The Sniff Test: Aphria’s $70 million cash windfall is a product of its still-unexplained past

A look at cannabis producer Aphria Inc.’s stock since it released its annual report suggests something of a turnaround.

After a surprise profit, Aphria’s APHA, +4.57% APHA, +4.16% U.S.-traded shares rallied 40% in a single day, adding over half a billion in market value to the name. It has since retreated, shedding $200 million in just over a week’s worth of trading.

Aphria appears as if it’s running as it should. The way the freshly installed chief executive tells it, one reason for the company’s success is that its brands are resonating with customers: high potency for a low price gets marijuana into a lot of hands.

“It comes back to being a low-cost producer — from a grow, to a production standpoint,” CEO Irwin Simon told MarketWatch last week. Simon until last year ran Hain Celestial Group Inc. HAIN, +2.57%, a food-oriented consumer packaged goods company which he founded in the 1990s. “You can’t really market your brands here, so how do you get consumers to try them? I want to get the brand in a lot of consumers’ hands.”

Yet Aphria has an ugly history that it has not entirely dispensed with — and will not vanish until October at the earliest. Its C$89 million ($70 million) windfall was a partial result of deal-making designed to enrich insiders at the expense of shareholders on both sides of the border. The new CEO Simon has also asked investors to accept a wildly optimistic projection for Aphria’s ability to sell cannabis. And he has asked investors to take in good faith an adjusted financial figure in lieu of profits that resembles his own history of using adjusted numbers to cut management bonus checks and present results that don’t track with what U.S. regulators demand.

In December, short sellers Hindenburg Research and Quintessential Capital Management made the case that Aphria executives had used a complex set of financial maneuvers to enrich insiders and associates by overpaying for assets held by friendly parties, including a stake in a little-known shell company. Former CEO Vic Neufeld and Co-Founder Cole Cacciavillani stepped down and the company promised an internal investigation by an independent committee and a point-by-point rebuttal of the accusations.

Aphria’s investigation is complete, but the public has not yet seen a rebuttal.

Despite dozens of media reports of the company’s promise, an Aphria spokeswoman denied that the company had promised investors that it would issue a line-by-line rebuttal to the short seller claims. Ex-CEO Neufeld made the promise of a rebuttal and not the company, she said.

See also: The ‘hostile’ takeover offer for cannabis company Aphria is littered with red flags

As shares were slammed in the wake of the short sellers’ report, a U.S. company that was little more than an idea on a napkin a year ago launched a takeover bid for Aphria. Now known as Green Growth Brands GGBXF, +6.22% GGB, +0.00% that company’s failed bid for Aphria battered the stock price in both directions. Green Growth listed on the Canadian Securities Exchange, buying into the shell company Aphria already owned, which has proven lucrative for Aphria, though it’s more difficult to figure out how it benefits shareholders.

In April, Aphria executives said that in conjunction with terminating the Green Growth takeover, Aphria would receive C$89 million ($70 million) for its shares through an investment vehicle that Aphria has a stake in, a stake that got more valuable after Green Growth made its takeover bid for Aphria. Aphria disclosed receiving the first C$50 million in April and agreed to take C$39 million due in the fall.

But it was hard to tell exactly how that payment contributed because Aphria — like several other Canadian companies and U.S. businesses traded over-the-counter — did not include a full set of quarterly financial tables with its year-end results released earlier this month. The company told MarketWatch that it did not use the cash to juice its fourth-quarter profits, but rather added the payment to the balance sheet and excluded it from the income statement altogether.

Aphria stock is cross-listed on the New York Stock Exchange, which should lead to greater disclosure than over-the-counter peers. One of the reasons for Aphria’s American listing is the obvious hope it can attract the valuable dollars of U.S. retail investors, but also snag the nearly-impossible-to-attract institutional money that has largely stayed away from the cannabis industry.

