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Warrants are Options, Too

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Even if you’re never going to trade an option, it can be helpful to have a basic understanding of how they work and what factors affect their value because many other securities have option-like characteristics.

The most obvious is the warrant.

When we use the term “option,” we are generally talking about an exchange-traded options contract that has standardized characteristics that facilitate trading.

At its core, a warrant is essentially the same security as an exchange-traded call option. They are both an agreement between two parties that gives one of them the right but not obligation to purchase shares at a certain price and on (or sometimes before) a certain date.

The difference is that warrants, instead of being created by the agreement of two parties (like an option is), are issued by a company for its own shares. If the warrant is exercised, those shares are issued by the company itself.

Warrants can be traded to a third party prior to expiration, but unlike exchange-listed options – for which there is the liquidity of a constant bid and offer – they’re fairly illiquid and therefore are usually held by the original grantee until exercise or expiration.

It used to be common for companies to include warrants with IPO shares as an extra inducement to invest in the speculative shares of new companies, though that happens only infrequently these days.

More commonly, warrants are issued by one company to another as part of a partial acquisition. In addition to the standard terms of number of shares, strike price and expiration date, warrants can be written to include additional contingencies.

That was the case when beverage giant Constellation Brands (STZ - Free Report) took a 38% stake in Canadian cannabis producer Canopy Growth (CGC - Free Report) . Under the terms of the deal, Constellation also received warrants to purchase enough additional shares to give them a majority ownership of CGC - if they desired.

The contract also included a contingency that would allow a change of the terms of the warrants in Constellation’s favor if Canopy were to enter into a deal that would dilute Constellation’s interests.

Last week, when Canopy announced it’s innovative deal to acquire US cannabis company Acreage Holdings, those warrants were adjusted.

Constellation’s Warrant Windfall

For the past few days, shares of Constellation have been rallying, closing Wednesday at $210.14/share, nearly 10% above their closing price on last Wednesday - before the Canopy Growth/Acreage Holding deal was announced. They’ve added almost $4B in market cap over the last four days.

The obvious reason is that Constellation owns approximately 38% of Canopy Growth, and since CGC shares were rising, Constellation shares should rise as well, but that’s only part of the story.

In the original deal Constellation made to purchase its stake in Canopy – which began in November 2017 and continued with an additional purchase in August 2018 – Constellation also acquired warrants to purchase an additional 139.7 million shares of Canopy over a rolling three year period between November of 2018 and November of 2021.

The exercise price for the warrants was split into two tranches, 88.5 million shares at C$50.40 and 51.2 million shares at the VWAP (volume weighted average price) over the five days prior to exercise. (The VWAP price would presumably be above the C$50.40 price, or they wouldn’t exercise the second tranche.)

The new warrants owned by Canopy will now instead be split into three tranches.

88.5 million with the same exercise price of C$50.40, but with a new expiration date two years later than the original first tranche – November 1, 2023.

38.4 million with an exercise price of C$76.68 and an expiration date five years later - November 1, 2026.

12.8 million with the November 1, 2026 expiration date and the 5-day VWAP exercise price.

(There are also a few more provisions that are favorable to Constellation, including allowing them to purchase shares in the open market instead of exercising options if that price is more favorable and requiring Canopy to repurchase 25% of the shares it issues to buy Acreage if tranche 1 is exercised.)

Anyone familiar with options pricing knows that options with more time to expiration are more valuable. Simply adding 2-5 extra years to those warrants makes them vastly more valuable.

For comparison purposes, exchange traded calls to buy Canopy for $37.50 American dollars (roughly an equivalent amount to C$50.40 at a .74/USD exchange rate) until January of 2021 are worth about $17 each in the open market right now.

Modeling the exact increase in value of Constellation’s warrant holdings would be extremely difficult, especially because of the floating strike of the VWAP options and including a currency hedge, but it’s safe to say they’ve increased in value by several billion dollars. My rough back-of-the-envelope guess is that it might be as much as $10B.

Investors who understood that Constellation’s warrants had dramatically increased in value got in early on the big rally.

-Dave

 

 

 

 

 


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