Replies to post #115634 on Canopy Growth Corp (WEED)

[Dogger05]

Thank you happyglass. I wasn’t comparing the 2 companies from an operational standpoint. My concern was I’m hearing similar things on this board that I heard from the Nortel employees. Accumulate, average down, buy some more, what a bargain these prices are...etc etc etc....I truly don’t want to be known here as uncaring towards my fellow human beings, but there are a few here that rub me as arrogant. I have taken a lot of abuse (not too much lately, as my prediction comes to fruition) because I dared speak negatively about their beloved stock. I truly tried to provide an unbiased point of view and hopefully some took it that way. Best of luck to you!!!

[FUNMAN]

Best cannabis article I've read in months. Very interesting total industry recap.

Weed And Beer: Canada Is Not Dry
Nov. 18, 2019 6:44 AM ET

Read the article at this link to see all of the illustrations or just continue reading the text below.

If you are not afraid to click on links, you really want to read it at this link.

https://seekingalpha.com/article/4307377-weed-beer-canada-dry

Summary

* There are many regulatory obstacles to the cannabis business globally. Investors must take this into account when investing now. Do not underestimate the risk.

* But, imagining a future where these issues become more settled in the US and elsewhere, the cannabis industry begins to look a lot like the brewing industry.

* In bifurcated brewing, we see a giant global conglomerate with hundreds of brands under their umbrella, a few smaller conglomerates, but also many small, local breweries.

* With their early adoption of legalization and regulation, the Canadian cannabis companies have a great shot at being like InBev from Belgium.

* I will look at the five largest Canadian cannabis companies. As recent events have shown, the risks are still large and the payout long term. Be careful.

Two Great Tastes that Taste Great Together

Here on the Left Coast, we have long known the pleasures of a local craft brew and the produce of Humboldt County, but it seems everyone else is catching on. According to the Brewers Association, a craft beer trade group, in 2018 craft beer accounted for 13.2% of US beer sales by volume and 24% of retail sales by dollars.

At the other end of the spectrum is AB InBev (BUD) with over 500 brands, more than double the number of the larger regional breweries in the Brewers Association data (there are many more in the smaller categories). Their 2018 global gross profit was more than all US craft brew retail sales.

Generally speaking, why this bifurcation has happened:

* There is very low barrier to entry to start a microbrewery and build from there. It’s a crowded market, but small brewers have gained market share in the US because of changing consumer taste and effective marketing.

* But there are also tremendous benefits, especially in distribution, to market concentration.

* Another benefit to concentration is that beer is not just competing with other beers, but also things that aren’t beer, like wine, spirits, new concoctions like hard seltzer, cannabis, and temperance.

All these same things are true of cannabis as a product. There is a low barrier to entry and consumer taste for small-batch artisan brands. At the same time, there will be huge benefits to scale here; like in brewing, global production/distribution, and variety of product and brands will be key. So I imagine a future where the global cannabis industry looks very much like brewing.

The investor’s question becomes: who is going to be the AB InBev of weed?

With legalization and regulation, Canadian companies have the early edge here. There is no substitute for having access to capital markets, transportation, banking and insurance services, and having your product treated like any other regulated product.

As contrast, here in California, most of the retail, and still much of the production and wholesale business, is done uninsured with cash and private financing. Production and retail are autarkic to a large extent and only extend to the borders of California. When neighboring Nevada first started recreational usage, retail supply dried up within hours in Las Vegas. At the same time, there was a glut of supply in California, and wholesale prices were plummeting, but no way to legally ship it across the border to Vegas. This is not a way to do business.

So Canada has the early edge, but there are still huge headwinds here. The domestic market in Canada is relatively small; there are only 37 million Canadians, 2.5 million fewer than just Californians. For a while, they are dependent primarily on their domestic market. There’s money to be made there, but the brass ring is the globalized conglomerate model, and that is still emerging. There’s really no telling when that might happen, so the challenge here is to develop that international footprint and vertical integration, remain nimble in a fluid environment, while trying to be profitable in the short term with those 37 million Canadians. As we have already seen, this is not easy to pull off.

