Description

Elevator pitch: Event-driven special sit arb opportunity not likely to last long.  Buy a best-in-class cannabis MSO at a ~15% discount to its current trading price via the stock of a soon-to-be acquired publicly traded competitor.  The target is being purchased at an extremely attractive price and investors enjoy the additional free option of a competing or higher bid for the target.

I wrote up AYR strategies a year and a half ago.  In the intervening time, management has executed well, adapted quickly to a post-Covid operating environment, and followed through on their promise of consummating a series of accretive M&A transactions, which have catapulted them into the top tier of US MSOs with enviable positions in some of the most attractive states.

The stock has had a nice run but is still undervalued relative to peers.  This discount to peers has persisted, but the valuation gap has become even harder to justify now that AYR is a truly diversified MSO with a stronghold in seven different states (they had a presence in only Nevada and Massachusetts at the time of my last writeup).  I will discuss valuation and the evolving competitive landscape momentarily.

This writeup is meant to serve as both an update to the Ayr investment, but more important, to call investors’ attention to a new opportunity to invest in this rapidly growing MSO at a ~15% discount to its current stock price by buying the shares of a soon-to-be acquired competitor being bought by Ayr in an all-stock deal.  In addition, there is a reasonable change that a competing bid for the competitor emerges or that AYR is forced to increase their price in order to secure shareholder approval of the deal.  A group of activists has publicly opposed the deal on the grounds that it significantly undervalues the company.

In a nutshell, the thesis is:

- Ayr is still cheap

- Ayr is getting LHS at an extremely attractive price due to an abundance of low-hanging fruit

- You can buy Ayr at a healthy discount by buying LHS

- While you wait for the deal to close, there is a resonable chance of a higher bid for LHS's shares

- The regulatory environment for the cannabis sector just got a lot better

The arb spread itself is arguably attractive as there is minimal deal risk, although I am long LHS outright as I am a long-term believer in AYR.

The Transaction –

On 12/22/20, Ayr announced an agreement to acquire 100% of the shares of Liberty Health Sciences.  Like AYR, LHS trades on the Canadian securities exchange, but Liberty’s business consists of a collection of dispensaries and cultivation and production assets in the state of Florida.

The terms of the transaction are as follows:

- Total value of consideration: $290m based on AYR’s closing price on 12/21/20.

- 0.03683 shares of AYR for every share of LHS, subject to a collar.

The Democratic victory in the Georgia run-off election is a boon to the cannabis sector, which is now likely to see some form of federal legalization.  As a result, the consideration has reached (and is likely to stay at) the upper end of the collar.

Why this transaction is critical for Ayr –

Florida is one of the US’s most important cannabis markets, and although recreational use is currently illegal in Florida, it is an excellent medical market with over 450,000 patients and the legalization of recreational use is simply a matter of time.

Liberty’s assets include a 387-acre cultivation and production campus in Gainesville with 300,000 sqft of cultivation and production already in operation.  One of the largest retailers in the state, Liberty has 28 dispensaries currently open, with another 14 slated to open in 2021.

AYR’s investor call to discuss the deals (they announced a smaller deal to acquire assets in NJ at the same time) is clearly indicative of how important this asset is to AYR, as well as how cheaply mgmt feels they have been able to buy it.  See these comments from Ayr’s CEO on the call:

AYR CEO Jonathan Sandelman: We have been trying to make a deal with Liberty for 18 months.  We thought it crucial to get this deal done today because Florida is a land grab.  Most municipalities are not going to allow 20 cannabis companies into their town.  They’ve already started limiting the number of brands they want.  So it was crucial to find a platform that could produce 42 retail stores through 2021 to make sure you’re locked in because if you’re not there today (and ours are already sited), you’re probably going to get locked out in the future.  So the land grab was significant.  That’s a big part of the motivation for moving now.

AYR’s additional disclosures on the call regarding Liberty’s performance metrics revealed a massively underperforming asset with a terrific footprint and a cultivation building already finished that simply needs some tweaking.

