Why this cannabis giant is betting on Europe to build a war chest ahead of the U.S. legalization bonanza

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Cannabis deals in Europe will help pot giant Aphria build up a war chest ahead of an expected frenzy of mergers and acquisitions in the U.S., the company’s chair and chief executive told MarketWatch ahead of the group’s earnings on Monday.

High-margin medical cannabis agreements in Europe represent critical waypoints on Aphria’s APHA, +0.06% APHA, -0.63% 0UI4, road to conquer the U.S., bolstering the company’s balance sheet and putting it on firm footing with European regulators, said Irwin Simon. 

As in the U.S., legal recreational cannabis remains on the horizon in Europe, where a combined population of more than 500 million in the U.K. and European Union makes it a lucrative proposition.

Aphria is set to complete its merger with Tilray TLRY, -0.05% this quarter, creating the world’s largest cannabis company by revenue. The combined company will push into the U.K., Sweden, Poland, Luxembourg, and China, with deal discussions ongoing in India, Aphria said.

The expansion in Europe will come in a few weeks at the earliest, when Tilray will begin distributing in Luxembourg, with Aphria and Tilray businesses pushing into Poland by the third quarter of this year. 

In China, the group will have a distribution agreement for wellness products with CBD — a non-psychoactive chemical in cannabis that is used to treat pain and anxiety, among other conditions. A similar agreement is under development in India.

Aphria is a key player in global cannabis with a market capitalization of $5.1 billion. The group is favored among analysts for being the first Canadian cannabis company to report a net profit. In December, Aphria agreed to combine with smaller rival Tilray, which has a market cap of $3.5 billion, through a reverse takeover. 

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In return for sharing its comparatively strong balance sheet with Tilray, Aphria would inherit the company’s presence across 10 European countries, including the U.K., Germany, France, Spain, and Portugal, where it has a cultivation facility. Added to Aphria’s growing site in Germany and European drug distribution business, the combined group would be the most dominant cannabis player in the region.

Since recreational pot remains illegal across Europe and Asia, cannabis companies are able to sell their products in the regulated medical market at far higher prices than in legal recreational markets in the U.S. and Canada. This boosts margins while the nascent industry faces barriers to profits, including price pressure from competing companies and a well-entrenched black market.

Countries in Europe have legalized cannabis for medical purposes, and the drug is decriminalized for recreational use in countries including Italy, Austria, Portugal, and the Netherlands. Many, including Simon, see the legalization of recreational weed as a matter of course in much of the region.

“In many ways, Europe is more progressive,” Simon said. “There’s a lot of learning to take away from Europe that ultimately we bring to the U.S. once legalization happens here.”

But for now, the drug remains federally illegal in the U.S., though individual states, including most recently New York, have legalized it. Prohibition at the national level has largely kept institutional money out of the sector and is a roadblock for interstate business and pot trade crossing the U.S.-Canada border. It has also ratcheted up stock market volatility with a high percentage of shares held by retail investors.

Optimism over federal legalization has increased with the Biden administration, but remains a hypothetical. National decriminalization would be crucial for a U.S. pot bonanza to begin in earnest, but analysts view the passage of the SAFE Banking Act by the Senate as a smaller steppingstone. The act would allow the cannabis industry to engage with U.S. financial services and insurance groups.

Plus: Tilray stock soars after reverse merger deal with Aphria, to create largest global cannabis company

While some of Aphria’s competitors have dipped their toes into M&A in the U.S. through takeovers that are conditional on changes to U.S. law, Simon wants to keep Aphria on the sidelines for now.

Kristoffer Inton, an analyst at Morningstar, told MarketWatch that U.S. assets with positive exposure to legalization are attractive to private equity, alcohol and tobacco, and Canadian cannabis groups alike. These assets are broadly expensive, Inton said, and groups like Aphria must be careful to not overpay in today’s optimistic environment or the M&A frenzy expected to come with legalization. “How are you going to translate optimism into actual exposure without overpaying for assets when everybody else wants in?” Inton said.

The most ambitious play Aphria made in the U.S. was its acquisition of craft brewer SweetWater last December, which gave the company a reliable extra sales channel from alcohol and exposure to cannabis-infused beverages. Consumable derivatives of the drug are widely viewed as the future of the industry, and Tilray has a partnership with beverage giant AB InBev BUD, +0.38%.

Ultimately, analysts point to inflated valuations across the cannabis sector as rooted in the market pricing in some level of U.S. legalization. For all the talk of expansion into Europe, Simon recognizes that America is critical to the future of the stock.

His game plan to pounce on the U.S. market largely rests on building upon successes in Canada and Europe. Simon’s ambitions are to grow Aphria and Tilray’s combined market share in Canada from around 20% to 30% while remaining cash flow positive. He also wants to remain the largest medical cannabis company in Europe, including through finding a strong strategic partner in the region, and leverage relationships with regulators to secure licenses in markets that legalize recreational pot.

If Simon is successful, the company will build up a healthy war chest for the coming battle in the U.S. The SweetWater business is a good start, Simon said, and Tilray’s assets include hemp food producer Manitoba Harvest, which is active in the U.S. But it may not be enough, and Simon knows that it could be an expensive fight.

“I will look to acquire the right [multistate operator] once I know what the market will legalize or how the market will legalize in the U.S.,” Irwin said. “I’d rather have to pay a little more when I can get into a business where the facts are known.”

Aphria shareholders will receive 0.8381 Tilray shares for each Aphria share they own when the companies merge, pending shareholder approval in the coming days. The group would operate under Tilray’s name with the shares trading via Tilray’s listing on the Nasdaq. Simon is to be chair and chief executive of the combined company, of which Aphria shareholders would own 62%.

Aphria stock is up more than 130% to date, while shares in Tilray have jumped more than 140% since the beginning of the year.