If you are looking for near-term growth opportunities, the Canadian domestic market is not it. It is the diving board, not the deep end of the pool.

We are now four reported quarters into this most Canadian of experiments. We will look at the Canadian Quints — the five Canadian companies with EVs over one billion USD — and see where they stand at this milepost.

Cannabis Cultivation

Just a few items to inform some of the discussion. Broadly, there are three ways to grow cannabis.

Indoors. This is the most expensive way to grow cannabis, but can result in the highest quality dried flower, AKA “weed.” There are added inputs for lighting and environmental control, and it doesn’t scale as well as the other methods. But it gives cultivators full control over the plants’ environment, and the ability to employ best scientific practices. I believe that top shelf weed production will remain indoors as the industry builds out, despite the costs. Advantage here will of course come with reducing marginal costs without sacrificing quality, which will likely mean scale and automation. Energy consumption and labor inputs are key here.

Greenhouses. Greenhouses have come to dominate Canadian production for good reason. Costs are much lower than with indoor production, and it still provides a controlled environment except for one key ingredient: the sun. This is not something in huge Canadian supply, even in the southernmost reaches of Ontario where most greenhouses are located. This is one of the reasons why obtaining production in sunnier places will be important, though the biggest is that local regulations tend to favor local production. In any event, the Canadians are producing very large crops in their greenhouses.

Outdoors. This is the highest volume, lowest cost environment, but is unsuited to Canada and many other places. The development of cannabis horticulture has been focused for decades on indoors and greenhouses for legal and security reasons, but if that were to change, we could see outdoor cultivation become more prominent because of the cost structure.
To get a crop in the shortest amount of time, seeds are not used, but rather clones off mother plants. These are large plants that are manipulated to never enter flowering stage, and all production comes from cuttings off the mothers. In this manner, a company can turn around a crop every 11-15 weeks (strain-dependent) rather than the 5-6 month natural life cycle. Moreover, it allows growers more control over the consistency and stability of their plant genetics. So these mothers are very important assets.

Emerging Product Trends

Weed will remain a large part of the product mix for the foreseeable future, but there is a growing trend towards extracts and edibles, especially among younger customers. Why is this important for our discussion?

High retail prices on weed are obtained, like most produce, on looking, smelling, and tasting good. Now that lab testing is more common and on the packaging, high levels of THC, the most plentiful of the many psychoactive “cannabinoid” chemicals in cannabis, also is a price-booster. But this also raises costs in production, with added labor and inputs.

By contrast, the cannabis that goes into edibles and extracts does not require that extra labor and inputs to bring out the flavorful “terpenes,” since those cannabinoids are being extracted and put into food, beverage, or some sort of oil medium. Some extract comes from trimmings, what cannot be sold otherwise. The food and oil are what need to look, smell and taste good.

This advantages companies who can grow medium-high THC strains in a low-cost, high volume environment, and can extract similarly. The goal here is to create flavorless, scentless distillates that can be used in a wide variety of end products. This is the Bud Light model. This advantages:

* Companies with scale.

* Companies developing their own strains and brands that are developed for this purpose.

* Companies partnering with food and beverage companies, who can bring that look/scent/taste to the edibles.

* Companies developing new extraction and bio-chemistry techniques, which are patentable.

The other emerging product trend is CBD. CBD is a non-psychoactive cannabinoid that both anecdotally, and now in an emerging body of scientific work, is shown to have a range of medical uses. So far, the most promising avenue seems to be several very serious neurological conditions, but for obvious reasons, there isn’t yet a large body of scientific studies.

But that hasn’t stopped anyone. Breeders have by now developed many strains that are almost devoid of the psychoactive properties of cannabis and have very high concentrations of CBD. The industry has started calling these strains “hemp,” which is a bit confusing. It differentiates it from THC products, especially with regard to US Federal law, but industrial hemp, also just called “hemp,” is grown for the fiber and seeds, and is a different crop.

Extracts and edibles tend to dominate the CBD segment. As much as any part of the emerging cannabis industry, CBD is in the wild west portion of its story, with all sorts of retail businesses selling CBD oils, edibles, drinkables, and topicals with unsubstantiated medical claims in a largely unregulated environment.

