Upcoming Aphria Inc (TSE:APHA) Extraction Division Could Be a Key Momentum Driver

Benjamin A. Smith
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Following its worst weekly performance since the Hindenburg Research debacle, Aphria Inc (TSE:APHA) (NYSE:APHA) (FRA:10E) investors face a conundrum: throw in the towel or ride out the storm, hoping that new management can turn the company’s operating performance around. Fortunately, the latter is poised to receive a boost as the company’s Extraction Center of Excellence will soon enter mainstream consciousness. We look at the importance of this under-appreciated and upcoming catalyst.

Before we go there, we’d be remiss to recap the unfortunate week that was.

As referenced, APHA had its largest fall in percentage terms since Hindenburg hit Aphria in early December 2018—falling ↓20.69% on the NYSE, and ↓23.56% on the TSX. Selling was predominantly triggered by a negative response to Q3 2019 earnings, which saw a $50 million non-impairment charge to the carrying value of LATAM assets, in combination with domestic cannabis sales volumes which decreased ↓32% sequentially. Although the latter wasn’t demand-oriented and linked to utilizing additional rooms for plant propagation, this current “show-me” market dropped the hammer nonetheless.

As a result of the LATAM write-down, additional $30 million in non-operating losses, and falling core cannabis sales, Aphria’s quarterly net loss soared to $108.2 million—or $0.43/share—in Q3 2019. Yikes.

Further fueling the dysphoria was an announced US$300 million convertible senior note offering, which will pressure Aphria’s balance sheet by committing the company to large semiannual coupon payment obligations—and possibly become dilutive in 2024. While there’s nothing concerning with the financing or terms (most of Aphria’s peers have conducted similar deals), timing couldn’t have been worse following its tepid financials. The market responded to the double-gut punch by pounding APHA mercilessly into submission all week. There was literally no meaningful bounce-back attempt.

If there’s a silver lining in this scenario, it’s that everything that could go wrong did. By jettisoning several pieces of bad news concurrently, Aphria fronted their dirty laundry and put the worst behind them. The material factors leading to this week’s drubbing: the LATAM impairment charges; plant propagation issues; soaring “all-in” cost of goods sold (and more), should mitigate themselves in subsequent quarters.

Looking forward, what Aphria arguably needs now more than anything is that decisive narrative-changing catalyst investors can rally around; the type of positive impetus the market hasn’t witnessed since the Hindenburg affair. Although the provisional approval in Germany for cannabis cultivation license was a good candidate, APHA barely flinched the day it was announced. Apparently, it’ll take more than 1000 kg/year of Deutschland grow to get investors fired-up (too long-cycle?).

We think that time may be approaching. While I’d posit this upcoming catalyst is still a few weeks away yet, it carries the potential catalyst to spark animal spirits in APHA stock. Consider this an early-warning signal rather than an outright call for action. Ironically, it was initiated by the old guard the Special Committee chose to replace.

Aphria’s Upcoming Splash Into The Hot Canadian Extraction Market

While the Canadian cannabis sector—as defined by Horizons Marijuana Life Sciences Index ETF components—has been weak lately, specialty cannabis extractor stocks have been scintillating. Industry leaders such as MediPharm Labs, Valens Groworks and Heritage Cannabis have remained red-hot for most of 2019, as valuations are less aggressive than many over-extended LPs and oil/concentrate overcapacity isn’t a concern. The upcoming evolution of Canadian edibles market in calendar Q4 also provides the basis for additional future demand and tolling opportunities. It’s set up ideal conditions for investor rotation into the extractor sub-sector.

Up until now, Aphria hasn’t been part of this conversation. The company does produce a limited amount of cannabis oil and sprays, but they are predominantly known for their expansive greenhouse cultivation (current production capacity 115,000 kg/year), mid-term capacity of 255,000 kg/year (pending Health Canada approval of Aphria Diamond), and expansive international asset portfolio. Whatever extracts Aphria does offer frequently sell out—despite holding 836.5 liters of cannabis oils used in softgel capsules in inventory.

But with the emergence of Aphria’s Extraction Center of Excellence (ECoE), all this is about to change. Within weeks, Aphria will vault from menial player with modest processing capacity to among the biggest extractors. On sheer extraction capacity per kilogram of biomass, Aphria’s poised to become a Top 5 player in Canada. Here’s the competitive breakdown.

Company Annual Extraction Capacity/input (kg) Comments
Heritage Cannabis up to 300,000 throughput via its Falkland and Fort Erie facilities
MediPharm Labs 250,000 kg over 7 extraction lines expected
Additional 75,000 kg of dried cannabis extraction capacity in Australia expected 2H 2019
Valens Groworks 240,000 kg confirmed throughout right now
Radient Technologies 200 kg/day ~ 73,000 kg /annualized
~1,500 kg-10,000 kg/day depending on feedstock, once Edmonton II facility complete; 1Q fiscal 2020
Aphria at least 240 kg (current) + *200,000 kg ~200,240 kg
*ECoE final completion expected sometime in the month of June
Neptune Wellness 200,000 kg
imminent; input capacity from 30,000 kg to 200,000 kg of dried cannabis expected March 2019

From a valuation standpoint, an intriguing aspect is that the ECoE doesn’t appear to be priced into APHA stock. Although I don’t have complete access to all Aphria research reports, the few I’ve seen do not factor the ECoE into the company’s valuation model.

