There will be a lot of demand for dried marijuana flower when Canada opens its recreational marijuana market next week, but the biggest market opportunity for marijuana growers, including Aphria Inc. (OTC:APHQF), isn't for marijuana the commodity but for marijuana the ingredient. Canada's regulators are expected to give an OK next year for the sale of cannabis-infused beverages, edibles, and other consumer goods products, and if that happens, the lowest-cost marijuana producer could be positioned to profit most.
This isn't lost on marijuana companies. Everyone's taking steps to tamp down marijuana production costs, but some companies are doing better than others, and Aphria's arguably been doing best. Because of its decision to focus on greenhouses rather than more expensive indoor facilities, Aphria's gross margin has consistently clocked in higher than that of its largest competitors: Canopy Growth (NYSE:CGC) and Aurora Cannabis (NYSE:ACB).
Aphria's record of envy-inspiring margin, however, got a black mark last quarter. Aphria's latest quarterly financials show its gross margin fell substantially in the period, and that's got investors wondering if its margin advantage is going to disappear. Do Aphria's latest results suggest its margins are in trouble, or is something else going on?
A big, emerging marketplace
Canada's medical marijuana market has been a big success since changes cleared the way for licensing growers and distributors in 2014. The medical market has steadily expanded since then, and in turn, that's translated into significant revenue growth for industry participants, including Aphria.
Canada's medical marijuana market totals in the hundreds of millions of dollars per year, but a much larger opportunity for cannabis companies exists in serving the adult-use market, or recreational marijuana market. Licensed growers will begin selling dried cannabis and cannabis oils to adults for recreational use on Oct. 17 following an OK from Canada's government earlier this year.
Estimates vary for how big Canada's recreational market will be next year, but most industry watchers anticipate that a significant chunk of Canada's marijuana sales will move from the black market to retail stores in 2019. For instance, Deloitte estimates two-thirds of Canada's black-market sales will move to the legal market, resulting in legal recreational marijuana sales of up to 4.3 billion Canadian dollars next year. If so, that would be a big windfall for Aphria and its competitors.
Preparing for the potential
Canada has licensed 120 marijuana producers. However, marijuana market share is concentrated among the biggest players, and that's unlikely to change when the adult-use market gets up and running. In fact, market share could become even more concentrated next year, because only the largest cannabis companies are prepared to meet the anticipated spike in demand.
Aphria isn't as big as Aurora Cannabis, which has funded production of 570,000 kilograms annually, or Canopy Growth, which is expected to have production capacity north of 500,000 kilograms next year, but it's still on track to be Canada's third-biggest grower, with roughly 255,000 kilograms of capacity per year.
Currently, Aphria's production totals 35,000 kilograms, so expansion work at Aphria One, its largest greenhouse, is key to delivering on the company's capacity target. Aphria One is undergoing a multipart expansion designed to increase its annual production to 110,000 kilograms per year. As part of that expansion, it's installing new automation equipment that can limit the use of labor, which is the biggest expense associated with greenhouse cultivation.
Once complete, automation will handle a host of time-consuming tasks at Aphria One, including:
- Transplanting cuttings into final pots for flowering
- Evaluating plant health and quality
- Watering and feeding nutrients
- Transporting plants for processing
- Debudding and trimming plants
- Disposing of waste from cutting, debudding, and trimming
- And distributing buds into the drying rack for curing.
The project's aim is to limit labor to the initial phase of cultivation and trimming and pruning throughout the growth phase. If successful, Aphria should be able to produce far more marijuana than it does today at a lower cost, allowing it to maximize profit as sales boom because of recreational demand.
Growth pains take a toll
There were plenty of bright spots in Aphria's latest quarterly financials. Its revenue more than doubled in the past year to $13.3 million; the percentage of sales from cannabis oils, which boast pricing power and offer better margins than dried flower, grew to 39% from 29%; and its net income jumped to CA$21.2 million from CA$15 million in the prior year.
However, these figures come with some asterisks.
Yes, revenue grew 10% from the prior quarter, but that was largely due to wholesale sales to limited partnerships. It would've been more encouraging if that growth had instead come from retail demand due to more patients being served.
The increase in cannabis oil sales as a percentage of revenue is good, but it was "driven primarily by an internal formula change for our equivalency factor." Management didn't explain in its press release exactly how it changed its gram equivalency formula, so investors will need more information to make a true apples-to-apples comparison.
Additionally, Aphria's net income performance is less exciting when we consider it was heavily influenced by gains on investments in other marijuana companies. Also, earnings actually fell on a per-share basis in the past year because the company issued more shares. On a per-share basis, earnings declined to $0.09 from $0.11 last year.
The company's cash cost to produce one kilogram of dried flower jumped to $1.30 from $0.95 in the period. If we back out tailwinds from its investment portfolio and exclude increases in fair value of biological assets due to production increases, Aphria's gross margin nose-dived to 63.6% in the quarter from 78.7% in the prior quarter.
Is this cannabis company losing its competitive edge?
The reliance on wholesale revenue rather than organic growth from consumers could simply reflect a flattening of medical marijuana demand ahead of the recreational market opening this month. Therefore, investors might not want to worry too much about that point.
It's impossible to know what will happen to marijuana stock prices in any given quarter, so investors probably shouldn't pay much attention to the impact of price swings on Aphria's bottom-line results, either.
The margin erosion is undeniably something we'll need to watch, but investors might not want to put much emphasis on last quarter's dip, because it was apparently due to a shortage of labor that forced it to "dispose of" one week's worth of crop rotation when it "outgrew its optimal harvest period." Since the company says it's doubled staffing at Aphria One as part of its expansion plans since the end of the quarter, that setback to margin could be a one-time event, not a sign of lasting margin deterioration. If we back out the negative drag caused by the operational hiccup, Aphria's gross margin would've been 7.4% higher, or 71%.
That's still lower than Aphria's gross margin of 75.6% last fiscal year and 78.7% in the previous quarter. But it outpaces Canopy Growth's gross margin of 43% last quarter, and it's within striking distance of Aurora Cannabis, which reported gross margin of 74% last quarter, and it was 52% last fiscal year.
Since Aphria's track record shows it has consistently delivered better margins than those companies, it might be worth giving management the benefit of the doubt that it can maintain its low-cost advantage.