Aphria Inc. (TSX:APHA)(NYSE:APHA) was the yang to Organigram’s yin Monday, releasing disappointing unit sales for a quarter in which they made persistent headlines for all the wrong reasons. Yesterday, the company announced that they would be writing US$ 300M in convertible notes to finance the next phase of their ongoing development. The idea is to sell US$ 300M worth of senior unsecured convertible debt units, that come with an option to buy another US$ 45M worth of notes within 30 days to top it off. An ambitious move that will no doubt serve as a testament to investor confidence if they are to successfully close the offering, and that might be half the point.

Successfully extracting such a vote of confidence from a cannabis-deal-starved US market, along with the money that comes with it, would be a tactical success from an Aphria who is showing the street so little in terms of direction and execution that questions about leadership aren’t going to be whispers for very long.

The Numbers

No way around it: Aphria missed on their unit sales, and missed BIG. The company moved 2,636 kilos of dried flower equivalent, 772 kilos fewer than last quarter, representing a -22% decline in a market thirsty for product. That’s barely more than half of the 4,987 kilos Organigram sold in the identical period. (Canopy and Aurora report next month, and will have to beat 10,102 kilos and 6,999 kilos, respectively, to show growth.) Aph’s 2,636 kilos in sales were good for $17.8 million in cannabis revenue, at a gross margin of 43%.

A close look at Aphria’s operations turned up mixed results.

Aphria doesn’t break its sales down by brand (nobody does), but we suspect that Duncan, BC-based Broken Coast, acquired by Aphria in February of 2018, carried these sales numbers. Aphria is proud of the Broken Coast bud, and they should be. It’s universally well-reviewed. The unit write up in the MD&A doesn’t make any excuses for under performance in relation to that facility, and says that they plan a Broken Coast expansion, adjacent land having been acquired to facilitate it. They put the build out timeline two years out from whenever it gets started.

Aphria had put the lid on a planned Broken Coast expansion last quarter – one that had envisioned them building up in the existing footprint. In the same call, they explained away a slump in harvest from the yet-to-be-fully-licensed-at-the-time Aphria One as a result of a scale-up; stacking inventory for the recreational market. This time around, with an additional 800,000 square feet having been just licensed in March, the for-real scale-up is under way, and Aphria expects to get Aphria One to a place where it is cranking out 110,000 kilos of flower per year.

The company tells us that, in order to facilitate that expansion on Health Canada’s timeline, it was necessary to “lower Aphria One’s functional capacity to 20,000 kilos per year,” which means it should have been good for 5,000 kilos or so in Q1. They make Broken Coast’s capacity at 5,000 kilos per year, which means it’s good for another 1,250 kilos in the quarter… inventory numbers aren’t far off from last quarter (5,271 kilos of harvested flower vs. 4,299 last time) The 2,600 kilos they sold adds up to 36% of Aphria’s company-wide capacity. Add in the 1,000 kilo inventory bump, and Aphria is still only moving half of their cultivation capacity in sellable product… so what gives?

Packaging and distribution Problems

Aphria is consistent among its peers in citing “packaging and distribution problems” as an impediment to their ability to fully supply the market with a product they’ve been given one of a very few special licenses to grow. Even Organigram gave the packaging difficulties a nod, but it didn’t slow them down, and this is certainly the first we’ve heard of it from Aphria, whose respectable 91% sales growth last quarter included a month and a half of recreational sales that were ostensibly packaged smoothly. Aphria handles sales and distribution to the provincial and territorial government systems through an agreement with Great North Distributors Inc., who aren’t explicitly thrown under the bus, which is making the “temporary packaging and distribution challenges,” explanation for the sales slump sound like an excuse.

We claim no special understanding about the ease or difficulty of packaging flower in government-specified plastic bottles, but expect that we could glean some insight on it from Aphria’s largest business segment by revenue: zee Germans.

CC Pharma

Aphria bought a German packager and distributor of pharmaceuticals back in January, the plan being to feed it with exports from Canada and supply the German market. CC Pharma carried the distribution unit which out-sold Aph’s cannabis business by more than 3x, delivering $56 million to the top line, ostensibly from the packaging and distribution of traditional pharmaceuticals, and at an apparent gross margin of 13%. That’s 75% of their total receipts, from a business segment whose carrying cost represents only $10 million of Aphria’s $675 million in Goodwill.

So bespoke! Wow! Much Automation!

