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Following the fortunes of cannabis stocks can be frustrating. Even with the regulatory picture becoming clearer as the summer 2018 deadline for a legal recreational market approaches, the sector remains prone to large swings.

Various factors contribute to the ups and downs, from new partnerships for distribution or branding to rule changes and rollouts. On Feb. 2, shares in Canada’s largest producers fell between 14% and 17% when lofty valuations prompted a large selloff.

Much of the turbulence comes from the difficulty in establishing a value for companies in the nascent industry. As governments prepare to launch the recreational market, investors are left figuring out the windfall for the companies jostling to meet increased demand.

In addition to building the capacity to supply that demand (Statistics Canada said in January that 4.9 million Canadians consumed marijuana in 2017, and a Deloitte study says the number of users may increase by 17% with legalization), keeping production costs low will be crucial as producers try to maintain the margins they’ve enjoyed in the medical market.

For now, there is no standard for reporting the cost of producing a gram of dried bud. This number will become more important when some provinces, including Ontario and Quebec, become large wholesale purchasers and distributors in the recreational market.

“There is the false belief that the licensed producers (LPs) of marijuana will get the same price from the provinces they have enjoyed in the retail-based medical market business,” Queen’s University economics professor Allan Gregory wrote in Maclean’s earlier this year. “However, aggressive bulk buying by large provincial authorities will whittle the producer price down markedly.” (StatsCan says the national average price for medical cannabis in 2017 was $8.18 per gram.)

Companies, therefore, are trying to show investors they can keep costs down; press releases accompanying quarterly reports often emphasize lean operations. Leamington, Ont.-based Aphria—valued at around $3 billion, making it Canada’s third-largest pot producer by that measure—is among those fighting for the mantle of lowest-cost producer.

With the countdown on for the recreational market to open later this year, we look at how analysts are scrutinizing reports for clues about how companies will fare in that market. For Aphria, we break down the numbers in its Q1 2018 quarterly report (for the months that ended Aug. 31, 2017) and the accompanying Management’s Discussion and Analysis (MD&A).

Revenue

Unlike other industries, revenue isn’t a top concern. The trend in revenue is more important than the absolute dollar amounts “given the nascent stage of the industry,” says Matt Bottomley, an analyst at Canaccord Genuity. Companies need to keep up with their peer group, but flashy revenue numbers aren’t “critical.”

More important is tracking capital projects, expansion plans and costs of production, he says, and understanding the wholesale outlook.

Aphria reported $6.1 million in revenue for the quarter, representing the product it actually sold on the legal medical marijuana market.

The amount is a mix of direct sales to registered patients and wholesales to other licensed producers. The company’s Q1 MD&A shows Aphria sold 851,999 grams: more than 660,000 grams to patients and 190,000 to other licensed producers.

Direct sales in the medical market are at roughly $8 per gram (the MD&A says Aphria increased its average retail selling price from $7.67 to $7.91 in the quarter) and wholesale somewhere in the $4 to $6 range. It’s possible to estimate an average selling price of somewhere around $7 per gram. That amount, multiplied by the 851,999 grams sold, gives $5.96 million.

The extra revenue reported in the quarterly could be from Aphria’s sales of oil, Bottomley says, which is priced higher than bud (more on this in the Inventory section below).

Production costs

The cost to produce a gram of bud is the most crucial number for cannabis companies striving to assert their competitiveness.

In the release accompanying its quarterly results, Aphria CEO Vic Neufeld said, “As legal recreational cannabis comes into market in 2018, low costs per gram will be a critical factor for the entire supply chain.”

But that number isn’t included in the audited quarterly report. The quarterly does include production costs, though, which are basically the expense of running the facility, Bottomley says. That number was just under $1.35 million for the quarter.

The “all-in” and cash costs to produce dried cannabis per gram aren’t International Financial Reporting Standards (IFRS) measures so they’re contained in the MD&A.

After getting cash costs to produce a gram of dried cannabis down to $1.11 in the final quarter of 2017, Aphria reported a cost of $0.95 in Q1 2018 (see Table 1, below).

