Akerna Is A Tilray With Warrants: Assessing The Extreme Arbitrage Play - Akerna Corp. (NASDAQ:KERN)

The extreme arbitrage that exists on paper cannot yet be enacted upon, but should be once registration of stock and warrants take place within the next month.

On June 17, MTech Acquisition Corp. (MTEC) (MTECU) (MTECW) announced that it completed a merger with MJ Freeway LLC to Form Akerna Corp. (NASDAQ:KERN) (NASDAQ:KERNW). Akerna becomes the first compliance technology company in the cannabis space to be traded on NASDAQ. The hype over the closure of the deal and excessively small float wasn't lost on the market as KERN rose from the low teens to over $70 in the first three days of trading before settling at $27.05 on Friday.

KERN's story has some things in common with Tilray (TLRY). While most of Tilray's float was in lockup last summer, the stock managed to rise from the $20's to touch $300 for an instant in a glorious two month run before the locked shares became free trading and TLRY has since settled to form a base around $50.

According to the June 17th SEC filing, KERN has 10,400,381 shares of common stock and warrants to purchase approximately 5,993,750 shares at $11.50 outstanding. $45.5 million in cash was used to redeem 4,452,042 shares of MTEC common stock so the company has a reasonably strong balance sheet that sits much closer to scenario 2 of the pro forma balance sheet below with approximately $16.5 million in cash (with the trade-off being the much lower than anticipated float).

KERN is expected to achieve a little over $11 million in revenue for fiscal 2019 (ended June 30, 2019). Assuming a fully diluted float of 16.4 million (and warrants would get exercised pretty quickly if the stock price remains where it is), that leads to a market cap of around $440 million and a revenue multiple of 40 as of Friday's close. Funny enough, that is still below Tilray's trailing revenue multiple so if the market is as bullish on a cannabis tech company as it is on cannabis companies, this is not an overvaluation.

While the exercising of warrants adds to the float, it also brings cash to the company. This limits or eliminates the need for dilution in the future. If all warrants get exercised, that brings in $69 million in cash.

The reason why I assume all warrants will be exercised in short order is that at this moment they are trading far below their intrinsic value, setting up an extreme arbitrage play. The warrant strike price is $11.50 so at a $27.05 stock price, the warrants theoretically should be worth at least $15.55. And yet they closed Friday at $2.66, an 83% discount or 6x arbitrage upside.

Even if KERN was trading at its initial price of around $10, you could make the argument that the warrants should be worth $3 based on expected implied volatility on the stock with five years before expiry. So there is very little downside to holding the warrants unless an investor is very bearish on KERN's near-term performance and expects the stock to tank well below $10.

A straightforward explanation lies within the terms of the warrants:

Simply put, the warrants are not exercisable yet, but should be shortly now that the business combination is complete. KERN is impossible to short right now so the extreme arbitrage play exists as just a theory that cannot yet be put into practice. Warrants cannot be exercised and the stock immediately dumped on the market nor can the stock be shorted while simultaneously buying the warrants to lock in profits until the time when the short can be covered with the warrant exercise. However, at some point in time in the near future both of these options will be available. That should create selling pressure on the stock and will add buying pressure to the warrants for as long as the stock price remains strong enough than an obvious arbitrage opportunity exists.

The holders of the MTEC stock also owned the warrants. Given that most of the shareholders opted to redeem their common shares, it stands to reason that they aren't all that interested in holding onto their warrants either. So they could be dumping these warrants at well below the intrinsic value just to exit the position and take what profits they can. That also adds to the temporary demand-supply imbalance we see on the stock when compared to the warrants. Keep in mind that this is a group of investors who chose to redeem their MTEC shares for $10.24 when KERN traded over $70 a few days later. So them dumping warrants at well below intrinsic value isn't exactly an indication of long-term market sentiment for Akerna.

Phunware, Inc. (PHUN) and its warrants (PHUNW) is a lesson in an extreme arbitrage play turning bust earlier in the year. Review this Twitter thread for commentary and risks around the arbitrage play at the time. The high level summary of the story was that PHUN and its extremely thin float as its previous incarnation as a SPAC saw the stock price soar from $10 to as high as $550 on light volume in the first few weeks of trading. It managed to stay above $50 for a couple months after that. During this time, PHUNW traded around the $1 mark despite having an intrinsic value of whatever the stock price was at any given time less the strike price of $11.50. The arbitrage opportunity was theoretically dozens or even hundreds of times your money, except that it was impossible to do so because the warrants were not yet registered and exercisable and it was impossible to find borrows to short the stock just like the situation on Akerna today.

Eventually PHUN warrants and stock did get registered with the fallout being extreme. On March 27, PHUN had its first daily volume of over a million shares with the stock price tanking over 50% from $34.90 to $17.00. After spending another four days in the teens, the stock price got demolished once again by over 50% on nearly 3 million shares to finish under $6.00 on April 3. The stock has drifted down to under $4.00 since.

While the stock price tanked, the warrant arbitrage play actually did result in buyers making very good money if they were quick to the exits, just not 100x returns that were theoretically possible. As the registration date neared and PHUN was getting ready to fall off a cliff, PHUNW actually rose from $0.82 on March 20 to its high of $3.12 on March 28.

The $3.12 high on PHUNW on March 28 correlates to a $14.62 stock price, right around where PHUN closed for the day. April 3rd showed one final push on the arbitrage play for the warrants as they traded as high as $2.85, correlating to a $14.35 stock price before both the stock and warrants tanked on the day and have drifted downwards since.

While Phunware is a perfect recent example of what happens to a stock and its warrants once the arbitrage can actually be acted on, it is in a much different industry than Akerna. There is nothing to suggest that KERN will drop below $10 and stay there since it may be buoyed by the sector hype of being the "first compliance technology company in the cannabis space to be traded on NASDAQ". It is a risk that investors will have to take, but it may not be such a big risk given the huge arbitrage cushion that currently exists as long as they monitor the situation very closely and are reasonably quick in taking profits.

If you are bullish on Akerna, KERNW clearly becomes the better play right now over KERN. As the warrants get registered and locked shares get absorbed into the float, there will be downward pressure on the stock just like Tilray and Phunware. How hard that drop becomes depends on the market's willingness to absorb those shares. And if somehow the demand for the stock remains robust enough that buyers of the stock at $27 today are still green by August, the warrants will have increased at least five-fold by then.

What we know for certainty based on the Phunware example as well as simple finance theory is that arbitrage gap will close simultaneously with registration. That means the warrants will rise as the stock falls or heavily rise as the stock stagnates. How high the warrants go all depends on how well KERN can handle the added float and arbitrage pressures. If KERN can hold $15 for a few days like PHUN did, buyers of KERNW at $2.66 today should be able to sell or exercise their warrants for more than $3.00. If KERN remains above $20, the return on KERNW becomes three-fold. If KERN tanks to $10, chances are that KERNW will still hold significant value even as the warrants are out of the money due to the long time to expiry. I believe that Akerna is an interesting enough play and that a large enough arbitrage cushion exists that the warrants make a very good trade in anticipation of registration.

Disclosure: I am/we are long KERNW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Seekingalpha.com

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