Back in Leamington, Aphria has big plans for the 1.1 million square feet that is now licensed at Aphria One, and for the 1.3 million square feet in the under-construction Aphria Diamond joint venture. Through “bespoke automation,” the company plans to run a greenhouse where the only human interaction with plants occurs in the cutting, trimming and harvesting phases, and takes place in work bays outside the greenhouses. The description of this facility is full of terms like “innovative” and “state of the art,” which might be a nice thing to hear in a pitch for a new type of consumer electronics, but isn’t what we like to see in a description of a flagship facility that’s just coming on line. In the context of Aphria scaling up a robotic Alien Dreadnought of a dope factory, Aphria’s production slump starts to make a whole lot of sense. It’s an ambitious move that certainly carries more risk than doing it the regular, boring, stationary way.

Aphria’s automation innovation is being undertaken to reduce costs, especially labor costs, but also energy costs. The company projects that this will produce a consistent product and improve quality control, but doesn’t say anything about an effect on overall quality or yield.

Meanwhile, in Aldergrove

A different attempt at keeping labor costs low at facilities that aren’t yet operating by fellow mega-LP Canopy Growth involved the hiring of temporary foreign workers to staff their Tweed BC facility in Aldergrove. The Financial Post’s Vanmala Subramaniam reports that that shop reached out and imported a Guatemalan labor force, ostensibly to get a head start on the rec market. While the federal government’s TFW program is officially extended only to jobs that Canadians are unavailable to fill, it’s generally used for jobs that Canadians aren’t available to fill at the price a company wants to pay. Subramaniam reports that the Tweed facility is off to a rocky start, having suffered from what Canopy explained as a planned crop cull for a poorly explained regulatory reason, but that social media observers are speculating is more likely a crop failure.

Allison McMahon, CEO of Cannabis industry recruiting specialists Cannabis at Work told Fundamental Hype last month that while there were certainly jobs being created that never existed before, she didn’t mention having trouble filing positions anywhere outside of specialists like master growers. We’ve said before that selling out to cut labor costs at the outset of a new kind of commercial farming – one that has never been done before at this kind of scale under these regulations – is the epitome of being penny-wise and pound-foolish, so we won’t belabor it.

Out of Focus

Fundamental Hype has been able to expand its audience by virtue of being seemingly the only marijuana business press concerned with how these companies perform operationally, and it isn’t a niche that we ever expected would be available. The meat of contemporary Aphria stories, both before and after their earnings release, has reliably been the LATM assets that were controversially acquired by an allegedly conflicted management, who are no longer there.

Certified Financial Analyst and Grizzle co-founder Scott Willis made the $50 million write down that Aphria took on those assets the lead in Monday’s treatment of these Aphria earnings, reasoning that the fact that the assets weren’t written down to zero “debunks the most important short seller allegation, that the LATM assets were worthless.” That could charitably be described as a misunderstanding of the short thesis and of the carrying values of pubco assets, but is mostly a misunderstanding of what is and isn’t important. No word on whether or not Scott is sticking to his $200/share price target for Aphria, but can someone go ahead ask him for us on twitter? Fundamental Hype has been blocked.

The fact that the LATM deal continues to be the narrative at APHA is enough to make us wonder if there’s anyone with a firm grip on the wheel in Leamington. This machine was designed on the fly by Vic Neufeld, who (unlike Scott Willis) was smart enough to understand that the LATM controversy had created a trust issue, and that he had to step down. That left the company with a bunch of spare parts, and seemingly nobody with the vision or ability to marshal a crew that can put them all together and make them work. Interim CEO Irwin D. Simon has a name that rings out in the grocery sector, and a bio that’s full of high-ranking jobs at Brands You Trust™, that were presumably all operating commercial enterprises when he showed up, in sectors that already existed, and had nothing to do with horticulture.

The production and sales drop is enough to cause us concern that there is an operational problem at Aphria, potentially as a result of a leadership team out of their depth. If they don’t find a way to give the street something to talk about other than the valuation of the assets that a now departed management team was once accused of grifting them into buying at an inflated valuation, it’s not going to get any better.

A successful US$ 300 million – $US 345 million raise will be a good start, but they’d better nail the encore.

UPDATE: We’ve added the licensing table out of Aph’s MD&A to this post, having mistakenly told our biggest fan over on r/weedstocks that we had included it. It WAS included in our last Aph earnings post, about a quarter in which the company’s business grew by 91%. That offering was strangely much better received than this one, about a quarter where it shrunk by 22%. Thanks for reading, Reddit!

As noted above, the company’s MD&A puts the present production out of Aphria One at 20,000 kg per year, allowing for the scale-up of “bespoke automation.”