Just when you thought that the marijuana industry could do nothing right, Ontario-based Aphria (NYSE:APHA) comes to the rescue, so to speak. Much in the same way that Aphria provided a temporary spark for the pot industry in early August after the company reported better-than-expected fourth-quarter operating results, it delivered again on Tuesday, Oct. 15, with its first-quarter results.

When the closing bell rang on Wall Street, Aphria ended Tuesday up by more than $1 a share, which, in its depressed state, translates into a nearly 25% gain. However, as you'll see, Aphria's operating results aren't all that they're cracked up to be.

A clear jar packed with dried cannabis buds that's seated atop a fanned pile of twenty dollar bills.

Image source: Getty Images.

Here's why Wall Street cheered Aphria's "profitable" quarter

Let's start with the basics of what got Wall Street and investors so excited.

For the quarter ended Aug. 31, 2019, Aphria generated net sales of 126.1 million Canadian dollars ($95.5 million), with CA$95.3 million being derived from its distribution business and the remaining CA$30.8 million coming from cannabis. Total distribution revenue fell about 4% from the sequential quarter, which Aphria attributed to a shift in business strategy at CC Pharma that's aimed at maximizing profitability following changes in the German government's medical reimbursement model. Comparatively, sequential cannabis sales rose modestly from CA$28.6 million to CA$30.8 million.

What really seemed to excite investors was the fact that Aphria delivered its second consecutive quarterly profit. The company reported net income of CA$16.4 million, as well as adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) from its cannabis operations of CA$1.3 million. With Aphria's peers losing money hand over fist, it allows the company's second-straight profitable quarter to really stand out.

Maybe most impressive were a number of other line items sprinkled throughout the company's press release. For example, Aphria notes that the average selling price per gram of adult-use marijuana rose in the first quarter to CA$6.02 from CA$5.73 in the sequential quarter. That's a totally different story from what HEXO recently implied with its preliminary fourth-quarter update. HEXO has suggested that pricing pressure is already weighing nationally on growers.

Additionally, selling, general, and administrative expenses declined from CA$60 million in the sequential quarter to CA$41.4 million in the first quarter.

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

Image source: Getty Images.

Let's face it: Aphria fooled Wall Street

But as I alluded to earlier, there's more than meets the eye with Aphria's quarterly report.

First, let's begin with the company's revenue generation. Though Aphria is generating a boatload of sales, it's predominantly being derived from its lower-margin and slower-growing medical distribution business and not the company's cannabis business. As we saw, marijuana sales in the adult-use market rose 8% from the sequential quarter, which is pretty poor, all things considered, and suggests that supply issues remain firmly in play in Canada.

Second, but most important, Aphria still isn't generating a recurring profit if we strip out a number of one-time costs and benefits. Feel free to call me an income-statement purist, but I'm putting a fairly sizable asterisk next to Aphria's first-quarter profit.

A quick glance at the company's cannabis operations shows CA$30.8 million in net sales and CA$15.5 million in production costs. That's a gross profit of about CA$15.3 million, not including its distribution gross profit or fair-value adjustments on biological assets, which bolstered gross profit by CA$18.9 million. A CA$15.3 million gross profit doesn't stand up well next to CA$41.4 million in operating expenses, even if some of these expenses are tied to the distribution business. In other words, without Aphria's one-time CA$18.9 million fair-value adjustment, it wouldn't have ended the quarter with a profit.

To be clear, International Financial Reporting Standards (i.e., IFRS accounting), which necessitates that Canadian growers estimate their crop values and cost of goods sold on their income statements, is perfectly legal. But that doesn't mean it's still not tricking its fair share of investors, as evidenced by Aphria's latest report.

A person holding a magnifying glass over a company's balance sheet.

Image source: Getty Images.

Aphria's potential powder keg

There's no doubt that Aphria has some positives to cling to with its Q1 report, such as the stability of its distribution revenue, the strength of adult-use cannabis per-gram selling prices, and the reasonable reduction in sequential operating expenses.

However, there's also a pretty big concern on the company's balance sheet that I've referred to as the marijuana industry's "powder keg" -- namely, Aphria's goodwill.

Goodwill is the amount of premium an acquiring company pays for another business, above and beyond tangible assets. While it's not uncommon for some amount of goodwill to be recognized when one company buys another, the amount of goodwill on marijuana stock balance sheets is getting extraordinarily high (no pun intended).

In Aphria's case, it ended the first quarter with CA$669.6 million in goodwill, down a mere CA$0.2 million from the previous quarter. This figure represents 27.5% of the company's total assets and is mostly derived from its March 2018 purchase of Nuuvera, as well as its acquisitions of Broken Coast Cannabis and Latin American assets.

In my view, it's growing increasingly unlikely that the company will be able to completely recoup the entirety of this goodwill. Aphria already took a CA$50 million charge against its Latin American assets earlier this year, and additional writedowns are a very real possibility. This has the real potential to constrain Aphria's upside and put the company's not-so-impressive income statement in check.