As far as large-cap Canadian limited partnerships go in the cannabis space, Aphria (NASAQ:APHA) is an intriguing option. Indeed, it’s a company with operating scale, is producing cannabis at a positive EBITDA margin, and has some international growth prospects. Investors in APHA stock seem to have a lot to like right now.
Additionally, the company’s recent deal to merge with Tilray (NASDAQ:TLRY) has stoked further interest in this name. The company expects to generate $78 million of annual pre-tax cost synergies as a result of the deal. Furthermore, the combined entity is expected to be the largest global cannabis player post-combination. For investors looking for size and scale, APHA stock has been a go-to investment of late.
However, it appears momentum is on the downside right now. Since hitting its 52-week high of more than $32 per share, investors can now pick up APHA stock at a 50% discount. This may seem like an attractive opportunity, considering the company’s leadership position in the legalized Canadian market.
That said, there’s a reason for this drop. The company’s valuation has always been a problem for shareholders, and absolutely went bonkers during the retail investor-fueled rally earlier this year. Additionally, this remains a company that’s largely locked out of the U.S. market. For those banking on federal legalization in the U.S., that’s not a good thing.
Let’s dive into these catalysts a bit more for investors wondering why shares are underperforming as of late.
Valuation Problematic for APHA Stock
The valuation of most cannabis producers has always been a problem for me.
Indeed, as a conservative long-term investor, grappling with outlandish growth estimates is something I have a hard time doing. I spend most of my time looking at the historical performance of a company as a baseline for projecting forward-looking growth. That’s meant I’ve missed a few opportunities here and there. I’m okay with that.
Maybe I’m completely missing the boat right now with cannabis stocks. Indeed, I can agree there’s a tremendous amount of growth likely long-term. However, how much I’d be willing to pay for that future growth is of utmost importance to me.
There are a range of different estimates for Aphria’s valuation multiple. However, most estimates peg Aphria’s price/sales ratio between 7.4 and 9.21 (subscription required), with a median somewhere in the middle. I’m going to use a rough 10-times sales multiple for discussion here.
Now, as a large-cap Canadian cannabis player, I think this multiple is insane.
First of all, Aphria’s $4.4 billion market capitalization is roughly 2.5-times the size of Canada’s entire cannabis market. In 2020, approximately $2.08 billion of cannabis was sold north of the border.
Yes, sales increased 120% year-over-year, however the initial projections for growth in this sector have been way off-base. Prior to legalization in 2018, estimates were that Canada’s legal cannabis sales would amount to C$6.5 billion ($5.2 billion). That’s a pretty stark overestimation of growth.
Given the massive supply glut that exists in the Canadian market right now, there’s real concern about not only demand growth, but the profitability of this growth over time. Indeed, this glut has grown to 1 million metric tons (or 1 billion unsold grams) of cannabis as of early this year.
In addition to the valuation concerns, another issue I have with Aphria right now is the lack of U.S. exposure.
Unlike U.S. multi-state operators (MSOs), Aphria is largely locked out of the U.S. THC market. Investors seem to be throwing a Hail Mary out there, betting borders will open up and the U.S. will welcome Canadian cannabis with open arms. Biden’s Buy America program suggests otherwise.
I think U.S.-based MSOs are the way to pay the cannabis sector right now, if at all. There’s more growth potential, and a market that’s not completely overloaded with excess supply right now.
At 10-times sales, with deteriorating margin expansion potential, there’s no way I can make sense of Aphria’s valuation today.
Accordingly, those investors that doubled their money this year may want to take it off the table. Aphria looks like too much of a gamble to me right now.
On the date of publication, Chris MacDonald did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Chris MacDonald’s love for investing led him to pursue an MBA in Finance and take on a number of management roles in corporate finance and venture capital over the past 15 years. His experience as a financial analyst in the past, coupled with his fervor for finding undervalued growth opportunities, contribute to his conservative, long-term investing perspective.