Pot giant Aphria (APHA +0.00%) released its latest earnings report on Jan. 14 for the second quarter ending Nov. 30, 2020, and investors were excited by the company's growth and bottom line. The stock jumped more than 20% on the news. However, the numbers weren't all great for Aphria, and there are signs that the stock could be headed for trouble.
Below, I'll look at three potential problems for the company moving forward, and examine why despite the seemingly positive results, investors may want to be careful with Aphria, especially with the stock coming fresh off a 52-week high.
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1. There was minimal growth in Canada
In Q2, Aphria's sales of 160.5 million Canadian dollars were up 10.2% from the previous quarter, and there wasn't a whole lot of growth in its home market. In North America, sales of CA$67.5 million only grew 6.4% from the first quarter, for the period up until Aug. 31, 2020. The main driver for the growth was Europe, where sales totaled CA$91.4 million and were up 13.3% from the CA$80.7 million that Aphria reported for that segment in Q1.
While Aphria's presence and growth in Europe provide great diversification, the North American numbers should be stronger, especially given the strength of the Canadian market this year. According to Statistics Canada, during the months of June 2020 through August 2020 (the period covering Q1), retail cannabis sales in Canada averaged CA$228.5 million per month.
For September and October of 2020 (the most recent available data), the average was CA$263.5 million -- an increase of about 15.3%, far higher than Aphria's rate of growth. And given the rising sales trend, November's results would likely push the retail numbers up even higher. This suggests that the company is losing market share in Canada.
Without a strong performance on its home turf, Aphria's sales could start to slow down in the quarters ahead and rely more on its European business. In Q2, sales from its German subsidiary CC Pharma totaled CA$90 million and made up the bulk of its revenue.
2. Gross margins are declining
In Q2, Aphria's gross profit before fair value adjustments was CA$43.8 million, or 27.3% of its top line. In the previous quarter, its gross margin was 29.7%.
A sliding gross margin means that even though Aphria's sales are rising, it's not seeing as much of that incremental revenue flow through its costs of goods sold to cover its operating expenses. For instance, if Aphria's gross margin remained at its Q1 rate, the company's gross profit would have been CA$47.7 million -- close to CA$4 million higher than it actually was in Q2.
Given that Aphria incurred a net loss of CA$120.6 million this past quarter, a slightly higher gross margin wouldn't have been enough to make a big difference this time around. However, without stronger margins, it's going to be difficult for Aphria to get close to breakeven. And especially with the company merging with Tilray, bringing down expenses is going to be even more important, since the British Columbia-based company has incurred net losses totaling $268.1 million over the past three quarters. For the newly combined company to have a chance of posting a profit, costs will need to come down and margins will need to be higher.
3. Inventory levels are higher and could be vulnerable to writedowns
One of the biggest problems in the Canadian cannabis industry is that companies are making too much pot -- more than they can sell. This can be dangerous because investors don't usually notice this until a company records a writedown. As of the end of Q2, Aphria's inventory was worth CA$321.5 million, which was relatively unchanged from the previous quarter, but it's 21.6% higher than the CA$264.3 million Aphria reported at the start of its fiscal year.
Fair value adjustments of CA$104.9 million have increased the value of the company's cannabis inventory, but those are estimates that can change, especially if products aren't moving to market quickly enough. The government-run Ontario Cannabis Store recently announced that it would be removing products from store shelves that weren't meeting sales targets. That means in the near future, cannabis companies could be writing down a lot more slow-moving inventory.
Is Aphria still a buy?
In the past year, Aphria's share price has risen close to 145% while the Horizons Marijuana Life Sciences ETF is up just 16%. But the stock may be approaching a peak, and once it merges with Tilray, the combined company could have a tough road ahead. Not only will it have the above Aphria-related issues to deal with, but Tilray's own operations aren't in great shape, either. That's why investors may be better off looking at other cannabis stocks.
