Legal cannabis is in its infancy, and the industry is growing rapidly – perhaps too rapidly. The April earnings report by Canadian producer Aphria (NYSE:APHA) highlights the problems – and the potential – of this emerging segment. In the words of Irwin Simon, Apria’s CEO, “There's not too many industries that are evolving and changing as quick as this one. If you come back and look at the size, CAD150 billion in size, so there's a lot of low hanging fruit in sales and opportunities for Aphria.”
He has a point. Legalization in Canada was only enacted at the Federal level this past October, and the Canadian market is somewhat isolated due to conflicted legal regimes (State v Federal, medical only v recreational use, legal v illegal) in the US. The result is, that while demand is strong in Canada, supply is tight, and the cannabis companies are facing headwinds due to shortages. In addition, there are added costs involved as they set up operations for their newly legal market. More on that below; for now, we’ll take a look at Apria’s quarterly numbers.
The Good News
Revenue was way up, leaping over 600% from the year-ago quarter to reach C$73.58 million, after a quarterly sales jump of 240%. These totals, and the huge increase they represent, justify Simon’s optimism that the cannabis market can grow to C$150 billion ($113 US). They are definitely powerful indicators for investors to consider.
They must also consider, however, Aphria’s net earnings. The company ended Q3 with a net operating loss of C$108.2 million, and an EPS loss of 20 cents. These figures add up to a total of C$181.78 in operating expenses, only partially offset by the strong sales, and somewhat worse than analysts had expected prior to the earnings season.
The expectation had been for a 4 cent EPS loss, and revenues of C$83.45. The actual numbers represent substantial negative surprises.
On a final positive note, Aphria reported C$107.5 million in cash on hand.
The Bad News
Investors didn’t like the EPS miss, and the operation loss prompted a retreat from APHA. Shares dropped 15% after the release, from $10.10 to $8.60 in US currency. The stock is currently selling for $8.69 in the US markets and C$11.58 on the Toronto Stock Exchange.
Growing Pains Adapting to the Legal Market
As mentioned above, Canada’s cannabis industry is facing serious issues of supply. Demand is strong; that is not a problem. On the supply side, however, the cannabis production companies have to adjust their operations from a scale sufficient for a small medical supply industry to one capable of meeting demand in a recreational use market for a country of nearly 40 million. It is a daunting task.
It is made more so by several factors. First, the grower companies don’t just want to increase capacity to meet Canadian demand. They also want to have some slack, excess capacity which they can activate as other markets open on the international front. Specifically, they don’t want to get caught off-guard should the US decriminalize – or even legalize – cannabis at the Federal level. There is some indication that such a policy could pass through Congress; hemp, a non-psychoactive relative of marijuana, was legalized for cultivation at the end of last year.
Second, the cannabis companies want to have enough supply to meet both medical and recreational demand. Specifically, they want to relieve the shortages in the Canadian domestic market.
Finally, building out to increase growing capacity entails a tremendous capital expenditure. Land needs to be cultivated, greenhouses need to be built for winter grows, extraction labs need to be expanded to meet medical needs, distribution networks need to be developed… the ancillary services required are wide and varied, and expensive.
Meeting those expenses will provide a firm foundation for future growth and profits, but in the immediate present, Aphria is having trouble meeting both expansion and current demand. In Q3, Aphria sold 2,636 kilograms of cannabis products, down by almost 800 kilos for the previous quarter. Building out offers promise going forward, but alleviating the current supply crunch will take time.
Aphria CFO Carl Merton alluded to all of this when he said, in the Q3 earnings call, “It is still early in terms of legalization in Canada. And as with every industry in its early stages, we are continuously learning and improving, including refining our methods for cultivation, production, packaging and distribution.”
That learning process entails costs. Turning back to CEO Simon, he noted in the earnings call, “Our all-in cost per gram increased from CAD2.60 a gram to CAD3.76 a gram. This temporary increase was driven primarily by an increase in packaging costs from CAD0.97 a gram to CAD1.98 a gram in the quarter. Our increased packaging costs per gram were a result of the demand from the adult-use market and in order to comply with the packaging requirements under the Cannabis Act.”
Looking forward, Simon sees the company not just expanding to meet the new scale of operations, but also adjusting to new techniques will streamline the expanded operations: “…we have reevaluated all of the total packaging used in our products... We are also working on packaging automation over the next two quarters and expect labor cost to decrease as that comes on line. Near term, we expect consistent packaging cost as we work through our existing inventory of materials, but expect to gain efficiencies from this automation and other cost savings initiatives in the mid-term.”
Market analysts remain upbeat about Aphria. Writing from GMP, Martin Landry gives the stock a solid 'buy' rating, saying, “Management remains confident in reaching its capacity goal of 255 tonnes which, using current average selling prices, translates into potential revenues from its Canadian cannabis operations in excess of $1 billion.” He sets a C$14 price target, suggesting a 20% upside for APHA.
Clarus analyst Noel Atkinson is also optimistic about Aphria’s forward outlook. He says in a note after the earnings report, “We had previously assumed a run-rate of ~$865MM by the end of CY2020; we are now in line with management’s target.” Atkinson’s price target, C$22.75, indicates an upside potential of 96%, in line with the impressive room for growth in the cannabis industry.
Overall, TipRanks’ data shows an overwhelmingly bullish camp backing this retail titan. The ‘Strong Buy’ stock has amassed 6 ‘buy’ ratings in the last three months, with just one analyst playing it safe with a hold rating. The 12-month average price target stands tall at $15.33, marking nearly 74% in return potential for the stock.
To read more on the nitty gritty of what’s going on in the rising cannabis industry, click here.