For example, Haywood Securities doesn’t mention the Extraction Center of Excellence at all in the firm’s Asset Review Highlights Value Disconnect report disseminated January 10, 2019. Nor does GMP Securities identify the ECoE as a potential catalyst even while upping their price target six days ago. In both cases, low relative peer valuations and Aphria’s large upcoming production footprint are the core basis for each firm’s buy recommendations. Same as it ever was.

To this we ask: how long before the investment banks start factoring the ECoE into APHA’s valuation model? How long before said price targets increase $1-$3 per share as the variables and intentions surrounding the ECoE become more clear. On an undiluted basis, both MediPharm Labs and Valens Groworks are valued at $556.5M and $357.0M, respectively. Perhaps such relative valuation increases are the kind of rough expectations investors could expect once the sell-side analysts do the number crunching.

If we’re reading this right, Aphria’s upcoming “extraction catalyst” could act as a material tailwind on its stock price. But it may not happen just yet—there’s still a few steps that need to occur before projections take shape.

Still Some Hurdles To Climb

Unlike the model employed by other specialty extractors in the space, Aphria’s ECoE appears to be specifically geared towards the edibles market. The project was originally announced back in June 2018, in the middle of cannabev fever gripping the sector. Although that objective could change, a primary intention was to attract a multi-national beverage partner to the table, using their low-cost and scalable production capacity as the bait. If this roadmap remains true today, we think analysts could be waiting for further clarity on upcoming Canada edibles regulations before pricing-in assumptions.

Furthermore, license timing remains an open question once the ECoE officially opens for business. That could take several weeks to several months, as Health Canada granting methodology remains a crap shoot. Ideally, Aphria would receive clearance before edibles become legal in October, but this is supposition. The truth is, nobody knows—although we’d note that lack of license procurement has not stopped analysts from pricing-in 255,000 kg/year production capacity assumptions for Aphria Diamond, and previously, Aphria One.

Keep in mind that ECoE completion timelines have been delayed twice before. Originally expected to be completed in March 2019, it was later pushed back to May 2019, and now “into the month of June” according to latest disclosure. These delays could be keeping the analysts from projecting.

The good news is, ECoE project timelines are becoming more exacting. According to Aphria’s Management’s Discussion & Analysis filed April 15th, “As at February 28, 2019, the Company has spent approximately $38.7M of its expected cost of $55.0M budgeted, for the completion of the Extraction Centre of Excellence.” In other words, 70.36% of the intended budget had been spent as of seven weeks ago, implying the facility is in the latter stages of completion.

This was echoed by Interim CEO Irwin Simon in Aphria’s post-ER transcripts, when he had this to day when asked about ECoE construction progress:

“So, in our MD&A, this morning, we announced that the construction will be finalized about two weeks later than we had originally anticipated, that’s going to push final completion into the month of June.”

Once these issues receive more clarity—especially how final HC edibles regulations will look like and additional management guidance on ECoE’s operating model—we expect Bay St. analysts to act.

Final Thoughts

With Canadian extractors becoming the darlings of the 2019 Canadian cannabis trade, we think Aphria has a real opportunity to join that conversation shortly. With over 200,000 kg of annual extraction capacity projected, the company will become a Top 5 industry player in Canada within the next couple of months. Furthermore, few (if any) investment banks have seemingly baked Extraction Center of Excellence revenues into the cake, leaving the possibility for upsized price targets and revamped projections going forward. This should act as a tailwind for APHA stock.

Most importantly, Aphria may finally attain the defining catalyst it needs to add life to its ho-hum stock price. After all, the company isn’t just another LP producing a lot of cannabis with long-cycle international revenue expectations. It will become a major player in the hottest segment of the market, with edibles legalization just a few months away.

Keep in mind that unlike the specialty extractors, Aphria will be cultivating its own mass supply, which opens the possibility for CPG joint ventures or equity-stake partnerships. That narrative isn’t new, but it’s an important differentiator specialty extractors with white label/outsourcing business model don’t have. Whether a premium should be afforded to this aspect remains unclear, but it surely can’t hurt.

Whatever happens, we believe current/potential investors should start factoring Aphria’s upcoming ECoE emergence into individual investment equations. Its potential as a momentum changer is too material to ignore.

Benjamin A. Smith

Benjamin A. Smith

Ben is a research analyst and capital markets professional with nearly 20 years of experience. His areas of expertise are broad-based, and include extensive knowledge of macro economics, stock/derivative trading, commodity complexes, cryptocurrencies and technical/quant analysis. He also maintains an particular affinity for U.S. politics and the macro-regulatory environment facing...
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