But it’s not hard to imagine a regulated near future where there is a larger body of medical research, and CBD prescriptions begin to be covered by third-party payers. Cost versus current medical treatments for epilepsy and other neurological conditions have to look attractive to them. Such a regime would dovetail with many of the advantages in the first trend:

* Companies with scale.

* Companies that have their own robust breeding program.

* Partnering with food and beverage will also be important, as this may be the preferred product for patients.

* Partnering with pharma will be even more important eventually for distribution.

* And again, patented extraction and bio-chemistry will be a key advantage.

So both these trends point in the same direction: greater scale, greater R&D on new strains, products and patentable techniques, and greater partnerships with food/beverage/topicals and eventually pharma.

So all this informs what we are looking for in a corporate strategy that balances

The limited nature of the Canadian market.
A sustainable capital structure.
With:


* Scalable growth.

* International footprint where regulations are friendly.

* Vertical integration.

* M&A strategy that can build out over time.

* Partnerships.

* R&D and growing patent portfolio.

We are now over a year into Canadian legalization, so it’s a good time to look back and see where it all stands. I’m going to look at the five Canadian cannabis companies with over a billion USD in EV: Canopy Growth (CGC), Aurora Cannabis (ACB), Tilray (TLRY), Cronos (CRON), and Aphria (APHA). We will look at how they are pursuing this strategy, and how their execution has been so far. As always, it comes down to execution.

Evaluating a Brand New Industry

The noble Loonie. Unless noted, all dollars are Canadian. All data from morningstar.ca and company filings. Chris Fournier

Evaluating the performance of these companies one year into a brand new business is challenging to begin with, but when you add in the pace of acquisitions and one-time accounting events, normal analysis sort of flies out the window.

What we are going to see across the board is flattening sales in the wake of the big leap after legalization. The Canadian government and the provinces are mindful that they are first here, and are proceeding with caution. When you compare to California or Colorado, there is far too little retail. There are 24 retail outlets in all of Ontario, Canada’s largest province with 14 million people, 38% of the total. By contrast, according to WeedMaps.com, who track this sort of thing, there are about 300 storefronts in LA County with only 10 million people, and another 900 delivery services.

But the provincial government of Ontario is listening. It isn’t going to happen overnight, but there is a clear path to about 100 stores, and it looks like they will adopt a more market-based approach like the other provinces in 2020, which would explode the number of stores in the province. For the time being, the Canada Quints' biggest competition is the still-thriving untaxed black market. Until there is enough retail and supply in legal channels, and the convenience and quality of product outweighs the extra cost of taxes, the black market will continue to exist.

In the meanwhile, we have these companies ramping up quickly while distribution is being limited by regulation, and as a result the retail price seems to be coming down considerably. We see it in thinning gross margins, and big inventory impairments that show up in the Canadian income statement (not on the balance sheet like the US) as “Fair Value Adjustments.” So clearly, valuing inventories is going to be challenging, as it is in any commoditized market, which is where this is all heading.

But also, putting changes in inventory values into the income statement has a large effect on our usual measures of profitability of operations. There are also other incursions from what we would expect to be on the balance sheet to the income statement in Canadian reporting.

Which brings me to the concept of biological assets, which further complicates the picture. These are mothers, clones, and plants at various life-cycle stages. The value of these assets is literally changing daily, and that also shows up in the income statement. After harvest, it goes to inventory, but it becomes hard to put a value on it, as we have seen for finished product.

So the income statements are not as helpful as with most companies, and we will be focusing mostly on cash flow from operations as our primary earnings metric, since most of the big accounting anomalies come out in the wash there.

So what I am going to be looking at more is:

* What is their strategy, and how does it stack up to what I’ve laid out above?

* On their own terms, how are they executing on that strategy?

* Do they have a sustainable capital structure for this long distance run?

* The Consolidated Canada Quints

First, a look at the consolidated companies, and how each stack up. A couple of data notes before we begin:

1) Unlike the rest who report in CAD, Tilray reports as a US company in USD. Tilray’s numbers have been adjusted for exchange rates.
Aphria’s quarters are a month ahead of the rest, so the periods do not match exactly.

