Last week, Curaleaf acquired Cura Partners for CAD$1.3 billion, breaking the record (once again) for the largest consolidation deal in the US. On paper, this represents on elf the best deals we have seen this year and results (immediately) in the creation of the largest MSO operating in the US.
Curaleaf is the leading vertically integrated multi-state cannabis operator in the United States. It is a high-growth cannabis company with a national brand known for quality, trust, and reliability. The company is positioned in highly populated, limited license states, and currently operates in 12 states with 44 dispensaries, 13 cultivation sites, and 11 processing sites.
Curaleaf has the executive expertise and research and development capabilities to provide leading service, selection, and accessibility across the medical and adult-use markets, as well as the CBD category through its Curaleaf Hemp brand.
The company is led by one of the strongest management team in the industry, with significant retails and `FMCG experience. They have exceptionally strong coverage of the East Coast of the US, with Florida being their strongest state, followed by Arizona and New York. They have also recently undertaken an aggressive expansion strategy to tackle the West Coast of the US, and their announcement last week to acquire Cura Partners (no relation) who have the industry-leading SELECT brand, now fully establishes them on the West Coast.
Their medical business currently operates under the Curaleaf brand with Curaleaf branded products. Currently boasting over 150,000 patients, they have a strong presence in the states of New York and New Jersey and hence will be very well positioned when these states fo legalise for recreational use. The reason being is these states operate under the limited licenses infrastructure creating a significant barrier to entry and first mover advantage for the company.
The company is vertically-integrated with 13 cultivation sites over 9 states, with current cultivation capacity of 63,000 kilograms per annum. They project to have over 1 million square foot of cultivation space by 2020, which would lift their production capacity to north of 130,000 kilograms of dry flower per annum. Their current 11 processing facilities are capable of producing over 50,000 grams of extracted cannabis oil per week. These cultivation and processing facilities are the keys to creating significant synergies in the Select deal.
In addition to their medicinal Curaleaf and recreational UKU brands, the company also has Curaleaf CBD Hemp. The company made global headlines when they announced that they had signed an agreement with CVS to stock their hemp product range in over 800 CVS stories. On the announcement, the stock price increased by over 30%. We see their hemp product and associated CVS agreement as being a key factor in achieving their FY19 revenue guidance (more on that below).
Cura Partners ("Select" to avoid confusion)
Select is widely respected in the industry for the methodology and innovation of its extraction techniques and its focus on setting standards for quality products across the industry. Select has pioneered a highly refined system that fulfills scalability and quality need unique to a company of this size, with an ability to produce one million grams of oil per month at each of its facilities.
The company is known for its Select Oil and Select CBD brands and offers a variety of white label products with emerging regionally-based and celebrity brands.
Select is the #1 brand on the West Coast. Currently operating in 5 states, they have the #1 oil brand in California, Oregon and Nevada, and the #2 oil brand in Arizona. The Portland-based company generated $117m in revenues in 2018 (up from $36.9 million a year earlier), but at a very low margin of only 10%. One of the primary reasons for this is that they do not cultivate their own cannabis but rather buy wholesale, in the market, and then process from there. Select purchased just under 100,000 kilograms of cannabis trim in California this year to create its Select products.
Given they are purchasing at wholesale prices and then distributing wholesale to the retail market, puts significant pressure on their margins. The most recognisable brand on the West Coast specialises in cannabis oils, vape cartridges, and edibles.
Select also has a cannabis purchase agreement with Cronos, agreeing to purchase 20,000 kg/year of cannabis from Cronos for five years back in August 2018. On the announcement of the transaction, Select's CEO and founder, Cameron Forni, stated, "Cura's partnership with Cronos marks a significant step in our mission to be the leading provider of cannabis oil to legal U.S. and international markets."
Interestingly, this deal was not mentioned in the Acquisition presentation, or on the Management call to walk through the deal. We are unsure as to how this will be handled moving forward, but given the size of the contract is not immaterial, one would assume some comment on this in the near term.
Curaleaf will acquire all outstanding equity securities of Select through the issuance of approximately 95.6 million subordinated voting shares (subject to certain adjustments), which based on Curaleaf's closing price of C$13.30 on April 30, 2019, the last trading day prior to announcement of the transaction, represents a total purchase price of CAD$1.27 billion or US$948.8 million.
Post-transaction, Select will have approximately 16% pro forma ownership of Curaleaf on a fully-diluted basis. Essentially, Curaleaf has made a big bet on the oils market – a very smart move in our opinion.
