Marijuana Earnings Reports Are Going to Be Particularly Tricky in 2019
Sean Williams, The Motley Fool
Updated
Last year will almost certainly go down as the greatest in history for the marijuana industry. In October, after many years of promises from Prime Minister Justin Trudeau, Canada legalized recreational marijuana, lifting the curtain on what had been nine decades of prohibition. When fully ramped up, we should see upwards of $5 billion in annual sales added to the industry.
The U.S. cannabis industry delivered plenty to cheer about as well, with the Farm Bill being signed into law, thereby legalizing hemp and hemp-based cannabidiol, and the Food and Drug Administration giving the green light to the very first cannabis-derived drug.
You could rightly say that the marijuana industry is flowering right before our eyes.
But as we barrel into what's traditionally the kickoff for earnings season, marijuana stock investors are going to have their hands full more so than the average investor. Whereas most operating results tend to be straightforward with non-cannabis companies, pot stock investors have a few extra things to worry about.
An accountant chewing on a pencil while closely examining figures from his printing calculator.
Image source: Getty Images.
IFRS accounting adjustments
To begin with, Canadian-based marijuana stocks follow International Financial Reporting Standards (IFRS), which are different from the generally accepting accounting principles (GAAP) you're probably used to in the United States. When it comes to marijuana stocks, which are treated as agricultural companies, IFRS accounting leads to some of the wackiest revisions you'll ever see on an income statement.
It begins with recognizing the "fair value of biological assets." This is pretty much a fancy way of saying that the marijuana growers have to make an educated guess as to how much their crop is worth based on the current stage of the growing cycle. That's right: As cannabis plants grow, flower, are harvested and processed, their value can change. Growers need to note this change throughout the growing cycle by adjusting the value of their crop.
If that's not enough, growers are also responsible for factoring in their expected costs of goods sold. This estimate is almost always done well before the company has actually sold the product.
And, as the icing on the cake, this fair-value adjustment is done above the line. This means, should the adjustment be a positive number, it could turn cost of goods sold, which is an expense we'd subtract from total revenue, into a positive number that gets added to revenue, thereby leading to a higher gross profit. With growers in a state of rapid capacity expansion, IFRS accounting is likely to lead to positive fair-value adjustments and, as a result, positive earnings per share in some instances.
For example, hydroponic giant CannTrust Holdings(NASDAQOTH: CNTTF) has recorded 29.5 million Canadian dollars in sales through the first nine months of 2018, to go along with CA$9.2 million in costs of goods sold. That's a gross profit of CA$20.3 million. However, CannTrust recorded a CA$17.2 million fair-value change in inventory sold that adversely impacted its gross profit and a CA$41.7 million unrealized gain on changes to the fair value of its biological assets. Ultimately, CannTrust has generated an IFRS accounting-based gross profit of CA$44.8 million, despite reporting just CA$29.5 million in sales.
What investors are going to want to do is remove this fair-value adjustment when analyzing pot stock operating results. In particular, you'll want to hone in on operating results without a bunch of one-time benefits and costs to get a truer look at how well or poorly a marijuana stock is performing.
A magnifying glass held over a company's balance sheet.
Image source: Getty Images.
Accounting for equity investments and other one-time costs and benefits
Also annoying are the number of possible one-time benefits and expenses that marijuana stock investors may need to sift through when examining the income statement of a publicly traded weed company.
One perfect example is brought to us by Aurora Cannabis(NYSE: ACB), the grower projected to lead the field with perhaps 700,000 kilograms of peak annual production. When Aurora reported its first-quarter operating results in November, it dazzled with a CA$105.5 million profit. Of course, this turned out to be mostly smoke and mirrors if you dug below the surface.
The bulk of Aurora's gains came from adjusting how the company recognized its influential investment in The Green Organic Dutchman. Having previously been treated as an investment in associate, which was reported at cost, Aurora's investment in The Green Organic Dutchman is now considered a marketable security and reported at fair value. This change, along with derivative gains, resulted in Aurora's quarterly profit. On an operating basis that purely looked at revenue and operating expenses, the company lost CA$111.9 million.
Moving forward, Aurora Cannabis is likely to continue losing money on an operating basis as it expands its production capacity, makes acquisitions (which can have one-time costs of their own), and builds up its recreational cannabis brands.
My suggestion, if you didn't catch it in the previous point, is to avoid these one-time benefits and expenses. Instead, focus your attention strictly on total sales and aggregate operating expenses.
A cannabis leaf lying atop a hundred dollar bill, with only Ben Franklin's eyes visible.
Image source: Getty Images.
Share-based dilution
Marijuana stock investors also need to account for a "necessary evil" that's allowed pot stocks to expand as quickly as they have: share-based dilution.
Most cannabis companies have very limited access to nondilutive forms of financing from banks. This means their only source of ready available capital, other than what minimal operating cash flow they may be producing, is bought-deal offerings. A bought-deal offering involves the sale of common stock, convertible debentures, options, and/or warrants to an investor or group of investors. While this method has been wildly successful in raising money for capacity expansion and acquisitions, it's a nightmare for shareholders. It weighs down the existing value of a company's share price, and a larger number of outstanding shares can lead to earnings-per-share adjustments.
Take Auxly Cannabis Group(NASDAQOTH: CBWTF), which began as a royalty company that provided up-front capital to growers looking to expand and, in return, would reap the benefits of receiving a percentage of production at a below-market cost. Today, Auxly is a vertically integrated business with what it considers upstream (growing), midstream (product addition and diversification), and downstream (retail) operations.
But Auxly has yet to recognize much in the way of revenue given that many of its partners won't come on line until 2019 or 2020. This means Auxly has been reliant on selling its own stock to raise capital. Over the past three quarters, Auxly's share count has risen from 263.5 million to 565 million. That's not good news if you're a shareholder.
More importantly, through the first nine months of 2018, Auxly lost CA$0.07 per share, which appears to be only marginally worse than the CA$0.06 per share it lost in the previous year through three quarters. But a quick look at the company's comprehensive loss reveals that it lost CA$28.3 million through Q3 2018 versus CA$8.8 million through Q3 2017. That's not marginally worse. A higher share count has simply given shareholders the impression that things are only a bit worse, when in reality the company's comprehensive loss more than tripled.
Investors are going to want to pay close attention to net income and loss figure and somewhat ignore earnings per share until this rampant dilution ceases.
Sean Williams has no position in any of the stocks mentioned. The Motley Fool recommends Auxly Cannabis Group and CannTrust Holdings Inc. The Motley Fool has a disclosure policy.