2) Beginning with market cap, as of November 15 close, the Canada Quints had a combined market cap of $13.4 billion USD:

Canopy is the largest, with Aphria bringing up the rear. But when we turn to revenue, a different picture emerges. The Canada Quints had consolidated net revenues of $358 million in calendar Q3 and $1.2 billion in the TTM. The first thing to note is that the full Canadian market is estimated at $6 billion annually, so they are still fighting the illicit market as their main competitor, even with their current $1.4 billion annual run rate from calendar Q3.

But the other thing that pops up is that revenue share does not match market cap. Calendar Q3:

The biggest thing that stands out is the overperformance of Aphria. Only 8% of the consolidated market cap, they captured 29% of consolidated revenues in the TTM and 35% in the last quarter. We’ll dig into this below.

We see two problems for the Canada Quints play out in inventories:

1) Ontario remains a challenging distribution and retail environment.

2) There were also mistakes in projecting final product mix demand.

So consolidated inventories have ballooned up to $845 million versus only $358 million in quarterly sales, for an inventory to sales ratio of 2.4. It will take 2.4 quarters at the current run rate to clear inventories as currently valued.

Canopy is leading the way here with 55% of the total:

Putting it together, the inventory-sales ratios:

Again Canopy comes out looking ugly and Aphria pretty sweet. They had less than three weeks of inventory on hand at the end of August. Canopy will take a year and a half to clear its inventory at the current run rate, and the others aren’t much better.

Bottom-lining it brings the real ugly, with the Canada Quints having negative cash flows from operation to the tune of -$1.3 billion in the TTM and -$429 million in calendar Q3, a -$1.7 billion annual run rate. Canopy again leads the way. The quarter:

Not pretty. The only bit of good news is on the balance sheet. While Aurora and Tilray are in a much more precarious position, Canopy and Cronos have great balance sheets, and Aphria’s capital structure looks sustainable when we dig down.

So three of the five look like they can handle some rough seas like they are seeing right now, but when we dig into Aurora and Tilray, we will see they are on the knife’s edge, and will likely have to tap now-unfriendly capital markets.

Call Me Goliath: Canopy

The 1-year price charts are all so brutal.

Canopy is the best place to start because it lays bare both the promise and challenges.

If you clicked on this article, you are already likely aware that Canopy just reported a pretty brutal quarter with negative gross margins, and -$0.58 cash flow from operations per share.

One bad quarter does not doom Canopy, but rather just highlights the challenges we already knew they were facing. This is still a company with $2 billion in net cash, or $6.14 per share, but they cannot afford to keep blowing through it like they did in Q3. This may be an example of growing faster than the current legal market can handle.

It is covered already here at Seeking Alpha, so I won't belabor the point, but the quarter collapsed for the reasons I described above. They got burnt by over-producing when legal sales channels in the largest province were being constrained. On top of that, based on California and Colorado, they expected oils and softgels to be 15% of sales, and that came in closer to 5% in Canada. That all worked out to about $40 million in various inventory-related charges that show up on the income statement in Canada, and thus negative gross margins. Oof.

They have $2.7 billion in cash, down from $5 billion at the beginning of the year. Assuming they are done with major investments absent some big regulatory shift, operations burned through cash at an annual run rate of $804 million in calendar Q3. So just based on that, they have about three and a half years of cash. But this quarter involved $40 million in extraordinary charges, so pulling that out gives us a -$644 million annual run rate, and more like over four years of cash. So their capital structure is sustainable, even if they have to keep absorbing large losses in the medium term.

But how do they stack up in strategy? Canopy is the company most self-consciously going for the AB InBev model. Then-CEO Mark Zekulin from their June quarter call:

As a first objective, we are focused on laying the foundation for dominance in an emerging global opportunity. To us this means developing intellectual property, building brands, building international reach and ensuring scaled production capability for current and future products. It means having a formula and level of credibility to ensure smooth and efficient expansion into new product forms, markets and channels.

