This Marijuana Stock Acquisition Would Make a Lot of Sense -- and Dollars, Too

Consolidation isn't coming in the Canadian cannabis industry -- it's already here.

The big story right now relates to the potential acquisition of MedReleaf (NASDAQOTH: MEDFF) by Aurora Cannabis (NASDAQOTH: ACBFF). There's no guarantee that a deal will be made, but the two companies announced that they were engaged in discussions.

Aurora is currently the second-largest Canadian marijuana grower by market cap, while MedReleaf fluctuates between being ranked No. 3 and No. 4. An acquisition of MedReleaf would enable Aurora to leapfrog over Canopy Growth (NASDAQOTH: TWMJF) to become the top marijuana stock on the market.

Should Aurora actually buy MedReleaf, there could be considerable pressure on Canopy to make an acquisition of its own. One obvious target to buy would be Aphria (NASDAQOTH: APHQF), which has roughly the same market cap as MedReleaf. But would this acquisition make sense for Canopy Growth? I think it could.

A lot to like about Aphria

Acquisition or not, there's a lot to like about Aphria. The company reported all-time high revenue in its fiscal third-quarter results announced last month. Aphria also posted its 10th consecutive quarter of positive adjusted EBITDA, an achievement that no other major Canadian marijuana grower can claim.

My colleague Sean Williams has referred to Aphria as "chronically undervalued" compared to its peers. I don't think that Sean is too far off. While my back-of-the-envelope calculations show that Canopy Growth is the best bang for the buck in terms of projected production capacity, Aphria comes in a strong second place.

One reason why Aphria's production capacity is substantial is that the company has engaged in its own fair share of deal-making. Aphria completed an acquisition of Broken Coast Cannabis in February. It followed that deal up by completing the purchase of Nuuvera in March.

The Nuuvera acquisition positioned Aphria especially well in international markets. The company now has a presence in 10 countries other than Canada. Germany ranks as the most important of these markets right now. Aphria's buyout of Nuuvera gave it a supply agreement with the second-largest pharmaceutical distributor serving the rapidly expanding German medical marijuana market.

Why strike a deal?

Canopy Growth certainly doesn't have to make any further acquisitions. The company should have plenty of capacity to enjoy strong sales growth in the domestic and international medical marijuana markets as well as the anticipated Canadian recreational marijuana market. However, there are some reasons for Canopy to consider a buyout of Aphria.

One is that acquiring Aphria could enable Canopy Growth to open up a lead over Aurora Cannabis in the German market. In addition, bringing Aphria (and especially its Nuuvera operations) into the fold would strengthen Canopy in other international markets.

And while Canopy's executives have been clear about their strategy of staying away from the U.S. as long as federal laws prohibit the sale of marijuana, Aphria has a foothold in the U.S. through its Liberty Health Sciences investment that could be attractive. That's especially the case in light of a recent agreement between U.S. Sen. Cory Gardner (R-Colo.) and President Trump, where the president committed to supporting legislation that would permanently keep the federal government from interfering with state marijuana laws.

Most important, though, is that Aphria would give Canopy Growth higher capacity and greater economies of scale. There are legitimate concerns that supply will outstrip demand in the Canadian market even after the country legalizes recreational marijuana. However, the international opportunities appear to be large enough that additional capacity will be needed in the coming years. As long as demand is greater than supply, capacity will be king.

Marijuana is an agricultural commodity. Over the long run, achieving low costs of production and distribution will be critical for success. The larger a business is, the more likely it will be able to reduce these costs. If Aurora buys MedReleaf, the combined entity could eventually enjoy lower production and distribution costs than Canopy does, putting Canopy at a competitive disadvantage. Buying Aphria should prevent that from happening.

Odds and ends

So what are the odds that a deal between Canopy and Aphria actually happens? My guess is maybe 50-50 at best. If Aurora buys MedReleaf, though, I suspect the probability of Canopy buying Aphria will increase.

MedReleaf seems motivated to sell. Aphria, on the other hand, has given no indication that it is interested in being acquired. Of course, the right price could change the dynamics quickly.

But while the odds right now are probably against a Canopy-Aphria combination, I wouldn't rule out such a deal. My view is that there will be considerably more consolidation among marijuana growers. This consolidation makes sense -- and, in the end, it will make more dollars, too.

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Keith Speights 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.