Reading an earnings report is a great way to assess the health and performance of a company. Unfortunately, when it comes to marijuana producers, the process of analyzing the results is not as straightforward as it is with companies in other industries. Not only has the cannabis industry gone through many changes over the past few years, but several items can skew perception of a company's performance.
Items like revaluation gains and losses on inventory and even liabilities can have significant impacts on whether a company is profitable during a quarter. A good example is Aphria (NASDAQ:APHA), one of the few pot producers to post profits with any degree of consistency. However, the way it's been doing so hasn't been by selling a product at strong margins and keeping its costs low, which is how you might expect most companies to turn profits. In Aphria's case, nonoperating items have played a significant role in the earnings results.
Last quarter, Aphria generated a profit of 16.4 million Canadian dollars. However, non-operating income came in at CA$20.3 million, while fair-value adjustments to the company's assets added another CA$17.9 million to its bottom line.
Why does this matter?
The big problem with these earnings reports is their quality. When there is a lot of noise on a company's earnings report, it can be difficult to compare one period against another, let alone to predict how the company will perform in future quarters. In a normal situation, investors might see a company's sales rising as a result of greater traffic through its stores and project that if that growth continues, sales will continue to rise to a certain level. Profits could be derived from those figures as well.
With marijuana companies, the process isn't nearly as linear. Knowing how much a company will add in fair-value gains or how its investments in other companies will do during the quarter are significant but unpredictable variables. There's no guarantee that revaluation gains will remain the same or even have the same impact as in the prior year or quarter, and it's possible that the gains could turn into losses and have the opposite effect.
When there's a lack of predictability in earnings as a result of nonrecurring items, the earnings are considered to be of lower quality than if the company didn't have any noise on its financials.
The good news is that marijuana earnings reports have improved over the years, and companies have adjusted their earnings reports to show gross profit before revaluation gains so investors can see a realistic gross profit number, as opposed to one where the number may be higher than revenue. If it were just the gross margin area that was the problem, this solution could suffice. However, the "other income and expenses" line can be full of nonrecurring items as well.
Ultimately, regardless of where the noise is coming from, it still has the potential to have a significant impact on a company's bottom line.
What should investors do?
When a marijuana company releases its earnings, investors should do a deeper analysis than they would for reports in other industries. Eliminating one-time revenue and expense items and nonoperating results is important for discerning just how well the company's core business did. The process might be a bit more cumbersome, but you'll get a clearer picture of whether a company actually had a good quarter or simply benefited from some accounting entries or investments in other companies.
In Aphria's case, the company still had a good quarter, and those nonrecurring items on its financials certainly shouldn't take away from that. However, investors should keep that in mind to ensure they aren't making investment decisions based on strong earnings numbers that might not repeat in future quarters.