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Editor's Note

Below is a complimentary research note from our Cannabis analyst team. If you are an institutional investor interested in accessing our research email sales@hedgeye.com.

Elevating Aphria to Best Idea SHORT | $APHA - cannabis 2152605 960 720

We are elevating Aphria (APHA) from our SHORT bench to a Best Idea SHORT

HEDGEYE OPINION

Aphria's interim CEO Irwin Simon is at it again. APHA’s stock popped up as much as ~27% in early trading today, after being one of the worst performing LP’s in the last month. Is this positivity warranted? Not in our opinion.

The point many like to bring up is that APHA trades at a significant discount to competition, especially given its revenue advantage (most of which is driven by a German distribution business), which is true. But we believe the discount is warranted due to our thinking that APHA will merely be a farmer/distributor long-term and likely supplier to more strategic players in the space.

CC Pharma just reported an adjusted gross margin of 12.8% (vs. APHA cannabis gross margin of 49.8% - which is declining) and will represent more than half of sales in CY20. You can’t give a premium multiple to a company that is primarily a distributor in a foreign country.

After the build-out of their current planned capacity is complete, they will have 255,000 kg/yr of capacity in Canada, an amount high enough to support roughly 25% of projected long-term Canadian demand.  Yes, European markets can be a near-term region to accept exports, but we don’t deem that to be a viable long-term solution.

For now APHA has a decent cash position, but continued cash burn, and unrealistic top and bottom-line expectations for the next 12-months and beyond will come back to bite management.

1Q20 SUMMARY

APHA reported revenues of C$126.1M vs FactSet C$131.1M, the top-line miss was driven by a slowdown in sales at CC Pharma (German distributor). Sequentially from 4Q19, Net revenue was down 1.9%, led by the previously mentioned reduction in distribution sales, down -3.9%, while net cannabis revenue was up +7.6%. KG equivalent sold were up 7.1%, there was a slight increase in average selling price to $6.02 (before excise tax), from $5.73 last quarter due to a positive mix shift. APHA beat on adjusted EBITDA, C$1.0M vs FactSet -C$1.1M. There was a meaningful spread in consensus estimates for adjusted EBITDA (-C$4.9M to +C$2.7M) headed into the quarter. In typical Irwin Simon fashion, there were no shortages of adjustments in the adjusted EBITDA…

IRWIN SIMON DOES NOT KNOW HOW TO BUILD A SUSTAINABLE COMPANY

Irwin talks a lot about building a long-term sustainable company in the U.S. over the last 25 years. Hain Celestial, the company he built, was merely a roll-up story, that he eventually destroyed through cost cutting, lack of brand investment and an eventual dry up in the well of small fast-growing companies he could tack on top to maintain top-line growth profile.

We think the same will happen to his plan with APHA, but investors may have already figured it out given the “discount valuation,” APHA is likely going to be a supplier of raw materials to extraction and branding companies in the future.  Irwin talking about “getting the best shelf space” and “branding” like cannabis is a traditional CPG industry today. It may be in the future, but that is not today’s game in Canada.

For anyone that has walked into a legal Canadian dispensary they should understand Irwin is a little out of his element with these comments. Irwin also maintained his thinking that dried flower would represent 60% of sales, vape would be 20-30% and then other derivative products would make up the remainder. Not exactly sure what is driving these assumptions in their model given what has transpired in developed US adult-use markets (flower trending closer to 30-40% of sales), maybe APHA’s lack of capabilities in alternative platforms.

HEALTH CANADA (HC) – VAPING

Aphria somehow getting expedited approval of cultivation facility, but management said HC didn’t contact them to discuss vape, while we know HC has contacted other LP’s. We are not believers that HC has not reached out to APHA (it’s just easier for management to say, “no we haven’t heard anything from them”), and this sends a more cautionary tone on vape in the near-term in our opinion.

GUIDANCE IS QUESTIONABLE AT BEST

Management reaffirmed guidance for revenue at C$650M to C$700M vs FactSet C$635.4M and Adjusted EBITDA of C$88M to C$95M vs FactSet C$57.7M. Furthermore, management doubled down on their target to achieve C$1B in annualized cannabis revenue by the end of CY20.

Management reported a current market share of 12% (extrapolating off of Ontario data), the legal cannabis sales market is currently run-rating at C$1.3B and the illegal market is estimated at C$4B, for a total of C$5.3B. Let’s assume for fun that all black-market sales convert to the legal market in the next 12-month, we do not endorse this thought at all! For APHA to achieve C$1B in sales they would need to grow market share from 12% to 19% in an increasingly competitive environment where everyone is increasing capacity and improving execution. Not to mention that over that time (and certainly beyond that time-frame), average selling price will decline, hurting that $1B expectation for APHA. Layer on the lack of door growth, excise tax (=higher prices than black market) and restrictive derivative product regulations, this number looks increasingly difficult to achieve.

Management was asked a great question in regards to what they expect from store growth, which they had no answer to during Q&A. Irwin did allude to the thought that Ontario will have 1,000 stores long-term during prepared remarks…his long-term must be really really really long-term.

We will get more into the cash burn and other details in a more detailed report in the coming weeks.

Shayne Laidlaw
Managing Director

Howard Penney
Managing Director

Jordan Minello
Analyst