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Tilray Should Make This Shocking Business Move Before It's Too Late

George Budwell, The Motley Fool

Strategic mergers and acquisitions (M&A) are commonplace in the corporate world for a number of solid reasons. Most commonly, two top companies in their respective field agree to join forces via a merger to rapidly expand their customer base and create positive synergies and cost savings across the supply chain. 

Over the past two decades, the pharmaceutical industry has been slowly consolidating for this underlying reason. In 1999, Pfizer agreed to a $90.2 billion deal with Warner-Lambert to form one of the largest pharmaceutical companies in the world. A year later, Glaxo Wellcome paired up with SmithKline Beecham to form Britain's top drugmaker GlaxoSmithKline. And this year, Celgene and Bristol-Myers Squibb agreed to the third-largest deal in pharma history.

Pot plants growing in a covered facility.

Image source: Getty Images.

Tilray should strike while the iron is hot

Tilray (NASDAQ: TLRY) has a glaring problem: its otherworldly valuation. With a market cap of $6.8 billion, the company's shares are now trading at a trailing-price-to-sales-ratio of 157. While this key financial metric should drop to a more reasonable 40 this year and to 20.8 by 2020 (assuming a steady state market cap over the next two years), Tilray's valuation is way out of line with the rest of the healthcare sector. Even highly prized orphan drug stocks and cancer specialists rarely achieve these kinds of valuations.

Complicating matters further, Tilray -- and all of its Canadian peers -- are staring down an enormous headwind. Over the next 18 months, the Canadian pot market is projected to be grossly oversupplied with dry flowers. That's not good news for gross margins across the industry.

Tilray, in turn, plans on making a pronounced pivot toward higher-margin product categories like beverages, hemp-based CBD products, and medical cannabis to maintain a top-tier growth profile during this widely anticipated supply glut. The company also hopes to make additional inroads into various international markets, and essentially let Canopy Growth Corporation (NYSE: CGC) and Aurora Cannabis (NYSE: ACB) dominate the highly competitive Canadian recreational market.

On paper, Tilray's strategic plan sounds feasible. But the nascent cannabis industry is so dynamic at this early stage that there's no way to predict how things will pan out. Tilray, after all, is not the only company eyeing the much-larger U.S. and European cannabis markets, nor is it the only major Canadian player attempting to take advantage of the enormous opportunity presented by the American hemp space.

The point is that Tilray's sky-high valuation doesn't make much sense in light of these complicating factors. The company could end up grabbing a significant share of the U.S. and EU markets -- but that favorable outcome is far from guaranteed.

The move to make

In light of these issues, Tilray should probably consider a move that would pair its top-shelf medical franchise and middling production capacity with one of the leaders in the recreational arena -- namely Canopy or Aurora. From a fit standpoint, Aurora is arguably the better choice of the two.

Long story short, Aurora is second only to Canopy in terms of recreational cannabis sales, but it has yet to land a major partnering deal to take full advantage of its operational capacity across the entire value chain. Tilray, on the other hand, has already signed a joint venture with Anheuser-Busch InBev to develop nonalcoholic beverages containing THC and CBD. Yet the company needs to dramatically boost its production capacity to realize the full potential of this joint venture. A merger with Aurora would thus make a lot of sense for both companies.

Overall, the combined entity would have the highest peak production capacity bar none, the largest international footprint by a country mile, and a formidable medical cannabis franchise, as well as the ability to rapidly expand into the high-growth beverage market through its ties to AB InBev. That's an exciting prospect from an investing standpoint and one that would arguably be worthy of a premium valuation.

Alternatively, Tilray will eventually have to make good on its promise to fend off bigger and better-financed competitors to become a market share leader in the EU and the United States. That's not to say that Tilray can't pull off this feat, but the company could also end up getting bulled over by its top competitors once these all-important Western markets come fully into play over the next few years.

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George Budwell owns shares of Pfizer. The Motley Fool owns shares of and recommends GlaxoSmithKline. The Motley Fool recommends Anheuser-Busch InBev NV. The Motley Fool has a disclosure policy.