When a big company buys a smaller company, shares of the smaller company usually jump higher. This can be a quick way to score a nice profit. However, it’s very difficult to predict which smaller companies will be bought.
That’s why I am going to reveal how to use a merger arbitrage strategy to profit from a corporate buyout.
Right now I see an opportunity to use this strategy on a $1 billion cannabis mega-deal that could produce a 41% gain in the next three months.
How does merger arbitrage work? Let me show you an example.
Back in 2016, Microsoft (NASDAQ: MSFT) made a bid for professional networking company LinkedIn, Their bid was equal to $196 per share. That $196 per share buyout price was a 50% premium to LinkedIn’s share price at the time. News of the deal sent LinkedIn surging – but shares did not jump straight to the $196 buyout price – they only jumped to $192.
The reason? The deal still needed to clear two critical hurdles in the coming months in order to pass.
#1 – Shareholder approval
#2 – Regulatory approval
By bidding shares up to $192, short of the $196 buyout price, investors were pricing in some risk that the deal would be blocked by shareholders or the Department of Justice.
This is where the merger arbitrage opportunity came in.
Investors who were super confident that the deal would close, could buy LinkedIn for $192 and bet that shares would rise to $196 if the deal was approved. The deal ended up clearing both hurdles and LinkedIn jumped to $196.
Investors buying LinkedIn at $192 were rewarded with a quick 2% gain with very little risk.
Merger Arbitrage for the Cannabis Sector
Today I see a merger arbitrage opportunity happening in the cannabis sector.
But this isn’t a potential 2% winner – if this deal is approved I see a potential 41% profit in about three months.
Let’s take a look.
Cresco Labs (CSE: CL, OTC: CRLBF) is one of the largest US cannabis companies with a market cap of $1.3 billion. On April 1, Cresco announced a deal to acquire Origin House (CSE: OH, OTCQX: ORHOF), also one of the largest cannabis companies in the US, for $1 billion. This would be one of the largest acquisitions in the history of the US cannabis industry.
The deal valued Origin House at $12.68 per share.
Today, Origin House is trading at just $8.92 per share – a 41% discount to the proposed buyout price.
The reason for the sharp discount?
Investors are pricing in a high level of risk that this deal isn’t going to close.
Although shareholders overwhelmingly approved the deal on June 10, the deal has hit a speed bump.
The Department of Justice antitrust division recently made a ‘second request’ for information from both parties. This increased uncertainty around the deal.
Firstly, it usually takes about three months to respond to a second request for information, putting the deal on pace to close sometime in October if everything looks good.
Secondly, second requests lead to enforcement action about 70% of the time. Enforcement action would require Cresco or Origin House to sell assets to comply or the companies could challenge the ruling in court.
Both outcomes could delay the closing even more, possibly until the end of the year. As you can see, this potential merger is having some issues getting through the DOJ. Cresco and Origin House have some work to do.
That’s the bad news. Are you ready for the good news?
Thankfully, I still see a high probability this deal is going to clear the DOJ antitrust and close.
I don’t think this deal got a second request because of antitrust concerns. That wouldn’t make sense because the US cannabis industry is still hugely fragmented with hundreds of local and regional players. I think the reason this deal got a second request from the DOJ is that it is the single largest merger in the history of the US cannabis industry – an industry that is still illegal on the federal level. The DOJ wants to demonstrate that the cannabis industry is being watched closely and put cannabis companies on notice that they are watching for bad financial behavior.
So despite the DOJ speed bump, I still see a high probability this deal closes. If that happens, I expect shares of Origin House to jump up to the buyout price of $12.68. That would be a 41% premium to Origin House’s current share price of $8.92.
The Big Picture on the Cresco and Origin House Merger Plan
The era of the cannabis mega-merger has arrived. The potential deal between Cresco and Origin House would be the largest in the history of the US cannabis industry.
Investors are skeptical this deal will receive approval from the DOJ. However, I still believe this deal is going to close. If it happens, Origin House should rally as much as 41%, creating an excellent merger arbitrage opportunity for savvy cannabis investors.
Michael Vodicka owns shares of Cresco Labs (CL, CRLBF).
About the Author
Michael Vodicka is an equity analyst with more than 20 years of experience trading and investing. His research has been featured in some of the industry’s most respected publications. He has been investing and leading investors in the cannabis sector since 2013.