Save Article

Canopy Growth Corporation might be the first Unicorn, but Aphria Inc. is becoming the industry benchmark: TSE:WEED, TSE:APH

David Bar | March 24, 2017 | SmallCapPower: One of the biggest concerns for most investors in the marijuana industry is whether or not the companies that they have invested in will become profitable. Although demand is set to explode, unless management can control costs while increasing production, profitability might not occur. With most producers in the start-up phase and burning cash faster than our Provincial Government, you should be thinking about what these companies would look like from an operational standpoint to determine whether or not they are heading in the right direction.

Normally you could look at industry averages or the big players to determine what a well-managed and profitable company should look like on paper. However due to the infancy of the marijuana industry, the average is non-profitable and generating negative cash flow from operations. That being said, there is one company that we can look at to start to generate that picture, Aphria Inc. (TSX: APH). Aphria is not only net-income positive, but more importantly generates positive cash flow from its operations.

Common Size Financial Statements

When comparing companies of different sizes, strategies, or locations it often helps to put their statements into what is referred to as Common Size Statements. This can be done by either taking the income statement and dividing every item by revenue, or the balance sheet and dividing items by total assets/ liabilities & shareholders’ equity. What this does is it gives you a look at various companies’ cost/capital structures in relative terms.

Below are the income statements from Aphria Inc.’s last six fiscal quarters in common size form. To provide some context to each of the following statements, the Unusual Expense (Income) item on each of the statements refers to the unrealized loss (gain) on biological assets, and the Labor Related Expenses item is for share-based compensation.

Below are the income statements from Aphria Inc.’s last six fiscal quarters in common size form. To provide some context to each of the following statements, the Unusual Expense (Income) item on each of the statements refers to the unrealized loss (gain) on biological assets, and the Labor Related Expenses item is for share-based compensation.

Figure 1: Aphria Inc. Common Size Income Statements

Although operating income turned positive only last summer, you can see that for the past six quarters Aphria, for the most part, had a continually improving margin. Compare this income statement to that of Aurora Cannabis (TSXV: ACB) (Figure 2, below) and Canopy Growth Corp (TSX: WEED) (Figure 3, below). One thing that you will notice, especially for Aurora and Canopy is that their Unusual Expense (Income) charge is substantial and has a huge effect on the company’s operating income.

In order to really understand the performance of the company for that time period I believe it’s best to ignore this item, as it’s more of a plug that represents what the asset ‘could’ be exchanged for between knowledgeable, willing parties in an arm’s length transaction, which includes the cost of selling, according to International Accounting Standard 41. I say that this is just a plug because it does not in any way represent a cash transaction, but only the potential value of one. As plants mature through their growth cycle, the value at which they can be sold at increases. Once the plants are harvested, that value is then transferred to inventory.

This expense isn’t to be disregarded completely as it’s good to consider for future sales growth, but you need to be weary. This is because Canopy Growth Corp. is currently a “profitable” business according to accounting rules, but has burned an average of $8mm in its operations per quarter over the last seven. In addition, the continued increase in this charge and resulting inventories also need to be watched over the short term because according to Health Canada, cannabis has a storage shelf life of just 12 months. This may seem like a substantial amount of time, but most cannabis producers are currently stockpiling for when recreational use becomes legal. However, with the announcement on Thursday, March 9th from Canada’s Health Minister, it may be longer for it to become a reality. If it takes longer than a year for all the laws to be passed and the back-end regulations and infrastructure put in place, this could cause huge inventory write downs due to spoilage and would have a negative effect on operations.

Figure 2: Aurora Cannabis Common Size Income Statement

Figure 3: Canopy Growth Corp. Common Size Income Statements

Looking back to Aphria’s common size statement you can see that the Company’s cost of goods sold has found relative stability around the 24% of revenues area. Compare that to the most recent numbers of 62% and 112% from Aurora and Canopy, respectively. Although much higher than Aphria, since Aurora Cannabis started selling its marijuana during Q2 of 2016, Aurora has significantly and steadily brought down its COGS quarter over quarter and could be heading to a gross margin similar to Aphria’s. Even for the SG&A expenses, Aphria is significantly lower than both Aurora and Canopy. Is this the optimal cost structure for the marijuana industry? Probably not, but it’s the first benchmark for profitability so can be used to determine when others may start to become profitable as well.

Does Aphria have the golden ticket to profitability in the Cannabis Industry? Maybe, maybe not. As the industry is still in its infancy, further cost reductions in producing and selling are definitely around the corner, as is larger volume sales, which will help improve margins. That being said, Aphria is certainly an industry benchmark producer and probably the best bet in the Cannabis Industry as it has proven profitable even before the legalization of recreational marijuana.

Side note: This activity can also be done on balance sheets to compare capital structures, receivables, etc. but also as a standalone analysis of the company. It can help you raise red flags and point you in the right direction if margins are decreasing, or receivables aren’t moving in relation to revenues (which could signal bad credit policy). All-in-all common size financial statements are a great way to start analyzing a company and to compare it to its peers.

***

David Bar is an MBA Candidate at the DeGroote School of Business. With an interest in the mining and marijuana industries, he hopes to work in the investment industry focusing in these sectors.

DISCLAIMER