The transaction is defined as a related-party transaction as the current Executive-Chairman of Curaleaf, Boris Jordan, is also the Chief Investment officer of Measure 8, a Venture Capital business that took an 11.5% stake in Select. With a $120 million of funds under management, the sale would return almost $146 million to Measure 8, generating well over 100% return on assets -a pretty good outcome in anyone's books. Jordan excused himself from the transaction, and it was fairly valued by an outside firm.
The all-stock transaction structure will enable Curaleaf to preserve financial flexibility to pursue additional M&A and other strategic opportunities.
Additionally, Select equity holders will be eligible to receive an earn-out of up to US$200 million from the issuance of additional subordinated voting shares, contingent upon Curaleaf exceeding certain 2020 revenue targets for its combined wholesale extracts business and Select-branded retail extract sales.
As far as deals go, this is one of the smartest we have seen in the industry to date. Essentially the synergies could be grouped into 3 key areas, namely coverage, costs, and revenue.
Given Curaleaf is one of the largest and most dominant players on the East Coast, and Select is undoubtedly the number one player on the West Coast, this deal really does ramp up the overall US coverage of the combined entity.
Given that Select does not grow its own cannabis, its input costs are a function fo the wholesale price it pays in the market. Curaleaf would bee able to significantly reduce these costs by providing the input in areas that it currently has cultivation facilities. Curaleaf also believes they could reduce the processing costs by up to 25% given their superior processing facilities and technologies.
This is a key area to focus on as it could have a significant impact on Select's gross margins. As mentioned above, their current margins are single digits too low double digits at best. By reducing the input cost of the trim, adding efficiency to processing, Curaleaf could significantly impact Select's gross margin. The company believes that Select's GM could be as high as 50% when operating with full economies of scale.
And finally, Curaleaf will be able to grow Select's revenue by expanding the brand and its products to a national footprint using Curaleaf's existing production facilities in Florida, Maryland, New York, and Massachusetts, where Select does not yet have any operations. There is also the possibility for Curaleaf to sell its range of medicinal and recreational products across the West Coast through the 900 retail outlets Select currently provides products to.
The Bottom Line
Curaleaf is paying $949 million for a business with $117 million in sales or paying about 8x sales. However, this is much cheaper than Curaleaf itself, which trades at an enterprise value of about $5.5 billion with $88 million in pro forma sales, which equates to about 62x sales.
But, Select also is a much lower-margin business than Curaleaf. Select generated (at best 10%) gross margin in FY 2018, whereas in contrast, Curaleaf generated gross margins on cannabis sales of 46% during 2018 and 50% during the fourth quarter of 2018.
Initially, it simply looks like Curaleaf paid $950m for approximately $17.7m in gross profit, which on the surface certainly does not look good.
However, Curaleaf also expects to increase Select's gross margins through lowering input costs, lowering processing costs, and selling Select products through Curaleaf's vertically-integrated retail footprint.
It would be fair to assume then that the Select brand will be able to achieve gross margins more comparable to that of Curaleaf's other cannabis sales. If we assume that the synergies can create economies of scale that lead to a 50% gross margin, then $950 was paid for approximately $60m in gross margins. Bear in mind too, that Select saw year on year growth of approximately 217% and they reported Q4 2018 revenues of just shy of $40 million, already putting them on a $160m run rate for 2019.
Curaleaf adds arguably the best West Coast brand to its offering and with it gains the management team at Select who have guided their company to its strong market positioning in California, including adding Select's CEO and CMO to the Curaleaf team. The CEO, Cameron Forni, will take up the position of Chairman of the combined entity.
It would be remiss of us, however, not to mention some of the downsides we see with this deal. Based on their latest financials, Curaleaf still doesn't have positive cash flows which are the reason the company issued an additional 95.6 million new shares to acquire Select. That's enough to boost Curaleaf's outstanding share count 22% higher than its level at the end of 2018, and anyone that bought the stock last year needs the company to earn that much more to realise the same return they were expecting when they pulled the trigger.
Even if Curaleaf was able to sell Select products produced out West in nearly all of its current retail outlets out East, $950 million would still be an enormous sum to spend on a wholesale distributor of processed cannabis.
But you cannot simply look at the deal in isolation. You have to consider the growth the US cannabis market is currently experiencing and the fact that in the end, it will be the retail stores and retail brands that will dominate the minds and wallets of the consumers. Curaleaf has just purchased the #1 selling brand on the West Coast (the #1 market for cannabis in the US), and if Curaleaf can re-create the taste and quality that Select brand cartridges are known for, this $950 million acquisition has some chance of paying off for investors in the long run.
Bottom line – we're very positive on this deal, and so was the market, with Curaleaf shares up over 10% on the announcement of the deal. Watch this space.