Dmitry Zaytsev Examines Latest Aphria Inc (TSE:APHA) Financials, Management Changes

Analyst Dmitry Zaytsev examines Aphria Inc’s (TSE:APHA) (NYSE:APHA) (FRA:10E) latest financials and the company’s announcement that CEO Vic Neufeld and Co-founder Cole Cacciavillani are stepping down. Zaytsev is surprised Aphria’s stocked rallied on relatively disappointing financial numbers and believes that the company’s stock bump likely reflected investors’ response to the management change. While Aphria earned a profit of 22 cents per share, Zaytsev cautions that a considerable amount of that profit is due to Aphria’s investments and related activities, not its recreational cannabis revenue. Zaytsev is particularly concerned by the increase in the company’s debt. Zaytsev shares his current Canopy Growth Corp (TSE:WEED) (NYSE:CGC) (FRA:11L1) investment strategy. He thinks Canopy is one of a handful of Canadian names investors should keep because it has significant amounts of cash, won’t have to dilute stock, and will be able to deploy capital in the US.

Transcript:

James West:   Dmitry Zaytsev is here. Dmitry, welcome back.

Dmitry Zaytsev:    Happy to be here as always, James.

James West:   Tell me what you’re buying, what you’re liking, what you’re selling, what you’re hating. [laughter]

Dmitry Zaytsev:    We’re accelerating this process, this whole interview thing. I mean, I bought a bunch of Canopy around a week and a half ago but nowhere near the kind of allocation I wanted for a longer term position, so many only 20 to 30 percent of what I was looking for before this move started going. So very nice move right now; I’ve sort of scaled out a lot of that. Why? We just rallied way too far, too fast, in my opinion. And for the diversity’s sake, I bought a little bit of puts.

James West:   Wow. Okay, so that’s hedging your bets.

Dmitry Zaytsev:    Well, I’ve scaled out of those positions that I had earlier. I also wrote puts before, and I was doing that way more aggressively like the last week or two or three, and so all of those things just decayed to zero, which was good, because I wrote them, and so I bought them back for very cheap, and that worked out, but as always, you know, you always wish you did a little bit more.

James West:   Right. Okay, so tell me, what’s your take on the whole Aphria announcement today: $0.22 a share in earnings plus Vic has hit the road.

Dmitry Zaytsev:    So I don’t know if the NDI or whatever we have here is linked up, but if the control room – but there we go, okay, now we got some numbers here, cool. I thought it was surprising, generally speaking, or at least it goes to show what the market is thinking when Vic can be phased out and Cole is going to be phased out on what I see as relatively disappointing numbers, in my opinion – that the stock rallies a lot.

James West:   So do you think that the stock is rallying because Vic and Cole are on their way out the door, as opposed to the reaction to the earnings?

Dmitry Zaytsev:    Yeah, absolutely, that’s what I think is happening.

James West:   And why do you think that’s no good? $0.22 a share, that’s nothing to sneeze at.

Dmitry Zaytsev:    Yeah, I mean, you guys were just talking about this, but I don’t know if it shows here, but yeah, so a good chunk of that – 75 million or so – is from gain or loss from equity investees and gain on long-term investments.

Something that kind of concerned me when I was looking at this is just from their highlights here from their MD&A is the fact that they burned through over $100 million of cash in a quarter. So if you see here right around the 313-184 and, you know, you be thinking, they’re building up their facility and all that, but there’s still a while, I think, before that’s really, fully completed. It’s completed, but the internal wiring and all that is still sort of in processes, as I understand it.

And I think they also, they don’t have a grow license for it yet, and there’s no sales license either. So I think it’s going to be a little more delayed than previously guided, which I think is going to be a little bit of an issue, as well, as far as I understood it in my quick little morning look at it.

James West:   Well, you caught more than I did, that’s for sure. Okay, so then, you think that this rally that has sort of characterized the market since the beginning of the year is over-effusive? You don’t think it’s got legs, you don’t think it’s going to keep going?

Dmitry Zaytsev:    Well so, if you look at the first chart I brought along here as well, it’s just the Canopy chart from – yep, there it is – and this is a pretty big break. There’s some really solid volume behind this move, and it’s just US institutional or retail investors, after the Constellation and Piper Jaffray’s initiation of coverage, and you got a big move. Part of it is definitely short covering. There’s a lot of shorts that were in here, and you know, I’ve been short, I’ve been long, most traders are as well.

To get greedy enough to be staying in a short position when it’s, you know, in the mid-thirties, already getting to the low thirties, especially when a good chunk of their balance sheet is cash, yeah, I think that’s just a little greedy. And as we’ve spoken on the program previously, I think the names you want to keep are Canopy and a very few select other Canadian names, and the rest you should focus on, you know, ancillary and US and very niche sort of plays that you’ve done a lot of due diligence on.

And you know what? Canopy, I think, I don’t know if Aurora has caught up to them yet, but I think Canopy is the top performer in terms of the larger cap stocks in the recent couple of weeks.

James West:   Sure. What about Tilray?

Dmitry Zaytsev:    I haven’t looked at them too much. I think there was an announcement today where privateer holdings is going to delay the unlock, but I think that’s why they rallied – I was looking at it at pre-market. It’s interesting, but I’d like to see more of the numbers come out for a lot of these names. I think the Canadian market is not as hot as everyone thinks it’s going to be, and only a few players will really do a good job. So just going back to even the breakdown here of the revenues, so 21 million net, I think net quarter they had 13 or something, so only about 48 million of revenue from a month and a half of rec, in essence, right?

I could be wrong, like I have to review this, this is early morning before work, right, but some of the other things I’m looking at here is, you know, general and administrative expenses as well as, you know, selling, marketing, all that. Kind of surprising that R&D was only $600,000 for the quarter.

James West:   That was Aphria, or that was Canopy?

Dmitry Zaytsev:    That was Aphria. This was from today, this was fresh from this morning. And this is just a breakdown of that SG&A. So kind of what I think a lot of analysts, what they’re trying to understand, and investors, what they’re trying to understand, is what the real run rate when, you know, this company actually scales up, what’s the actual run rate going to be, and what are these margins going to be? So what you’d be looking at is all the operating margins after all the operating expenses, which is currently negative which is, you know negative $21 million right now. Try and understand that a little bit better and the dollar per gram costs and all this stuff, it doesn’t really matter right now. I mean, it’s a bad number right now, but you really have to do a little bit more work to try and understand what the steady state expense line items look like.

And so all of these like $0.22 or whatever gains on investment, that’s not like a sustainable, long-term sort of strategy.

James West:   Sure. The in addition to the $100 million burn, there’s an increase in debt from 140 at May 31^st to $302 million as of November 30^th, which is like, what? So I mean, is that, is the spend that we saw coming, is that coming in the form of debt or is it coming from cash on hand?

Dmitry Zaytsev:    Well, clearly it’s both, clearly it’s both, and I think a lot of these names, they’re really – at this rate, you know, Aphria is only going to have another three to five months of cash if they continue spending it like this. And as you’ve seen, the sales numbers, even if it’s, that was only a month and a half, aren’t that impressive. And you know, it’s true that the OCS and other producers had issues as well, right. I think Aphria has a labelling issue where they had people licking the stamps or something –

James West:   That’s common, I’ve heard.

Dmitry Zaytsev:    Yeah. So you know hopefully that will improve the numbers, and you know, there’s edibles, there’s stores, there’s rollout, but you know what? Of the five people that I know that were buying from the illicit market, I think only one of them or two have them tried, and one of them sort of switched off to the legal market. And so the numbers that I was looking at, you can find it online. They have their own online stores, a lot of these illegal dispensaries, and their prices are pretty good. They’re like Triple A, 5A bud, whatever, 1 ounce, the most expensive that they have is at the lowest end of what OCS has, in terms of pricing. So I think it’s a hard sell for now.

James West:   So do you think then that the Green Growth brands buyout of Aphria at $11 is going to be sort of like a coup de gras that might actually breathe new life into the whole Aphria value proposition while transforming Green Growth into now becoming that big brand royalty company that it envisions becoming based on its past association?

Dmitry Zaytsev:    Yeah, I think Aphria used to be a very interesting and strong story a year or so ago, and now it’s become a Dumpster fire, and this Green Growth brands thing, it’s great that their raising this $300 million or whatever, but it’s just, they’re going to need it for, I think, all of the expenses and new investments and ventures that they’re going to have to go through. And it will be very interesting to see that as, you know, as we sort of see consumers choose brands that they like, companies that they like, I think we’ll see a lot of interest from the investors really dry up for a lot of these other companies. And so, like in all kind of booms and busts, you’re going to have some names dry up – not saying Aphria specifically, let’s say, but you know, capital markets are cyclical, and I think we get to actually see what the cash flows look like and then people start actually basing decisions on that. Think about it: what are the catalysts, now there’s really the US expansion right, and I had a chance to speak with some of the actually one or two people from the management teams from some of the large MSOs this week, and you know, they’re doing some very impressive numbers; they’re doing some very impressive things there.

I encourage everybody to take a look at the US names.

James West:   Which ones in particular? Um, Curaleaf, I know, is targeting a $225 million run rate.

Dmitry Zaytsev:    Oh, I think it’s even more for 2019. But, like, iAnthus, Curaleaf, Acreage, Green Thumb…

James West:   iAnthus is an interesting name. there’s one that really rebounded from the tax loss discount that kicked in in Q4 2018. Why is iAnthus not sort of demonstrating sort of a participation in the herd movement to the upside?

Dmitry Zaytsev:    I think iAnthus to this has been around for a long time, so I don’t think it has that same excitement factor. i think you are giving too much credence to retail investors and how they look at some of these names. I think over time, I think especially in 2019 as the revenues from the US really start coming on and you’re going to get to, you know, compare companies’ valuations, whether they’re EV to sales or EV to EBITDA, I think iAnthus is definitely one of those stocks that’ll do really well in that kind of environment.

One thing I will caution though, and I don’t think too many people know about this, but in the US there’s something called 280E. it’s the IRS code there that says you can’t deduct to claim tax credits on the sale of a Schedule 1 or 2 substance, which cannabis currently is. And I’m not saying this is, you know, something permanent, but it’s just something that’s going to really hurt margins for a lot of these names. So if the company you’re looking at has a very large retail dispensary-type presence or makeup of their revenue, that may not actually translate to as much EBITDA as you hoped it would for the next couple of years.

James West:   Right, right. I noticed in the listing statement of Acreage that the structure of their acquisitions was such that the – it was designed to circumvent the negative implication of 280E in that they were offloading those things into separate vehicles.

Dmitry Zaytsev:    Yeah, SPBs and stuff like that. I mean, I’m sure that’s definitely one way to do it, and I don’t know how much you want to play around with the IRS in terms of this. But sorry, going back to Canopy and all these big moves, like one of the reason I like Canopy is, they have a significant amount of cash. They only need to dilute themselves. And as the US sort of starts opening up, they’ll be able to deploy that capital, whereas for other names maybe they won’t be able to raise at as favourable multiples.

So another chart, actually, and it didn’t load quite properly, but I like to put it up here – I didn’t update it until recently, until the big moves started happening; it might be a little bit of a complex chart, but in essence, what you have in blue on the left here, Canopy’s price over the last year or so, let’s call it, and on the right is a moving average of open interest of calls and puts.

James West:   Okay.

Dmitry Zaytsev:    So this is just a ratio. So for example, here, at 1, so roughly, I don’t know if my mouse is on that, I don’t think it is, but roughly around 1 is when there’s as many calls written as there are puts.  And so what this kind of shows, for example, currently this line is really up there, so its around, you know, 2.5, 3 –

James West:   So that’s the ratio of calls to puts?

Dmitry Zaytsev:    To puts, at all strikes, in all expiries. So what’s interesting about this is, it means there’s three times more calls created than puts.

James West:   That indicates bullishness.

Dmitry Zaytsev:    So I would argue yes, and the reason why is because I think here’s not a lot of option sellers, and going into the market to actually sell, I think there’s a lot of retail option buying and banks are just market-making them.

So if you look at this chart, once again, if you pop it back up, what you see is, around the periods where you had big declines or big rises, you see that ratio kind of move back in. so for example, before the Constellation deal, you saw this really big rally of all these people buying more calls than they were buying puts. And then as you sort of had that rally going into October 17^th,you saw that number sort of stabilize, and this is a 20-day moving average, so it smooths it out a little bit; just that way as opposed to being all over the lace.

And so recently, if I had checked this, and updated this chart, there is a really intense amount of buying in terms of call options versus put options. So if you see the ramp earlier on the chart and then you get closer to the end, and that could have, you know, presaged this big move that we saw. Technically, you saw a lot of good things line up in the last week or two; equity market stabilize, Powell further came off, and sentiment really improved4. And we were sort of in this good move where there was a lot of bearishness and short interest that was just ready to be squeezed out. So that’s why I think we had this big move.

James West:  Okay, so the ebullience in the cannabis sector has been, in large part, I’m sure you would agree, driven by broad market strength. We saw the price of oil coming back, the S&P has delivered I think 8 positive sessions in a row now. Is this trend, is this effusiveness in the cannabis sector, is it reliant 100 percent on the broader market movements, or it is in some degree non-correlated to the broader market movements?

I mean, if we look at the Q4, we saw that it was very closely correlated to the broad market, but in Q1 2019, we’re seeing cannabis have much bigger moves to the upside than does the broader market.

Dmitry Zaytsev:    Yeah, I would just say that cannabis really, in the last, until these last three-four days or so, has actually under performed the broader market, and you would think a high risk, high growth segment like cannabis, you would think it would have a much higher beta, so it would actually rise 2-3 times faster than the markets. So I feel like cannabis is just playing catch up right now.

Generally speaking, during selloffs, correlations increase between asset classes. And all that really means is when everything’s going to shit, it all just collapses together. But when markets are stable or they’re in a small uptrend, maybe not huge bullishness, sort of each sector takes a life of its own, and that is more driven by, I think, news, and I won’t say fundamentals but sector-specific –

James West:   Headline catalysts.

Dmitry Zaytsev:    Headline catalysts, or just, you know, I guess kind of that’s the fuel that’s been driving it.

James West:   Sure. Okay, so then what is your macro strategy in 2019?

Dmitry Zaytsev:    Yeah, so I mean I think this rally and why I’m not getting super bullish or anything right now, I think this rally in the S&P 500 is done for now in the very short term, so we’re talking next couple of weeks. I could be wrong, but see, I think a lot of people were a little scared, a little shaken, after just that December run we had there, and some of the numbers that I saw and things that I heard was, a lot of the retailers missed yesterday. So they talked about guidance, and what’s interesting is, the consumer in the US was spending aggressively through like November and the holiday season, but for some reason it seems like around December they really slowed down their purchases.

And this could be due just to the wealth effect. So if you have an IRA or if you have, in Canada, a TFSA or whatever, and you see your stocks dropping, your net worth dropping by 20 percent, you say, maybe I shouldn’t get that $1000 thing I really wanted to get on credit today. And so that could have a feedback effect.

So generally speaking, what’s my macro strategy? That was your question. I think it’s great that cannabis, or some of the key kind of names have broken out; as we’ve been talking, you know, it was time in the last couple of weeks to really start scaling in. now I think you wait, you let things kind of consolidate a bit, see how the next quarter of the other LPs, you know, pans out. I think have some more exposure if there is any kind of rollover this next couple of weeks. Buy some names you like, and I think, really be on a few names in Canada that you really understand and like your story. I would really focus on the US.

James West:   Okay. Dmitry, that’s great as usual. We’ll come back to you next week; thanks very much.

Original article: Dmitry Zaytsev Examines Latest Aphria Inc (TSE:APHA) Financials, Management Changes

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