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British tobacco giant Imperial Brands PLC is investing $123-million in Auxly Cannabis Group Inc., using a cautious investment strategy that stands in contrast to the all-in approach to cannabis taken by competitor Altria Group Inc.

Imperial, which is the fourth-largest tobacco company in the world, is making the investment using convertible debentures, a type of debt that can be converted into common shares at a preset price. Imperial has the option to convert the Auxly debt any time in the next three years into a 19.9-per-cent ownership stake in the Vancouver-based licensed cannabis producer.

Imperial’s investment comes eight months after a much larger deal by Marlboro maker Altria, which invested $2.4-billion in Canadian cannabis grower Cronos Group Inc. Both investments are part of a broader push by tobacco firms to diversify their offerings amid declining cigarette sales in Europe and North America.

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As part of the deal, Auxly is getting the rights to license Imperial’s vaporizer technology as well as access to technology developed by Nerudia, a subsidiary of Imperial focused on vaporizers and e-cigarettes.

“Diversifying our NGP [Next Generation Product] portfolio with this investment provides Imperial with further options for future growth,” Matthew Phillips, Imperial’s chief development officer, said in a news release on Thursday.

Imperial’s investment shows a willingness by a major international firm to invest in the Canadian cannabis industry despite a broad sell-off in marijuana stocks, and several recent hits to investor confidence, including revelations of a regulatory breach at Ontario producer CannTrust Holdings Inc.

Imperial’s strategy, however, is more cautious than that of Altria and alcohol company Constellation Brands Inc., which invested $5-billion in Canopy Growth Corp. in August, 2018. Imperial did not take a direct equity stake in Auxly, but instead decided to hedge its bet using convertible debt.

Alimentation Couche-Tard Inc. took a similar approach with its investment in cannabis retailer Fire & Flower Holdings Corp., announced on Wednesday. Couche-Tard invested $26-million into Fire & Flower using convertible debentures, giving it exposure to the firm, but also protection against declines in stock price.

“What we also like about this move is the amount paid … $123mn for possible 20 per cent ownership of a Canadian LP seems like good business, especially when viewed in the context of the size of a recent Altria investment,” wrote Ryan Tomkins, an analyst with Jefferies International Ltd, in a research note.

The Auxly convertible debentures will bear 4-per-cent interest for three years, and be convertible into Auxly shares at $0.81 a share. The price of Auxly shares jumped 24.6 per cent on Thursday to $0.91, while Imperial share price saw a modest increase of 0.37 per cent.

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Auxly is not Imperial’s first cannabis investment. Last year, the maker of Davidoff and Gauloises cigarettes took a minority stake in British biotech firm Oxford Cannabinoid Technologies, which focuses on medical cannabis research.

“We believe cannabis is an excellent strategic fit for tobacco,” Mr. Tomkins of Jefferies wrote. “There is little evidence that it cannibalises tobacco to any significant degree (it cannibalises beverages more) which means it could be a sizeable incremental value driver. It also seems a logical fit: Big Tobacco knows how to cultivate crops, knows how to deal with regulators, is at the forefront of vapourisation technology, and arguably has less reputational risk than other [companies].”

Imperial will have the right to nominate one board member to Auxly’s five-member board. The head of Imperial’s product stewardship and health group will also sit on Auxly’s newly created safety board, which will oversee product safety, efficacy and quality.

“We think it’s a tremendous vote of confidence,” said Auxly president Hugo Alves in an interview. “Someone may say it’s a debenture, so it’s not straight equity … [But] this is an exclusive arrangement we have with them, and they’re entrusting us with one of their core assets, their vape IP portfolio on a global basis.”

Imperial’s investment in Auxly comes several months ahead of Canada’s next round of legalization, which will introduce a number of value-added products, such as cannabis-infused edibles or vaporizers, into the market. Auxly owns several extraction-focused assets, including Prince Edward Island-based Dosecann Inc. and Ontario-based KGK Science Inc.

"We made a pivot well over a year ago to focus on Legalization 2.0, to make sure we were at the starting gates with all or competitors at that industry reset,” Mr. Alves said.

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BMO Capital Markets acted as Auxly’s financial adviser for the transaction.

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