Read: Short sellers are increasing bets that cannabis stocks will fall

Tilray Inc. TLRY, +4.61%   avoided similar issues for American investors by listing on the Nasdaq, reporting with U.S. accounting standards and accepting Securities and Exchange Commission oversight. Canopy Growth Corp CGC, +2.04% WEED, +1.66%  the world’s largest pot company backed by Constellation Brands Inc. STZ, +1.55%   seems to understand the importance of bowing to the will of American investors too. In its recent earnings call, former Constellation executive and now Chief Financial Officer Mike Lee, said it would soon report in U.S. generally accepted accounting principles.

Aphria could do the same thing.

The hardest thing to understand about Aphria’s results wasn’t buried in an arcane footnote to the financial statements or obfuscated by holding companies and attorney jargon. It was that executives boasted over the course of the coming fiscal year that the company would collect as much as C$700 million in revenue, half of which would be from cannabis sales.

To accomplish the task may require more than 150% revenue growth from recreational cannabis for four quarters in a row. It’s hard to understand exactly how Aphria plans to do that. Simon acknowledged that the company’s fattest margin producer, top-shelf pot brand Broken Coast, is at capacity, and to add to it would require at least two years of work, according to its regulatory filings.

In the fourth quarter, the company disclosed that it sold C$28.6 million of pot, with about C$18.5 million stemming from adult recreational sales in Canada, or about C$74 million in annualized sales. In the prior quarter, it sold C$7.19 million worth of recreational pot and just over C$10 million in medical sales.

To hit its target Aphria will have to grow recreational revenue by a multiple of four, assuming medical revenue stays relatively flat, and there is little to suggest it will be able to expand quickly enough to make that happen. Macgregor, the Aphria spokeswoman, says that Aphria‘s forecast is tied to the company’s expectations of when Health Canada will license its Aphria Diamond facility’s further expansion plans and its other already licensed expanded facilities.

If Aphria decides to try to buy additional capacity, that would likely be a problem. Though CEO Simon touted the company’s war chest, it could be competing in the acquisition market against the likes of deep-pocketed Altria Group Inc. MO, +1.84% -backed Cronos Group Inc. CRON, +5.73%  , CRON, +5.15%  Tilray and its IPO war chest, and Canopy Growth, with its $4 billion investment from Corona beer distributor Constellation Brands STZ, +1.55%. It’s hard to see where Aphria could buy more revenue, even from a problematic set of greenhouses that CannTrust Holdings Inc. CTST, -2.16% TRST, -1.32%  owns.

While working toward that revenue goal, Aphria could look to coast on its profitable fourth quarter, which some declared the first big pot company since recreational weed sales began in Canada. As Aphria says, its profits aren’t the result of the C$50 million from Green Growth — but the bottom line is obfuscated by a series of adjustments: C$40 million in “nonoperating” gains from changes in value of its convertible debt, foreign exchange and other items.

Aphria also used this carefully selected financial information packaged into familiar jargon — earnings before taxes, interest, depreciation and amortization — to maintain the appearance of profitability. Ebitda is already an adjusted number, so the term “adjusted Ebitda” is an adjustment of an adjusted number. Welcome to pot stocks, enjoy the adjusted Ebitda.

CEO Simon himself is no stranger to inventing new ways to describe profits. While running Hain Celestial, Simon asked investors to monitor “adjusted net income,” removing items that appeared central to his strategy of rolling up niche organic-food businesses. The tactic appears to have obfuscated the company’s profits and issues surrounding the company’s distributor discounts, which came to a head several years ago, forced Hain to delay its financial results (Ultimately the company concluded there was no wrongdoing and the resulting adjustment had no “material” impact on its finances). After an activist investor insisted on board changes, Simon departed the company more than a year later.

Regardless of Simon’s past creative definitions of profit, weed companies such as Aphria have taken to using it as a substitute for standard figures and are expanding its definition to include accounting that goes well beyond what the acronym typically includes. And because it’s not an accounting principle recognized on either side of the border, cannabis companies are free to define it how they please.

Simon says: let there be profit. Maybe so. Until there isn’t.

Read all of MarketWatch’s cannabis coverage

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