They have invested heavily in a fully vertically integrated Canadian operation from production to retail. They are pursuing recreational, medical, and CBD products wherever the regulatory environment allows. They have a partnership with Constellation Brands (STZ) for beverages which we should see announced soon. They have grown their patent portfolio through their own R&D and acquisitions, and new extract products — “Cannabis 2.0” as they prefer — should be coming soon.

But they have been paying a pretty price to do it:

In the last 9 months they bled off almost $2 billion of cash net debt. Cash flows from investment in the TTM was -$3.8 billion, with $1.7 billion in acquisitions and related costs. But absent big regulatory changes, this will slow down considerably going forward.

So what did they get for all that?

* A fully vertically integrated Canadian operation that can also supply medical products to five European countries, five South American countries, Australia, and South Africa. Did I mention Jamaica? Of course, Jamaica.

* They have 22 owned stores in Canada, and 5 more with partners. They have licenses for an additional 45 in the non-Ontario provinces, but the key will be getting new stores into Ontario once they loosen up the regulations.

* A portfolio of brands led by Tweed, Tokyo Smoke and Spectrum Therapeutics. They also have DOJA, a high-end British Columbia brand, and TWD, their low-cost Tweed offshoot. There’s also Van de Pop, marketed towards women. They also have brands in edibles, drinkables and topicals.

* 130 issued patents and another 300 pending.

* DNA Genetics, a longtime pre-legalization leader in breeding.
Partnership with Constellation, and also beverage and topicals acquisitions.

* Two nice German assets: C3, a producer of pharmaceutical CBD, and Storz and Bickel, manufacturers of high-end medical vaporizers.
A Danish greenhouse for medical production.

* Outdoor growing facilities in Columbia (1.26 sq km) and Lesotho (0.2 sq km)

* A toehold in US CBD hemp farming.

* A partnership with Drake! Drizzy is the most Canadian of all celebrities.

* The Acreage Holdings deal

The Acreage deal is the most interesting part of this. Acreage is a New York company that runs a pretty well-integrated operation in 20 states. Canopy gave them $300 million USD for call options to merge the companies through a stock swap “at such time as the occurrence or waiver of changes in United States federal law to permit the general cultivation, distribution, and possession of marijuana or to remove the regulation of such activities from the federal laws of the United States.” Canopy is required to make the transaction, so long as the regulatory changes happen before 2026.

There’s a bunch of wiggle-room in that quote, but the combined entity would instantly be a North American giant with a lot of room to run. Importantly, it protects Canopy in that early US-legalization period, where the danger to the Canadians is getting swamped by larger US firms once they have access to capital markets.

But execution has been poor, and management has acknowledged as much both in words and deed. CEO Bruce Linton left the company, and the rest of original management is soon to follow once they can find a new CEO who can get his or her arms around this now fairly large multinational company.

The biggest near-term issue new management will face is still dealing with their inventory overhang. They say they are in the right position now, but the numbers don't tell the same story. They are switching to US reporting next quarter, where these inventory charges all stay on the balance sheet. Look for them to take more impairment there.

But even with that, their balance sheet is healthy, and they will be able to weather this storm, and maybe one or two more.

Balance Sheet Bad Boys: Aurora and Tilray

(Reminder: Tilray reports in USD which have been converted to CAD.)

This is already a long article, so I won’t waste space on these two except to warn you off. They have problems on the balance sheet, and both will likely have to hit capital markets within a year. Those markets are likely to be unfriendly.

For starters, large negative cash flows from operations:

Canopy booked loses more than both combined in calendar Q3, but they also have $2.7 billion in the bank. Aurora has $237 million cash, or 2.5 quarters at last quarter’s operational burn rate. Tilray has $122 million cash, or 2.15 quarters at last quarter’s operational burn rate.

Tilray management said they will have positive EBITDA in the current quarter. You tell me what you think of that claim:

Aurora does have one big thing going for them, which is likely why the stock price had remained buoyed despite their cash situation and poor execution. They are very attuned to using best cannabis horticultural practices, and are the leaders in high-quality production at low unit cost. They came in at $850 per kilo cash cost this quarter, which is lower than everyone else by a lot. They also did not see the same margin thinning on the retail side that the others saw, because they produce a high-quality product.