Table 1: Investor highlights (Q1 2018 MD&A)

Q1 2018Q4 2017
Revenue$6,120,359$5,717,866
Kilograms equivalents sold852.0738.3
Cash cost to produce dried cannabis/gram$0.95$1.11
“All-in” cost of sales of dried cannabis/gram$1.61$1.67
Adjusted gross margin78.0%85.7%
EBITDA from operations$1,548,149$2,870,667
Cash and cash equivalents and marketable securities$118,731,275$167,257,202
Working capital$135,127,644$169,051,562
Capital and intangible asset expenditures$23,704,138$31,955,214
Strategic investments$20,131,330$33,561,864

“A dollar is very low in this industry right now. So you want to track, if they say they’re the lowest-cost producer, that they’re sticking around that dollar mark or maybe below,” Bottomley says.

The company attributes the decrease to new economies of scale after completing part two of its facility expansion. Aphria expects to be selling product from the third part of the expansion by May 2018 and from the fourth by the start of 2019, and for costs to come down further as a result.

The MD&A defines the all-in cost of sales of dried cannabis per gram as “equal to cost of sales of dried cannabis plus (minus) increase (decrease) in plant inventory divided by gram equivalents of cannabis sold in the quarter.”

Table 2: “All-in” cost of sales of dried cannabis per gram (Q1 MD&A)

Three months ended
Aug. 31, 2017May 31, 2017
Production costs$1,346,162$814,906
Add (less):
Cost of accessories($36,966)($31,398)
Cannabis oil conversion costs($40,915)($27,857)
Increase in plant inventory$100,000$480,000
Adjusted “all-in” cost of sales of dried cannabis$1,368,281$1,235,651
Grams equivalents sold during the quarter851,999738,299
“All-in” cost of sales of dried cannabis per gram$1.61$1.67

Table 3: Cash costs to produce dried cannabis per gram (Q1 MD&A)

Three months ended
Aug. 31, 2017May 31, 2017
Adjusted “all-in” cost of sales of dried cannabis$1,368,281$1,235,651
Less:
Amortization($389,123)($267,826)
Packaging costs($170,400)($150,695)
Cash costs to produce dried cannabis$808,758$817,130
Gram equivalents sold in the quarter851,999738,299
Cash costs to produce per gram$0.95$1.11

The all-in cost includes amortization for equipment and facilities, Bottomley says, while the cash cost removes upfront costs that weren’t paid in the quarter (see Tables 2 and 3, above). The company says the cash-cost measure is useful “as it removes non-cash and post production expenses tied to our growing costs and provides a benchmark of the company against its competitors.”

Bottomley says it would be helpful for companies to adopt a consistent template for cash cost per gram—something more like the mining industry, where there’s a templated cost for gold mined. “If there were a consistent way, people [would] have faith in that.”

For now, companies can use that discrepancy “as a way to sling mud,” says Bruce Campbell, founder and portfolio manager at StoneCastle Investment Management in Kelowna, B.C.

In its MD&A for Q4 2017, Aphria contrasted its own definition with other companies’. Aphria’s definition includes indirect labour expenses and quality control costs, which it says “certain of its publicly traded competitors” leave out. It included charts in that MD&A showing the totals using its own method versus that of its competitors (see Table 4).

Table 4: Comparison of cash costs to produce dried cannabis per gram (Q4 2017 MD&A)

Three months ended May 31, 2017
DefintionAphriaCompetitor
Cost of sales of dried cannabis excluding IFRS adjustments$1,235,651
Amortization($267,826)
Packaging costs($150,695)
Cash costs to produce dried cannabis$817,130
Post production costs($230,902)
Cash costs to produce dried cannabis$817,130$586,228
Gram equivalents sold in the quarter738,299738,299
Cash costs to produce per gram$1.11$0.79

“The street will eventually put the onus on the companies to report it in a certain way,” Campbell says. For now, though, companies are more focused on growing than the bottom-line number.

Expenses

Campbell predicts the expense line will be the greatest disappointment for the sector in the future. For now, as with revenue, companies get a long leash.

“These guys have had very little cost control and that will become more important down the road because they’re going to turn into real businesses—not just where they raise a bunch of money and build a bunch of plant,” he says, speaking about the industry in general. “They will actually need to profitably sell what they grow.”