For example, Liberty’s current cultivation yield is an abysmal 20 grams/sqft, while AYR’s average is 70 grams/sqft.  Liberty’s yield is so low that their retail dispensaries literally only have flower to sell four days / week.  Of course, everything they manage to make sells out and they never have any inventory on hand.  On top of this, Liberty inexplicably sells no edibles or concentrates of any kind.  Here’s AYR’s CEO again on the call:

AYR CEO Jonathan Sandelman: Our plan for yield improvement was very important to the Liberty board.  Their current yield is so bad that it creates a real problem on the retail side because they only have flower four days/week.  They have stores ready to open now that they are not opening because that would mean they only have flower two days/week.  So we see a real value proposition here, where if we just do what we already do everyday there is tremendous upside.  We expect there will be 42 stores open by the end of the year, making us the number 2 player in the entire state.

Liberty’s revenues/dispensary are currently less than half of the state’s average (Liberty at $2m/store vs top performers in the state that range from $4-10m/store).  Ayr is consistently a top performer in their other markets (NV and MA), and they are confident FL will be no exception.  AYR’s CEO also revealed on the call that Liberty had just hired a new head cultivator who happens to be a close friend of one of Ayr’s head cultivators, who could vouch for the Liberty hire.  Yet, this new hire has been at Liberty for only one month.

AYR CEO Jonathan Sandelman: No one grows only 20 grams/sqft.  That’s juts not a number that is seen in this industry.  If we can just get this to what we already do elsewhere (70 grams), or even 50 grams, this investment looks extremely inexpensive.  Here we are talking about stores that don’t have flower three days/week and offer no edible or concentrates of any kind.  Think about this.  They have north of 25% crop failures in testing.  We have less than 5%.  If we just take it from 25% failure to our current average there is tremendous upside.

Transaction guidance –

AYR believes they are purchasing these assets at 4.8x 2022 EBITDA.  Embedded in that guidance are the following reasonable assumptions:

- add one store per month from now until 2022.

- similar increase in throughput from 20 grams/sqft to 70 grams/sqft over time, which is more than enough to feed those stores.

- achieve only $4m revenues/dispensary in FL even though that is well below what Ayr does elsewhere ($10m in MA and more than double that in NV).

Possibility of a higher bid for Liberty –

Ayr has announced that 29% of Liberty shareholders have agreed to vote in favor of the deal.  However, a group of shareholders claiming to control tens of millions of shares of LHS (led by investor James Baker - https://seekingalpha.com/article/4396686-liberty-health-sciences-shareholders-want-higher-price) opposes the deal on the grounds that the price is insufficiently low.  He pins reasonable value at ~$3/share (nearly triple the implied Ayr offer). 

I wouldn’t go so far as to call a higher bid “likely,” as this was a competitive process with multiple bidders.  What’s more, Baker’s activist group is disorganized, full of retail investors, and likely not of sufficient size to mount a serious campaign.  Nevertheless, there is some optionality here and the worst case scenario is that you end up owning more Ayr at a discount.  In the event that a competing offer does emerge, Sandelman's enthusiasm on the call suggests he would be willing to considerably increase his offer should the need arise.  His excitment on the call about the deal Ayr is getting is palpable.

The Pro Forma AYR –

AYR’s acquisition of LHS, along with a flurry of other deals announced during the latter half of this year, create a best-in-class seven state MSO which mgmt expects to produce industry leading EBITDA margins.  Four of these seven states will have adult-use programs in 2021.

Pro forma for all the recently announced M&A, Ayr has 60.5m shares outstanding and $224m of net debt for an enterprise value of ~$1.9B at the current share price.  Mgmt is guiding to pro forma EBITDA of $325m in 2022, putting Ayr at a multiple of 6x EBITDA, well below that of peers despite the fact that Ayr is now the US’s 4^th largest MSO.

Happy to address questions in the Q&A but wanted to get this out ASAP as the arb spread is not likely to last long.  In summary, buy LHS to get one of the US's highest-quality MSOs at a 15% discount to its current price, with additional optionality around an increase in the offer.

Catalyst

- deal closure, collapsing the discount

- increased offer from Ayr or a competing bidder