So Aurora has a real compelling element, one which is a crucial part of the preferred strategy. Likely they are going to have to keep going to capital markets and sell more US shares in 2020, so now is not the time for them. They are likely still inflated in price.

But I have a feeling we will be returning to Aurora at some point, just at a lower price, even after this collapse. If it crosses $1 billion USD market cap headed in the wrong direction, it all of a sudden becomes an interesting merger for a company with a higher marginal cost structure like Canopy.

The Marathon Runner: Cronos

Cronos is sort of a special case. They got a $2.4 billion dollar investment from Altria (MO), of which $2 billion remains. They are being super-cautious, with an asset-light model, mostly focused on production and product/brand development.

But they also have the lowest sales, only 4% of the total. Though their inventories did not explode like Canopy, Aurora and Tilray, their revenues are so small that they still have a year of inventory on hand at last quarter's run rate. Not having retail may be hurting their sales. They may have recognized that, and set up a joint venture with MedMen, a chain of high-end US dispensaries (“the Apple Store of weed”), to open up retail in Canada. They have very limited international distribution.

They have production at their Canadian Peace Naturals facility, and more coming on line in Canada and Israel. The new Canadian greenhouse is a 50-50 partnership with Bert Mucci of Mucci Farms, a large-scale greenhouse operator with 60 years experience in Canada. This will be a key advantage in keeping marginal costs down and yields up. This facility will likely not be operational for another year.

They have the third highest R&D spends of the Canada Quints, and have focused on extraction, fermentation, vaporizer hardware, and skin care topicals.

But as I said, execution has been particularly poor, with only $35 million in revenues in the TTM. They believe the unregulated US CBD market may become even bigger in the near term than the Canadian market, and the partnership with Altria will certainly help with distribution into liquor stores, gas stations, convenience stores, and the like.

So Cronos has so much cash, and the smallest business on several measures, that they have cash to burn for the foreseeable future — 75 quarters at the current quarterly operational cash burn rate. At this point, they almost resemble an investment fund that is waiting for the opportunities to come a-knocking.

On the one hand, this may ultimately be the correct strategy — this is not a sprint. They have the Altria global distribution network at their back, and they can be more choosy in when and where they want to invest, and hope to use that muscle to fill distribution channels. But trying to ramp up ad hoc as regulations change may turn out to be too difficult in the end.

Cronos is going for the same model as Canopy, but in an entirely different way. Canopy has front-loaded their investments, and retained sufficient cash for the medium term. They believe that being prepared for the opportunity as soon as regulations permit will be the key to success. They are running a 10K.

Cronos is running a marathon. They are keeping their powder dry, and waiting. Obviously, this quarter, that looks a lot smarter than Canopy, who jumped out ahead and is now saddled with a ton of inventory. Even if Cronos wrote down every dollar of their inventory tomorrow, $54 million, it would make little difference to their balance sheet or current ratio, now at 3.45.

But whether this is a 10K or a marathon will be determined by the pace of regulatory change, and is entirely out of the control of either company.

The Sleeper: Aphria

(Reminder: Aphria is a month ahead of the rest in their reporting, so the last quarter ended in August, not September)

Aphria is the smallest of the Canada Quints, but by no means worth ignoring. They are currently more focused on staying profitable in the Canadian market, but still have a growing international footprint, mostly on the distribution side. Like with Cronos, this slower-growth model may turn out to be the more sustainable choice.

As of last quarter, over 90% of their production comes from a single recently expanded greenhouse facility, Aphria One. They have just received permitting from the government on a second facility. It is a joint venture with Double Diamond Farms, a large-scale grower of greenhouse produce. Like with Cronos’ Mucci partnership, this is a differentiator moving forward. The new Aphria Diamond more than doubles their capacity.

Through acquisition, they have distribution of medical cannabis in a variety of places where it is legal in Europe, Latin America, the Middle East and Africa. And Jamaica, naturally. They have a German production facility with EU certification pending, and a 30% interest in another facility in Lesotho that gives them controlling interest over part of the output. They are only one of three companies granted a production license in Germany, but this will be three regulated medical strains destined for pharmacies in Germany. The good news is that it is covered by third-party payers, so it will be interesting to see where that goes on the medical front in a large domestic market with insurance. In any event, it’s a nice toehold into the German market should they adopt recreational legalization. They also bought a German pharmaceutical distributor, and took a 25% stake in a Berlin hospital, so they are looking to vertically integrate their German medical operations.

