On Wednesday February 21, Aphria posted on its social media accounts that their phase 3 expansion was complete. The next step before the greenhouse can have marijuana plants move in is receiving Health Canada approval.
A timely phase 3 expansion is key to meeting EBITDA expectations over the next year – Phase 3 is expected to more than triple Aphria’s production capacity (excluding their Broken Coast acquisition) from 9,000 KG/year to 30,000 KG/year. This is well above retail and wholesale medical demand for Aphria’s marijuana products, which are selling at a 5,000 KG/year run rate. In other words this expansion is entirely for the recreational cannabis market in Canada set to open up later this summer.
The company has generated a trailing 12-month EBITDA of $9 million and an EV/EBITDA ratio of 240x. However expectations are that the stock can trade at a run-rate of 35x EV/EBITDA by fiscal Q3/19. A timely greenhouse expansion with a clean launch will be key to increasing EBITDA at a time when it is expected to increase, opening the stock up to a larger investor base.
Delays have helped push APH lower relative to other Canadian Licensed Producers – As shown in Exhibit 1, Aphria’s share price has lagged both Aurora Cannabis (ACB.TO) and Canopy Growth (WEED.TO) since phase 3 has fallen behind schedule. While not the only reason for the underperformance, the first harvest from the phase 3 expansion not being 100% ready for legalization later this summer is an increasing concern.
EXHIBIT 1 – Relative Share Price Performance of the Largest Canadian Marijuana Producers
Source: Perspectec
Further delays could impact initial yield/supply to the retail market – The delays of phase 3 have caused us to lower our revenue and EBITDA expectations (excluding acquisitions) over the next four quarters.
Aphria is now facing an increasing risk that it will be forced to either transfer plants that are too mature into the greenhouse late (similar to what happened with phase 2 HC approval delay) and/or they may force the plants to flower and trim early (resulting in smaller plants and/or less potency). Both strategies will result in lower yields, less kilograms harvested and higher costs per gram.A rushed harvest may lead to Aphria not being able to maximize revenue and EBITDA when retail stores begin selling cannabis in August/September. At worst the delay could cause a rushed product to not have the THC potency expected and that their brand suffers as a result.
EXHIBIT 2 – Risks of Phase 3 Expansion Delays Increase
Source: Perspectec
Canadian marijuana supply will outstrip demand – While there will be long line-ups across the country when retail stores begin selling marijuana products, there is not likely to be a shortage of marijuana in the first few months following legalization at the least. According to Health Canada, there was nearly 38,000KGs (29k of dried marijuana, 9k of Cannabis oils) of Cannabis products in licensed producers’ inventory at the end of September 2017. Cannabis production was outpacing demand by about 1,500KG/month at that time, and is likely increasing with production capacities rapidly increasing in anticipation for recreational legalization.
Using Colorado as a rough proxy for demand in Canada, sales per person over 18 years old averaged about 0.5 grams per person over the first month that recreational weed was legalized. This translates to about 15,000 KGs of retail product demand for the first month in Canada. Even with Canada allowing online sales and delivery, this demand will not outstrip supply. Given the current increase in supply, retail demand will not draw down all licensed producer inventories. We believe there will be an oversupply to the tune of thousands of KGs of dried marijuana when recreational sales begin.
Aphria risks leaving money on the table – Despite the likely oversupply in the industry, Aphria theoretically will be in a strong position to sell all of its inventory (we estimate it at 5,000KGs by that time excluding Broken Coast), being the low cost producer in Canada and having a number of supply agreements in place including with SAQ, Shoppers Drug Mart and Nuuvera.
We would expect Aphria could supply the additional 3,500KGs of cannabis product (dried, trim products, oils) from their first phase 3 expansion harvest in time for the August/September sales launch. However total potential sales of 8,500 KGs over the first month or two of a retail launch (fiscal Q1/Q2 2019) are increasingly likely to fall short, again due to potential lower initial yields from a rushed harvest.
Product mix could be an issue – Having a wide variety of popular strains and oils will be key to finding early success with distributors looking for popular sativa, indica and hybrid buds. Currently Aphria, similar to other large Canadian producers, does not offer most popular East or West coast strains. This may cause distributors to turn to other licensed producers.
EXHIBIT 3 – Popular strains being supplied
Source: Perspectec
Health Canada approval will shore up some worries – We are keeping an eye out for a Aphria press release highlighting Health Canada’s (HC) approval for their phase 3 expansion. For phase 2 it took five months for HC to approve a much smaller expansion. Although HC has aimed for shortening the approval process, there is no strong evidence that approval times are improving. We think a June approval date is most likely at this point. This compares to Aphria’s original timeline of a January HC Approval.
A June HC approval puts first sales from the phase 3 expansion at September 2018. This might be a little late for meeting retail demand in some Provinces. The process to grow, flower, dry, trim, extract, package, box, ship and other steps would take at least three months even with aggressive flowering for some strains.
Rough Timeline for Marijuana Production Process
Source: Tilray
What this all means to the stock price – We are lowering our fiscal 2018 and 2019 Adjusted EBITDA and net comprehensive income estimates. The primary reasons for doing this are the higher likelihood that the first harvest for the phase 3 expansion will result in lower yields and higher costs. We have also modified our estimates for Broken Coast, Grow Co. and Nuuvera.
We see retail distributors being more aggressive on price then we previously anticipated. We also see the share dilution to acquire Nuuvera and Broken Coast as well as the $115 million equity raise as causing EPS to remain steady in fiscal 2019.
We think it’s best to value Aphria on an EV / adjusted EBITDA basis as they will continue to recognize gains/losses from buying and selling equity stakes in other companies. This skews net comprehensive income versus sustainable profitability. We believe the stock price will move lower in the short to medium term as momentum and technicals win out prior to reporting higher adjusted EBITDA, which would in turn push value conscious investors in. Perspectec subscribers can receive further updates and specific thoughts on when we believe the right time to buy APH will be.
EXHIBIT 4 – Fiscal 2018 and 2019 Estimates
Source: Perspectec
