digits. This gap may provide a relatively low-risk opportunity for investors of all types to capitalize—from hedged spread traders to long-only alike.

To briefly recap, Aurora Cannabis had previously agreed to purchase MedReleaf in an all stock deal worth $3.2 billion fully diluted. Holders of MedReleaf common shares would receive 3.575 common shares of Aurora for each MedReleaf common share held, based on the 20-day volume weighted average price on the Toronto Stock Exchange as of May 11, 2018. That represented a 34% premium to MedReleaf investors at the time of the deal.

In the early post-announcement days, the exchange price ratio between both companies actually widened significantly. Over the first six trading sessions thereafter, the gap between Aurora’s closing price x 3.575 and MedReleaf’s daily close price rose from ↑11.82% to↑19.83%—at which point we stopped keeping track. The spread ultimate crested somewhere in the low 20-percent range.

Whether the lofty gap stemmed from skepticism regarding the deal going through, or the inability for investors to procure Aurora Cannabis stock short in unclear. However, investors who fully hedged ACB short-LEAF long and/or purchased naked long positions with LEAF (hoping the built-in exchange ratio disparity would act to buffer losses in a downturn) were rewarded handsomely.

A similar—albeit less prolific—opportunity exists today. That opportunity, in my view, comes in two forms.

Unlike the large premium witnessed early on, the merger endgame is much more visibility now. With a week to go (July 18) before Aurora Cannabis and MedReleaf shareholder vote on the acquisition proposal, and there’s been zero sense of imminent danger. Not only is any chatter suggesting deal imperilment lacking, Aurora/MedReleaf recently received the Competition Bureau green light to move forward. Combined with the passage of Bill C-45, regulatory risk has been removed from the equation.

Secondly, cannabis sector volatility has been grinding precipitously lower in recent sessions—Canopy Growth’s late June hiccup aside.

In particular, Aurora Cannabis has entered the summer doldrums. Over the past nine sessions, closing prices have ranged between $8.96-9.41/share, with volume finishing well below its 50-day average over the past seven. It’s like investors and institutional traders all headed to cottage country at the same time.

The lack of volatility is important to long-only arb speculators because it allows people to purchase MedReleaf positions now (as of this writing, $29.76 share) and theoretically not lose money unless Aurora Cannabis dips below $8.33/share. The latter is a near 10-percent (↓9.77%) draw-down, equaling the current exchange ratio price disparity between Aurora Cannabis and MedReleaf. The $8.33 number is a moving target, as MedRelaf moves in tandem, thus pushing the break-even point ever lower.

Of course, the above scenario assumes shareholders of both companies approve the deal. Publicly, we know that 56% of MedReleaf’s issued and outstanding common shares have entered into irrevocable hard lock-ups to vote their shares in favor of the transaction. More recently, two leading independent proxy advisory firms have both recommended that MedReleaf shareholders vote FOR the previously announced arrangement. It’s hard to envision how the deal falls apart on the MedReleaf side—although anything is possible.

On the Aurora Cannabis side, it only takes a simple shareholder majority to approve the transaction. Theoretically, this is where the greatest risk of deal malfunction resides.

Aurora Cannabis Inc. CCO Cam Battley on MedReleaf, Aphria and earnings

However, with the stock up ↑15.69% on a closing basis since May 14 (deal announcement), there’s little reason why shareholders should be dissatisfied with the post-deal outcome. This is especially true when you consider Aurora has deeply our-performed direct competitors like Aphria Inc (↓0.99%), and has kept pace with arch-rival Canopy Growth (↑17.54%), during that stretch.

If Aurora Cannabis shareholders hate the deal, they sure aren’t voting with their wallets.

Final Thoughts

Although there’s little evidence of to suggest the ACB/LEAF deal will fall through, investors should exercise caution. Even though complimentary price action, lack of negative dissuasion and regulatory clearance has been observed, it doesn’t guarantee that (Aurora) shareholders don’t pull the pin come July 18th. As the famous literary poet Oscar Wilde once said: “To expect the unexpected shows a thoroughly modern intellect.”

That said, the near 10-percent exchange ratio spread sitting on the counter may be too tempting to pass up. Ideally, any position is best suited as a perfect hedged short/long entity between Aurora and MedReleaf; this hedges out risk entirely—assuming the deal goes through. But long-only investor can participate as well, should they believe the sector—and by extension Aurora Cannabis—won’t roll over in the next six days. At least not beyond ten percent.

Midas Letter will continue to cover events leading up to next Wednesday’s dual shareholder meetings.

Benjamin A. Smith

Benjamin A. Smith

Ben is a research analyst and capital markets professional with nearly 20 years of experience. His areas of expertise are broad-based, and include extensive knowledge of macro economics, stock/derivative trading, commodity complexes, cryptocurrencies and technical/quant analysis. He also maintains an particular affinity for U.S. politics and the macro-regulatory environment facing...
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Midas Letter is provided as a source of information only, and is in no way to be construed as investment advice. James West, the author and publisher of the Midas Letter, is not authorized to provide investor advice, and provides this information only to readers who are interested in knowing what he is investing in and how he reaches such decisions.

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