In another year or 18 months, the expense line will be more of a concern, he says. “If they’re still doing the same thing on percentage terms […] most investors aren’t going to be happy” (see Table 5, below).

Table 5: Expenses (Q1 2018 quarterly)

Three months ended
Aug. 31, 2017Aug. 31, 2016
General and administrative$1,735,217$959,592
Share-based compensation$2,508,901$203,095
Selling, marketing and promotion$1,947,586$1,380,647
Amortization$238,648$201,670
Research and development$90,367$249,313
$6,520,719$2,994,317

General and administrative expenses should slow as companies reach scale, as should share-based compensation, Campbell says. Selling, marketing and promotion will remain significant and could potentially increase, depending on the rec market’s level of competition.

R&D could also become a larger component. “I suspect that, over time, more companies in the sector are going to become more active on the R&D side of things as they try to build their business from pure cultivation to being more fully integrated,” he says, including new products and delivery methods.

For now, Bottomley says most of Aphria’s R&D work is through strategic partnerships with other companies. He would want to determine if any significant quarter-over-quarter difference reflects a change in business strategy.

Gross profit before fair value adjustment

Gross profit before fair value adjustment (GPBFVA) appears directly below revenue and production costs in the quarterly.

Accounting standards for harvesting cannabis treat it like other commodities: once it’s harvested, there should be a fair market value for your goods, Bottomley explains. The fair value is generally the “net amount you would get in present value terms if you sold your inventory,” he says.

In the MD&A, Aphria says the GPBFVA is “equal to gross profit less the non-cash increase…in the [fair value] on growth and on sale.”

The IFRS requires inclusion of the fair value adjustment on growth of biological assets as part of the company’s cost of sales, the MD&A says. But Aphria believes the GPBFVA is a better representation because it excludes the “non-cash fair value metrics required by IFRS.” The measure has no standardized IFRS meaning, though, and isn’t necessarily measured the same way by other companies.

Campbell says the number still provides an entry point to compare cannabis to other products. GPBFVA “is probably the easiest way that most people can look at this and compare this to their manufacturing company that they might own,” he says (see Table 6, below).

Table 6: Gross profit (Q1 2018 quarterly)

Three months ended
Aug. 31, 2017Aug. 31, 2016
Gross profit before fair value adjustments$4,774,197$3,321,596
Fair value adjustment on sale of inventory$1,135,535$1,339,538
Fair value adjustment on growth of biological assets($4,265,779)($1,800,087)
Gross profit$7,904,441$3,782,145

Inventory

Once the recreational market is operating and regulations allow for new categories, the number of products available will change “quite dramatically” from the current inventory, Campbell says (see Table 7, below).

Table 7: Inventory (Q1 2018 quarterly)

Capitalized CostFair value adjustmentAug. 31, 2017May 31, 2017
Harvested cannabis$943,904$1,761,552$2,705,456$2,506,963
Harvested cannabis trim$394,434$849,624$1,244,058$420,322
Cannabis oil$586,192$987,327$1,573,519$682,056
Packaging and supplies$445,470$445,470$277,266
$2,370,000$3,598,503$5,968,503$3,886,607

“That’s going to become increasingly important because those will be higher-margin items. You’ll probably see the trim continue to be a smaller component of inventory,” he says.

Aphria’s quarterly release emphasized this, saying it was developing “new product innovations” that will serve the medical market for now and eventually support its place in the rec market.

Campbell points to U.S. states where a recreational market already exists and producers expanded their margins on value-added products such as oils and edibles.

Industry consolidation

While Aurora Cannabis’s $1.1-billion acquisition of rival producer CanniMed Therapeutics in January has received the most attention, Aphria has made purchases of its own. In the same month, Aphria announced the $230-million acquisition of B.C.-based Broken Coast Cannabis, as well as an $826-million deal to buy Toronto’s Nuuvera Inc.

Medical producer Nuuvera has “a strong presence in Europe, Africa and the Middle East,” a release said, allowing the combined company to leverage its “extensive international network and best-in-class manufacturing practices.”

U.S. regulatory developments, however, prompted Aphria to sell its holding in Arizona’s Copperstate Farms in February.