Article by Seeking Alpha
Like everyone, I have biases, but I try to be explicit about them, so I’m going to lead with that. Since all this started in Canada, I’ve had a totem pole of the Canadian cannabis companies. Aphria (APHA) was on the top of the pole, and Tilray (TLRY) was on the bottom with Cronos (CRON). Some quarters I wondered if they were in the same business.
You see my snap judgement on the news above, and it’s a reminder to me that I should tweet less often. The reason this article is so long in the making is because I’ve changed my mind a bit. On balance, it is pretty clear that Aphria is overpaying for what they are getting, and the market agrees with that judgement.
The biggest reason is that Aphria would also be acquiring $438 million in convertible note liabilities on Tilray’s balance sheet. Because of these liabilities, Aphria shareholders are overpaying by about 20% in my calculations. I still like Aphria as the long-term winner in the crowded Canadian field, but I am mildly against this merger, mostly on basis of price, and those convertibles.
But I do think rather highly of Aphria management, who have proven to be the best both strategically and in execution. I am 60-40 against, but were I a shareholder, I would give them the benefit of the doubt, and vote for the merger. But I am not a shareholder in Aphria or any other cannabis company because the regulatory environment outside Canada is too unsettled, and Canada is still too small.
Also, for Tilray shareholders, this article is mostly from Aphria’s perspective.
Canada Is A Different Country
One of the problems in analyzing this merger is that while both are headquartered and operate primarily in Canada, Tilray is domiciled in the US, and reports in US dollars. One of the things Aphria gets out of what is technically a reverse-merger, is that they get the US domicile and listing with the deal. They were headed that way anyway. So regarding that:
- Unless noted, all dollars are US dollars.
- For balance sheet, I will be using the exchange rate they used for the purposes of the merger, which is 0.7835 CAD to USD.
- Price and market cap figures will be based on the stock prices at close the day before the merger was announced. Aphria was CA$10.31 on the Toronto exchange, so that’s $8.08 at our conversion rate.
- Tilray’s fiscal year is the same as calendar quarters, but Aphria’s ends in May, which is the one thing I truly hate about them. All quarters are calendar quarters, with charts adjusted for the month’s difference.
But this brings up issues beyond exchange rates, because Canadian reporting is different. The primary difference is that the Canadian cannabis companies put fair value changes in sold inventories and biological assets into cost-of-goods. As has been noted in many places, this is kind of silly:
- In a business this new, with a whole new class of products coming online, it is near impossible to put the right number on inventories, and we’ve seen huge changes here that distort the income statements.
- Biological assets are plants and clone mother plants at different stages of development. The value of these are literally changing every day. Putting that into a quarterly income statement really doesn’t tell us anything.
It really distorts the reported numbers on the income statement from gross profit on down. But when analyzing new companies, I find the GAAP numbers to not be entirely helpful anyway. I like to focus on: what are the questions I want answered, and how can I answer them?
- How efficient is production? Here I will remove the non-cash portions of Canadian cost-of-goods for “adjusted COGS”. Revenue minus adjusted COGS is “adjusted gross profit,” and that as a percentage of revenue is “adjusted gross margin.”
- How much is that adjusted gross profit costing them in customer acquisition? For this we will uses sales and marketing as a percentage of adjusted gross profit, or “customer acquisition cost rate.” Lower is better.
- How efficient are non-production operations? For this we will use general and administrative as a percentage of adjusted gross profit. Since lower is better, we’ll call this “office inefficiency.”
- Netting it all out yields “adjusted operating profit” and “adjusted operating margin.”
The Canadian Cannabis Companies From A Top View
First, I want to briefly talk about the way I view the whole environment here. My last article about Aphria was titled “Canada Is Still too Small” and that remains the central problem for all these companies. Canada is a country of only 38 million people, less than California by a couple of million.
Right now, the Canadian companies are limited to the Canadian domestic market, and what they can eke out of medical, hemp and CBD products elsewhere. On top of that, retail rollout in the most populous provinces has been too slow. But the experience of Alberta, the most libertarian province, shows that with enough retail, legal recreational cannabis can really thrive. Unfortunately, Alberta is also too small, at 4 million people, about the size of Los Angeles where I live.
The brass ring is the global recreational market in the wealthier parts of the world. Canadian companies have the early regulatory edge. Nothing substitutes for legal banking, insurance and transportation services, and access to public capital. I know the owner of one of the larger dispensaries in my neighborhood. She is still doing payroll in cash. In 2021. It’s no way to run a business.
My point here is that until we see big regulatory shifts elsewhere, this remains the central issue for the Canadian companies. Since you’re here reading this, I assume you can imagine, like I do, a future where regulations everywhere look more like Canada’s. But over two years in, it’s still in our imagination.
Canada is not the deep end of the pool. It is the diving board.
We’ll also talk a little about the implications of the US elections in a moment. I don’t know enough about Mexico and the recent changes there, so I am going to have to save that for a later date.
Why I Like Aphria and Not Tilray
Let’s leave aside the balance sheet issues and just talk about operations now a couple of years into this very Canadian experiment. Starting at the top, let’s look at revenue:
So right away, we’re looking at two very different experiences after legalization in October 2018. Both have plateaued to some extent, but Tilray more so. No matter what they do, they seem to have about $50 million in revenues every quarter. Like other companies, Aphria has seen a pandemic bump in recreational sales.
When we turn to adjusted gross margin – how efficient is production – Tilray mostly does better:
As you can see, Aphria’s margin keeps rising slowly. The issue they’ve had is they grow a very high quality product at a very low cost, and have marketed it effectively with well-regarded brands, and their medical distribution operation is also doing great. How is that a problem?
Unlike so many of the Canadian companies, Canopy most prominently, Aphria was cautious early on about bringing production levels up, and we see more companies moving towards an asset-light model now after bloated and overvalued inventories in 2019. Aphria was not part of that. Aphria focused on getting a replicable, expandable greenhouse model together, and waited to bring their Aphria One and Aphria Diamond facilities on line. Regulatory delays also did not help. So they were a bit of a victim of their own early success, and demand rose beyond what they anticipated. They were forced to go out on to the wholesale market to fill the hole:
inventories elsewhere, and as you see, it was almost fixed at the end of their August quarter. They actually have one of the lowest production costs in their greenhouses at CA$870 per kilo.
But customer acquisition and office inefficiency is where Tilray really falls down (lower is better).
Except for the very bad Q4 2019 for everyone, Aphria has kept a lid on their marketing costs. That’s still too high, but to be expected in a new business. But as you see, Tilray spends more in sales and marketing than adjusted gross profit, except those last two quarters. What happened? Tilray made a strategic decision to scale back considerably on OpEx and pursue a merger with a cleaned up financial statement. So, here we are.
We see pretty much the same pattern in office inefficiency: