As you are probably aware, Aphria Inc (TSX:APHA)(NYSE:APHA) has recently been the target of a short seller report alleging that the company purchased fraudulent assets in Latin America at grossly inflated prices in order to benefit insiders at the expense of shareholders.
At the same time, while Aphria’s management has unequivocally denied the accusations, a lot of the short seller’s claims have largely gone unaddressed in an official capacity, particularly the apparent conflicts of interest between Aphria insiders and associates and the purchased Latin American companies, as well as evidence (or lack thereof) for the actual physical existence of the said companies.
Whether you believe Aphria is an innocent victim of a frivolous short attack or that it is guilty of rampant fraud, the prudent course of action if you’re looking to start a position anytime soon is to simply discount its questionable Latin American assets entirely. Fortunately for Aphria, these companies, even if they do not exist, represent a tiny fraction of Aphria’s forward earnings. So, let’s look at what Aphria does have.
First, Aphria’s Canadian operations are 100% verifiable. For example, Aphria has supply agreements with every province in Canada, such as annual commitments to Quebec, New Brunswick, Manitoba and BC for up to 12,000 kilograms, 2,500 kilograms, 2,700k kilograms and 5,000 kilograms, respectively.
Second, aside from the provinces, Aphria has supply agreements with other companies in the cannabis space, including a wholesale agreement with Emblem Corp (CVE:EMC) for 175,000 kilograms of dried flower over a five-year period.
Third, Aphria is a very low-cost producer. Aside from the last quarter, which saw a one-time logistical adjustment to its cultivation facilities, Aphria’s cash-cost per gram usually comes in around $1, or roughly 20 to 30 percent less than the peer average.
Fourth, Aphria owns the hugely successful Broken Coast suite of products. Based on a popular customer review platform, Broken Coast currently holds over 8,660 product reviews and an average 4.5 stars out of a possible 5 rating, which is far more than any of its competitors.
Given these undeniable competitive advantages, how much then should one be expected to pay for Aphria? Let’s do a quick back of the envelope projection to calendar year 2020 to find out. In two years’ time, Aphria would have finished its ramp up in domestic capacity, and should comfortably be producing 255,000 kilograms annually from its company-wide facilities.
Based on Aphria’s supply agreements, we can expect Aphria to sell at least 75% percent of its domestic total output. Using a blended selling price of $5 per gram and EBITDA margins of 30% (in line with industry estimates), we arrive at 2020 EBITDA of approximately $287 million.
Assigning an appropriate forward multiple is a bit tricky, as it would be naïve for investors to pay the same consensus 11 times 2020 EBITDA that Aphria was previously trading at given all the risk surrounding the stock. To factor in further negative shocks and potential legal overhang over the share price, we must adjust this multiple downwards.
Thankfully we can use Valeant Pharmaceuticals as a proxy. Pre-Philidor scandal, Valeant was trading at 18 times forward EBITDA, and post-Philidor, the multiple had contracted by roughly by 50%. Applying the same “scandal” contraction, we can assign a 5.5 times forward multiple to Aphria’s earnings, and adjusting for cash and debt and dividing by diluted shares, we arrive at a fair value post-scandal price of approximately $7.50 per share, or a 50% upside from Wednesday’s close.
In other words, even after discounting its Latin American operations entirely and taking into consideration all the regulatory and legal concerns surrounding the stock, the current price presents a buying opportunity, and it’s a risk worth taking.
