A Marijuana Mega-Merger Between Aurora Cannabis and MedReleaf Would Be a Bad Idea

Big changes are expected to sweep across the marijuana landscape over the next two months.

In late June, the U.S. Food and Drug Administration (FDA) is expected to announce its decision on whether or not to approve GW Pharmaceuticals' cannabinoid-based drug Epidiolex as a treatment for two rare types of childhood-onset epilepsy. If approved, it would mark the first time the FDA has given the green light to a therapy derived from the cannabis plant, and it might be the impetus that leads to the rescheduling of cannabidiol, the non-psychoactive component of the cannabis plant that happens to be the basis of GW Pharmaceuticals' lead drug.

On an even broader scale, Canada appears to be on the verge of legalizing recreational cannabis and, in the process, becoming the first developed country in the world to have done so. With its ducks neatly in a row, the Cannabis Act looks set for approval in the Senate on June 7, with legalization to follow shortly thereafter. Legal adult-use weed should lead to $5 billion, or more, in added annual revenue for Canada's marijuana growers.

Is a cannabis megamerger on the horizon?

The expectation of the Cannabis Act being signed into law has set off a veritable capacity expansion frenzy in Canada, which has been constrained only by the amount of capital found on the balance sheets of pot growers. As recently as six months ago, just three Canadian pot stocks were expected to top 100,000 kilograms of annual growing capacity. However, as of May 5, there are seven that are expected to deliver at least 108,000 kilograms of dried cannabis a year. And with the way partnerships and acquisitions have been made lately, this figure could continue to climb.

Last week, Wall Street learned that there might be the potential for a megamerger on the horizon. In a statement released last Thursday, Ontario-based MedReleaf (NASDAQOTH: MEDFF) noted that it's been in discussions about a tie-up with Aurora Cannabis (NASDAQOTH: ACBFF), among other companies. As is customary of these press releases, both companies refused to comment on the nature of the discussion beyond admitting that a tie-up has been loosely discussed, and both cautioned that nothing could come of their talks.

What would the combined company look like?

If they did merge, here's what the combined company could bring to the table.

Recently, MedReleaf announced that it was acquiring 164 acres of land in Ontario for a little less than $21 million (26 million Canadian dollars). The purpose of this acquisition was to, at minimum, quadruple its annual production to 140,000 kilograms a year. On 69 acres of its purchase sits the 1-million-square-foot Exeter facility that MedReleaf plans to retrofit to grow cannabis. Buying an existing facility and retrofitting it for marijuana production is significantly more time- and cost-effective than building a new greenhouse from the ground up. Plus, with 95 acres of adjacent land, roughly 1.5 million square feet of cultivation space could be built in the future.

Beyond Exeter, MedReleaf has its 210,000-square-foot Bradford facility and what had once been its flagship grow site, its Markham facility. These two sites combine for about 35,000 kilograms of production a year.

As for Aurora Cannabis, it's expected to deliver more than 430,000 kilograms of dried cannabis at full capacity. It has its organic Aurora Sky project, spanning 800,000 square feet and expected to yield 100,000 kilograms a year, as well as the Aurora Nordic site, where it maintain a 51% interest in the 1 million-square-foot facility capable of 120,000 kilograms of production per year. Add in the production acquired from its pricy acquisition of CanniMed Therapeutics, as well as its recently announced 71-acre purchase in Medicine Hat, Alberta, that'll house the Aurora Sun facility (a 1.2-million-square-foot facility capable of 150,000 kilograms a year), and you have a recipe for more than 430,000 kilograms of production a year.

Combined, based on currently announced projects, this duo could likely generate over 570,000 kilograms of weed per year. Assuming Aurora takes advantage of MedReleaf's adjacent acreage to Exeter, topping 700,000 kilograms of production a year by as early as 2022 would potentially be doable.

Combining these two companies wouldn't be a good idea

However, bigger isn't always the answer, and I personally believe Aurora Cannabis would be biting off way more than it can chew if it pursues MedReleaf.

Don't get me wrong -- I understand why Aurora would consider such a move. Cannabis growers with clear production advantages are the likeliest to secure long-term domestic and export supply deals, as well as have an opportunity to forge an emotional connection with consumers. Plus, MedReleaf's focus on oils and extracts would ultimately be a margin-booster for Aurora Cannabis.

The problem with a prospective deal is twofold. First, MedReleaf is already sporting a market cap of $1.83 billion, as of its closing value last week. When Aurora got into a bitter battle with CanniMed's board of directors, it took a 181% premium to convince CanniMed's shareholders and board to tender their shares in favor of the deal. While a 181% premium shouldn't be expected for MedReleaf, there's the belief on my part that it would still require a purchase price that's north of $2 billion. That's not chump change considering that Aurora Cannabis still isn't profitable.

The greater concern here is that it would almost certainly decimate shareholder value via dilution. When Aurora acquired the bulk of CanniMed's outstanding shares (95.9%) prior to the closing of its merger, it did so with about $104 million in cash, and by issuing 69.3 million shares of stock. These 69.3 million shares weren't factored into its outstanding share count as of the end of its most recent quarter.

However, Aurora Cannabis' share count has ballooned by more than 2,900% to almost 490 million shares as of its February-reported quarter since the end of fiscal 2014. Numerous bought-deal offerings that have seen the company sell its common stock, convertible debentures, stock options, and/or warrants have rapidly inflated its outstanding share count. In doing so, it dilutes the value of each existing share held by investors, and it makes turning a meaningful per-share profit all the tougher.

Even with $333 million in cash on hand as of the end of its most recent quarter, Aurora would probably be forced to fund the bulk of its purchase with common stock. The company would have to issue more than 211 million shares of its Canadian-issued stock just to raise $1.7 billion. And mind you, this assumes that MedReleaf is happy to take just a 10% premium over its current market cap. If the asking price is higher, Aurora could destroy shareholders with its rampant bought-deal offerings.

Long story short, I don't see this deal coming to fruition. But, should Aurora Cannabis and MedReleaf prove me wrong, I'd strongly suggest investors keep their distance.

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Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.