Right now, almost all distribution is supplied by that Aphria One facility, and the Diamond facility to come on very soon, but their acquisitions have given them a range of licenses, including production and export licenses they can leverage in the medium term.

They are still in watch-and-wait with the US market, with no significant investments to speak of.

But what interests me the most about Aphria is their focus on adopting best practices from agriculture, and automating production, and this is where the Double Diamond partnership is key. Cannabis cultivation is very labor intensive traditionally, and they have automated large portions now. The entire Diamond facility is built around this model.

This goes back to the extract/edible/drinkable/topicals market that is growing, and I think will continue to grow. The advantage here, as I said, will be to companies who can produce at scale, with a high THC/CBD to square meter ratio, keeping marginal costs low, while still producing medium-high quality cannabis or hemp destined for extraction. The Bud Light of weed. Another key, as I said, will be patented extraction techniques that produce a pure, tasteless, odorless extract usable in many ways.

It’s unclear exactly where Aphria is on the extraction part, but they seem very focused on the first part of that equation. Because of their size and this focus, I think they make for an early M&A target when we reach the consolidation phase of this journey.

Adding it all up:

* They are the smallest, but seem to have a nice scalable model for production in their Aphria One facility.

* Their international footprint is primarily in distribution. The toehold in Germany is very interesting here. They are being hesitant with the US, which may turn out to be the wise choice.

* They are not as vertically integrated as other companies, though the German medical operation is moving towards that.

* Their M&A strategy has been less aggressive than others, and there are big holes in their portfolio. They do not have a ton of capital for new acquisitions.

* Their most important partnership is with Double Diamond. They don’t have any with food/beverage/topicals.

* They have invested in automation, but not as heavily into extraction as others.

So how are they executing on their objectives? Cash flows from operations per share are not so rosy at -$0.12, but their loss margins are far better than their competitors. They have two quarters in a row with revenues over $125 million, also far better than their competitors.

They have a sustainable capital structure, though their cash net debt just dipped below zero at the end of the quarter. They have no large debt repayments in the near term, and at current operational cash burn, they have 15 quarters of cash.

Since they have put so much focus on automation, and scaling the Aphria One facility, we should look at how that is going. So far, not good; their cash cost per kilo was actually up last quarter from $1350 to $1430. What happened was they dedicated a portion of their grow space to growing new mother plants both for the Aphria One expansion, and the new Diamond venture. This lowered the output of the facility considerably, and they are still not quite done, so it will linger into the current quarter. But they claim once that’s done they will have their cash cost per kilo under $1000, which is a huge margin improvement. This would give them one of the lowest cost structures for medium-high quality production, the only one close to Aurora’s $850.

All together, Aphria is being circumspect and choosy in their investments. They have been more aggressive than Cronos, but without the Altria cash. The result is the highest revenues, the lowest losses, and a sustainable capital structure. But also they lag in international reach, patents, extraction, and vertical integration as a result. They lack the capital right now to make any further major investments.

Risks to the Canada Quints

The number one risk here is regulatory. Canada continues to march forward in the slowest, and most deliberate of Canadian ways. But there are no guarantees that legalization will proceed globally, or that it will proceed in a way favorable to multinationals. There is a huge amount of uncertainty here, and as the recent vape scare has shown, there are all sorts of negative developments that can derail the long-term plan, as good as it may be. Trends of course are in the right direction now, but Canada remains the only country with broad legalization, and there are no guarantees anyone else will follow.

In the near term, the course set by the Ontario provincial government will be key. If they allow a market-based approach, we may begin to see some positive cash flow. For now, the illicit market remains the biggest competition in Canada.

