The article below appeared first in our daily markets newsletter. Subscribe here.
We spoke on Friday about the spread of coronavirus and its impact on the markets, and fears intensified today as stocks dropped. It wasn’t until the weekend that the first case of the virus was diagnosed in Toronto, Canada.
The Dow posted its fifth consecutive decline by 1.6%, along with the S&P500 (by 1.6%), marking the first drop of over 1% since October. The VIX climbed to its highest level since October, and closed at 18.23, up over 25%.
The weekend saw a rapid rise in diagnosed cases, with over 2700 people infected and over 82 deaths. Even though most deaths are contained in China, citizens across the globe are being diagnosed.
The stocks affected the most are airlines (American Airlines dropped 5.5%), and industries that are dependant on tourism in China and the States (Wynn Resorts – that owns a gambling hotspot in Macau – dropped 8.1%).
For firms that are listed on US exchanges, those affected the most were the ones with large operations or factories in China. Apple stock has enjoyed a bullish run over the past 12 weeks, rising over 24.43%, but saw a decline of 2.9% just two days before earnings.
Oil continued its losing streak as Brent Crude declined by 2.3% to settle at $59.32 a barrel.
Hexo Sued by MediPharm
The traditional way to run a business is to create some sort of value in the market, be it either your efficiency, your “synergies”, or your ability to reduce costs of production at scale, and sell your product at a markup. Sometimes this means that you will lose money before you make money, and this period is often called the “growth stage” of a company (read: Amazon).
However, the ultimate goal of any business is to create value, the closest measure and proxy of which is profit. It would be kind of obvious? I guess implied? – that you can’t make a “profit” by simply taking money from other investors and just paying yourselves, or, you know, rob a bank, or be the only person with the password of everybody’s digital “tokens” worth $190 million.
What you certainly shouldn’t be doing is to borrow money from investors, and then borrow money from new investors to pay back your old investors, and then claim that you “made a return”. Doing this would be the literal definition of a Ponzi scheme.
Well, seems like Hexo executives missed the memo because they just closed a $20 million round in a direct offering, and are now being sued by MediPharm labs because they failed to pay for $9.8 million worth of cannabis oil. (Take a wild guess what the money might be used for)
MediPharm’s lawsuit alleges that no payments have been made towards the outstanding amount. I think this will bring up an interesting legal battle that will bring forth questions about what M&A really means. Why?
Because the original deal isn’t between MediPharm and Hexo, it’s between MediPharm and Newstrike Brands Inc, a company that Hexo acquired in an all-stock deal for $260 million.
Now I’m not saying that this is a Ponzi scheme. I’m not Chris Parry and don’t have the resources or the energy to fight a defamation lawsuit, but this is what it looks like:
- MediPharm signs a contract to sell product to Newstrike – stock rises because investors are optimistic about the fact that the firm has sold product in an oversupplied market.
- Newstrike is bought out by Hexo in an all-stock deal – stock rises because investors are optimistic about the newly acquired growth capacity for Hexo
On paper, the series of events seem to have the potential to “create value” for all shareholders. Except it didn’t.
According to MediPharm’s claims, Hexo is in breach of contract. It’s no surprise that the industry is in troubled waters right now, so one interpretation for MediPharm’s lawsuit is that its not a spiteful move intended to hurt Hexo, but simply a firm trying to ensure its own survival.
Or you could say this was a spiteful move: like a hospital (in the US, Canada has universal healthcare) telling you that you have to pay us right now even though we know you are going through cancer.
MediPharm’s price target was cut down by analysts at PI Financial from $8.50 to $7.25, which means the stock still has a “buy rating”, even though it took an 18% nosedive today as the story broke.
On the other hand, perhaps this is Hexo reaping what it sowed, and that it should’ve taken its legal obligations, whatever they may have been, a little more seriously before acquiring companies and raising money with direct offerings.
Or maybe there is a third interpretation that lies somewhere in the middle – that we ought to take normative judgment out of the entire equation and examine this from a purely Darwinian perspective – it’s the wild west and one will do anything to survive.
Either way, this looks pretty bad for the industry as a whole and virtually ensures that no institutional money will touch the firms involved with a ten-foot pole.
A Hexo spokesperson told BNN Bloomberg that the firm plans to “vigorously defend the claim”. I’m not sure what that looks like, and whether they will claim that 1) they paid (and thus don’t need to anymore), or 2) they don’t have to pay now (acknowledging that they should’ve paid, but the when part is something they can’t be held legally liable to).
As Sorkin wrote in the Big Short, people always underestimate the likelihood of bad things happening, so they always underestimate their impact.
I don’t know what Hexo’s defence is going to be, but the entire ordeal of events tells us something about the industry as a whole – the worst is yet to come. Money is drying up, the market is oversupplied, the bills are due, and there is only so far that you can kick the can down the road.
Cannabis M&A gone wrong? or a straight-up Ponzi scheme in disguise? I’ll let you decide.
MediPharm stock dropped 18.55%, closing at $3.03 CAD.
Hexo stock dove 5.67%, closing at $1.33 USD.
What we’re talking about
Disclaimer: ALWAYS DO YOUR OWN RESEARCH and consult with a licensed investment professional before making an investment. This communication should not be used as a basis for making any investment.
Latest posts by Arth Gupta (see all)
- Powell: “Nothing about this expansion that is unstable” - February 12, 2020
- The story of Amazon’s trillion dollar empire - January 31, 2020
- Cannabis M&A Gone Wrong or Ponzi Scheme in Disguise? You Decide - January 27, 2020