Editor's Note: This article was updated June 7, 2019 for accuracy. The previous version incorrectly interpreted the balance sheet and included a mathematical error.
In case you hadn't noticed, it's earnings season on Wall Street. For weeks on end, the largest publicly traded companies in the world lift their proverbial hoods and give investors a peek at the "engine" to see what's really going on. Ultimately, it's these earnings results that provide the spark for long-term rallies in the stock market.
But it's also an important time for marijuana stocks, which are delivering their early results in the post-legalization environment, at least in Canada. Following huge rallies in pot stocks since the beginning of 2016, it's essentially "show-me" time for the marijuana industry.
Village Farms rockets higher after releasing its latest operating results
One such company that delivered the goods last week was Village Farms International (NASDAQ:VFF). Following the release of the company's first-quarter operating results, Village Farms' stock rose by nearly 15% and has firmly re-emerged as the top-performing marijuana stock of 2019.
The headline figure that got investors excited was the company's announcement that its 50-50 joint venture with Emerald Health Therapeutics (OTC:EMHTF), Pure Sunfarms, saw its sequential quarterly revenue triple to $10.8 million, resulting in net income of $8.6 million.
Pure Sunfarms is a joint venture that Village Farms and Emerald Health entered into in 2017. Initially, it involved Emerald Health financing the retrofit of Village Farms' Delta 3 facility, which had been used for vegetable growing. Now complete and planted, the 1.1 million-square-foot facility, which features 1.03 million square feet of grow space, as well as nursery, should yield 75,000 kilos of marijuana per year.
More recently, Emerald Health, via the Pure Sunfarms venture, announced that it would be exercising an option to acquire a second 1.1-million-square-foot facility adjacent to Delta 3, which is now known as Delta 2. Like Delta 3, the new facility with be retrofit for cannabis production, but will feature a slightly larger grow space considering that a nursery won't be needed, given its proximity to the Delta 3 facility. All told, Pure Sunfarms now has 2.2 million square feet of combined space, and is on track for a combined 150,000 kilos of annual run-rate output by the midpoint of 2020. In other words, if it's already profitable this early on, investors are envisioning how profitable Village Farms could be once Pure Sunfarms is fully operational by mid-2020.
As one added note, Emerald Health also expects Pure Sunfarms' positive operating cash flow to pay for at least half of the Delta 2 retrofit, as opposed to having to cover the entire costs of the retrofit, which ran around 60 million Canadian dollars for Delta 3.
Three reasons investors shouldn't be impressed with Village Farms
Based on the reaction of Wall Street and investors, Village Farms' quarterly report must've been pretty solid, right? Well, before you go anointing Village Farms as the greatest thing since sliced bread, here are three reasons not to be so impressed.
1. Without this accounting quirk, Village Farms would have lost money
Although Village Farms produced a total profit across all of its businesses of $7.65 million (not including relatively nominal foreign currency adjustments), this profit would not have been possible without Emerald Health exercising its option for the Delta 2 facility. By selling this vegetable-growing facility to the joint venture that it owns 50% of, it was able to recognize a gain of $13.57 million. Here's how Village Farms described the transaction in its SEDAR filing in Canada:
On March 30, 2019, Pure Sunfarms exercised its option to utilize the Delta 2 assets and operations. The contribution of the assets has been accounted for as a disposal of the land, greenhouse facility and other assets in exchange for 25,000,000 common shares of Pure Sunfarms. This was a non-cash transaction, and it was estimated that the fair value of the land, building and other assets was CA$25 million (US$18.7 million) at the date of contribution. The Company recognized a gain of $13.6 million on the contribution of the fixed assets.
Aside from the almost laughable fact that it profited from selling an asset to itself (sort of), the company wouldn't have made money if this one-time gain was removed from the equation. Even with a $4.27 million share of joint venture income from Pure Sunfarms, Village Farms would have posted a loss if Emerald Health didn't exercise its option on Delta 2.
2. The company's fallback business performed poorly
In addition to producing a profit that was based solely on a one-time gain, Village Farms' soon-to-be ancillary vegetable-growing business went stale. Even though it reported an 8% increase in sales to $31.89 million, cost of sales rose at a much faster pace of 22% to $31.58 million. The company blamed these higher costs on higher volumes associated with its partner contracts. The end result is a gross profit of just $0.31 million from its vegetable-growing operations, which works out to a gross margin of 1%. Yuck!
However, things get worse when selling, general, and administrative (SG&A) expenses are factored into the company's vegetable operations. Year-over-year SG&A expenses rose by almost $2 million (56.3%) to $5.43 million. A marked increase in share-based compensation to employees, and a more than doubling in professional service fees, led to the bulk of the increase.
On a purely operating basis, Village Farms' vegetable business lost $5.22 million in the first quarter, or $5.12 million if the negative $0.1 million in fair-value adjustments to biological assets (i.e. cannabis plants) is removed. Either way, Village Farms is still losing money on its core business.
3. Pure Sunfarms' efficiency and dealmaking leaves a lot to be desired
Last, but not least, something I've harped on for a while now: the production efficiency at Pure Sunfarms.
On an aggregate basis, Pure Sunfarms slots in at a tie for sixth with HEXO, in terms of peak annual production. Both should be able to deliver 150,000 kilos a year when operating at full capacity. But production isn't everything when it comes to being a successful cannabis grower.
In terms of production efficiency, I've struggled to find a grower that offers worse metrics than what Emerald Health's and Village Farms' Pure Sunfarms brings to the table. As noted, Delta 3 and Delta 2 are each 1.1 million square feet, with 1.03 million square feet of cultivation space at Delta 3, and a little extra in Delta 2, since it doesn't need a nursery. That's pretty much 2.1 million square feet of growing space and 150,000 kilos of projected output. This works out to 71 grams to 72 grams per square foot.
Furthermore, Pure Sunfarms hasn't secured many supply deals outside of what Emerald Health has agreed to buy – and I'm not giving the joint venture any kudos for selling product to its owners. Just a small handful of Canadian provinces have supply deals in place with Pure Sunfarms, which could leave the joint venture particularly exposed to margin deterioration if and when cannabis oversupply strikes.
Long story short, I believe Village Farms completely pulled the wool over Wall Street's eyes with its latest quarterly results, because there's not much worth celebrating here.