The next biggest risk lies to the south. Adding up both legal and illegal markets, the US dwarfs the Canadian market. Were Congress to take cannabis off Schedule 1 tomorrow, it would likely be the worst thing that could happen to the Canadians. If US companies had access to capital markets, interstate commerce, banking, insurance and transportation services this soon, before the Canadians can scale elsewhere, they would likely swamp the Canada Quints. Their sweet-spot scenario is that they can build scale internationally in smaller markets in Europe and elsewhere, and have enough muscle to fight off challenges from the south.

Only Canopy has a buffer against this with their Acreage deal.

One of the big challenges that the US poses is outdoor cultivation, which is the lowest marginal cost way to grow. Canada is pretty unsuitable for this, but there are plenty of places in the US, Latin America, Africa, Asia and the Mediterranean that are. Not that much land is required to grow a large amount of cannabis. As I said, the previous decades of cultivation development were geared towards developing indoor strains, and now greenhouse strains. There has been very little attention paid to strains that can thrive outdoors, adapted to microclimates. But if there were full legalization in the US, we may see that change, and outdoor cultivation could swamp a lot of the greenhouse production.

Another big risk is the mysterious vape disease seen mostly in the US. Much is unknown, so I won’t comment besides the obvious. Many of these companies have made big investments here, which could all be for naught if this goes the wrong way. This does not affect their investments in extraction, so much as final product mix they were expecting in the near future, and this would be another near-term headwind.

Relatedly, companies are making big investments in drinkables, edibles and topicals, and these may fail to catch on for any number of reasons.

Recommendations

Not a good week.

Right now, my recommendation is to do nothing. There is still way too much turmoil in valuing these companies.

I turned a quick profit on Canopy during the early bubble days but have stayed away since. But after last week we are now finally past the bubble phase, and I will begin to watch these stocks more closely, primarily Canopy, Cronos and Aphria. I may become interested in Aurora if it gets super-cheap.

Tilray, I fear, is a lost cause. If they actually show positive EBITDA this quarter I will reevaluate, but I just don’t see that happening. You could hear the incredulity of the analysts on the call over this claim, and I share their skepticism. With this whopper sitting out there, it’s hard to take anything else management says seriously.

The big near-term trigger for the industry will be how Ontario decides to go. A lot is riding on that, but it looks like good news is coming.

Canopy:

* They most closely match the preferred strategy we laid out in the open.

* But they have paid a heavy price to do it, and made mistakes along the way.

* Despite that they remain well-capitalized for the medium term.

* Much will be riding on new management, and how they decide to move forward with the challenges they face.

I will be watching new management closely, and will not make a Canopy investment until I see what their plan is. I can tell you right now, if it is a McKinsey-type who will hollow out the company to make it look like progress, they will gain a bear here.

Cronos:

* They have the slowest buildout, and $2 billion of Altria’s cash left.

* But sales are very low as a result.

* They are waiting for regulatory triggers to put that cash to work.

* This may turn out to be the right choice, but it also may be difficult to ramp up quickly to enter new markets as they become legal.

This is also a watch-and-wait situation. Before we get a sense of how they intend to use all that dry powder, it’s too difficult to evaluate.

Aphria:

* They have the lowest market cap, but the highest revenues, and lowest operational loss margins by a lot.

* Despite the small size, they have a decent international presence.

* They have nice scalable greenhouse models in Aphria One and the new co-owned Diamond facility.

* They are invested into automation, and are moving towards the second lowest cash cost per kilo.

I’m not quite ready yet, as I’d like to see some more stability in share pricing, but Aphria is the one I am most likely to dip into first. Like Aurora, they are moving towards very low marginal costs. But unlike Aurora, and every else for that matter, they are actually executing fairly well in a tough environment. They are the most likely to be showing positive operational cash flow in the near-term.

Also, I like them or Aurora as an early merger candidate for Canopy. Canopy could use some help getting marginal costs down, and it looks like Aphria can help with that.

Aurora:

* They are the leaders in high quality production at low marginal cost.

* But execution has been otherwise abysmal, and they will likely be hitting up capital markets soon like Tilray.

Until they can get their balance sheet situated, or stop having large losses, Aurora is a no-go. But that first bullet makes them super attractive as a takeover target, should the share price continue to fall.

Now that bubble is popped and we have returned to reality, I will begin updating every quarter. See you in three months.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.