Please ensure Javascript is enabled for purposes of website accessibility

It's the Truth: You're Being Fooled by Pot Stocks

By Sean Williams – Dec 18, 2018 at 2:21AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Most early-stage marijuana profits are nothing but smoke and mirrors.

In less than two weeks, we'll close the book on what's been a history-making year for the marijuana industry.

Leading that charge was Canada, which this past October became the first industrialized country in the world to legalize recreational marijuana. With nine decades of recreational weed prohibition now lifted, the legal Canadian pot industry is free to build what should be a multibillion-dollar market by the turn of the decade.

We also witnessed plenty of game-changing moments in the United States. In 2018, a handful of new states legalized medical and recreational weed, and the U.S. Food and Drug Administration approved its first cannabis-derived drug.

Two rows of cannabis buds covering neatly arranged hundred dollar bills.

Image source: Getty Images.

Admit it: Marijuana stocks are completely fooling you

Even more recently, marijuana stocks reported their first quarter of operating results since Canada legalized adult-use pot. Even though these quarterly reports incorporated little or no sales from the post-legalization period, quite a many pot stocks delivered significant sales growth and, in some cases, a quarterly profit.

Though not an all-encompassing list, here's a snapshot of the adjusted net income for some of the biggest growers in the industry in their most recent quarter (all figures in Canadian dollars):

  • Aurora Cannabis (ACB -0.23%): CA$105.5 million
  • OrganiGram Holdings (OGI 0.81%): CA$18 million
  • Auxly Cannabis Group (CBWTF 6.87%): CA$6.7 million
  • Aphria (APHA): CA$21.2 million

When investors saw these quarterly profits, they were probably wide-eyed. Of course, if they were to dig a bit deeper, they'd see that all marijuana stocks did was legally fool investors.

Aurora Cannabis was able to turn its profit thanks to a combination of unrealized noncash gains from derivatives and the revaluation of its "influential" stake in The Green Organic Dutchman. Basically, some legal accounting adjustments led to Aurora's more than CA$105 million in net income. But, focus solely on the company's operating performance and you'd see an ugly loss of nearly CA$112 million

Likewise, the currently embattled Aphria generated its profit from an asset sale. Without this asset sale, Aphria would have recorded a marginal net loss. 

A skeptical accountant chewing on a pencil while closely examining figures from his printing calculator.

Image source: Getty Images.

Investors had better familiarize themselves with IFRS accounting practices

As for OrganiGram and Auxly Cannabis Group, they both benefited from International Financial Reporting Standards (IFRS). IFRS accounting is something that marijuana stock investors are going to have to familiarize themselves with, as it's likely to impact the bottom-line results for pot stocks in each and every quarter going forward.

Under IFRS accounting, marijuana growers are classified as "agricultural" companies. As such, they need to estimate not only the value of the crop they're growing, but the cost to sell this crop (oftentimes well before the crop is even harvested). And it gets better. Marijuana growers are required to revalue their crops throughout the grow cycle, as cannabis plants bear different values based on whether or not they're flowering or if they've been harvested and/or processed. This constant revaluation is really nothing more than guesswork on the part of pot stocks and their management teams.

But here's the "best" part: This fair-value adjustment to biological assets is taken as an above-the-line adjustment. That means it impacts gross profits before expenses are factored in. In some instances, we've witnessed cost of goods sold -- which is a number that would be subtracted from total sales -- become a positive number as a result of fair-value adjustments to biological assets. In OrganiGram's latest quarter, a nearly CA$31 million fair-value adjustment fueled its quarterly profit, while Auxly Cannabis recognized a CA$6.2 million unrealized and fair-value adjustment gain in the third quarter. 

A hundred dollar bill on fire atop a lit stove burner.

Image source: Getty Images.

Yet, what a lot of investors might be overlooking is the idea that the IFRS accounting door can swing both ways. At the moment, with capacity expansion underway, marijuana stocks are realizing a considerably higher value for their biological assets. Or, to put things more succinctly, they're planting a much larger crop and, as a result, expecting to see their shares of sales costs relative to this crop fall. But as this expansion period wanes within a few quarters, this fair-value adjustment door could reverse, leading to above-the-line reductions right as these pot stocks angle to produce recurring operating profits.

In other words, the market giveth, and it taketh away. Investors will want to take fair-value adjustments, derivative gains, and asset sales with a grain of salt as they analyze the quarterly operating results of marijuana stocks in the future.

Sean Williams has no position in any of the stocks mentioned. The Motley Fool recommends Auxly Cannabis Group and OrganiGram Holdings. The Motley Fool has a disclosure policy.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.