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Pot Stock Aphria Takes the First Step to Regaining Investors' Trust

The marijuana industry had an incredible 2018, with the cannabis movement gaining validity like never before. The pinnacle of that legitimacy was the legalization of recreational weed in Canada this past October. As the first industrialized country in the world to green-light adult-use weed and only the second country overall to allow it (other than Uruguay), Canada has opened the door to billions of dollars in added annual sales in the years to come.

But it wasn't such a jovial year for pot stocks -- especially Ontario-based Aphria (NYSE: APHA). Although the company was expected to be one of Canada's top producers by annual yield, Aphria's share price declined by 61% last year. Some of this decline was tied to the air being let out of pot stocks during the fourth quarter, but a big portion was the result of a crisis of confidence with management.

Image source: Getty Images.

Aphria's crisis of confidence

In early December, Aphria's stock was decimated after a short-side report was released alleging that Aphria had purchased three Latin American assets at a hyperinflated price. The report, which was co-authored by Quintessential Capital Management and forensics analysis firm Hindenburg Research, alleges that the three properties acquired for around 300 million Canadian dollars via Aphria's common stock are "worthless." As evidence, the report suggests that these properties had previously been owned by shell companies and purchased by Scythian Biosciences (now known as SOL Global Investments) for much less than they were sold for to Aphria.

Making matters worse, the report uncovers a connection between SOL Global Investments and Aphria's advisors. Namely, it shows Andy DeFrancesco, the chairman of SOL Global Investments and an advisor to Aphria, as a vested party to all three assets. In essence, it suggests that lining the pockets of an Aphria advisor was more important than doing what's in the best interests of shareholders (i.e., paying a fair price for these assets).

For what it's worth, Aphria has vehemently denied these claims and is conducting an internal review of the acquisitions. That hasn't, however, quelled the crisis of confidence from within.

As a refresher, this isn't the first time that an Aphria deal has failed the sniff test. Following the company's acquisition of Nuuvera at the end of March 2018 for CA$425 million, the company's executives came under fire for disclosing equity investments in Nuuvera a day prior to the deal closing. While it's not unheard of for management teams to have a vested interest in a company they're acquiring, investors would certainly want to know about it well in advance to ensure that they're getting a fair deal and not one that's made to enrich insiders.

Image source: Getty Images.

Aphria takes the first step toward redemption...

The good news is that some degree of progress is being made to once again instill confidence in Aphria. It began last Friday, Jan. 11, when the company reported its fiscal second-quarter operating results. Within its report, Aphria announced that its CEO of nearly five years, Vic Neufeld, and co-founder Cole Cacciavillani would be transitioning out of their existing roles in the months to come.

According to the press release, Aphria's recently appointed independent chair, Irwin D. Simon, and its president, Jakob Ripshtein, will work to find a CEO replacement while facilitating a smooth transition. It's worth noting that both Neufeld and Cacciavillani will remain on Aphria's board of directors, but neither will be directly involved in day-to-day operations.

Removing Neufeld after two very questionable deals in a span of just over nine months is necessary if Aphria is going to have any chance to clear its name from Quintessential's and Hindenburg's co-authored report. Understandably, investor trust isn't going to be regained overnight, but putting a fresh face in at CEO and hopefully producing tangible evidence that a fair price was paid for its Latin American assets will go a long way toward bolstering investor confidence in the company and management.

After all, if these allegations can be debunked, there are few cheaper growers on the basis of market cap ($1.7 billion) to peak annual production (255,000 kilograms).

Image source: Getty Images.

...but it's a long road to walk

Of course, redemption won't be easy to come by for Aphria with a number of other factors potentially working against the company.

The first issue you'll encounter is from the company's second-quarter operating results. Even though it produced what looks to be a healthy operating profit of CA$54.8 million, this was entirely the result of a gain from equity investees and a gain on long-term investments. These are one-time benefits and not an indication of Aphria's business turning the corner.

Although revenue nearly tripled to CA$24.5 million, and the company generated CA$10.2 million in gross profit before fair-value adjustments on biological assets, its operating expenses nearly quadrupled to CA$27.5 million. On an operating basis, Aphria is still losing quite a bit of money, and investors are going to have a hard time believing in the company's business model until that changes.

Shareholders also have to be leery of Aphria's penchant to issue stock via bought-deal offerings and when making acquisitions. A ballooning outstanding share count can weigh down existing shareholders, as well as push earnings per share lower if a company is profitable. In Aphria's case, its outstanding share count rose to 249.9 million from 151.9 million in just one year.

Lastly, there are ongoing concerns about a cannabis supply shortage in Canada. Even if Aphria isn't having much of an issue finding buyers of its product in the early going, regulatory red tape is causing a shortage industrywide. This might lead some consumers to opt for the black market rather than legal channels, ultimately hurting the top-line prospects for most growers.

As noted, Aphria isn't going to regain the trust of investors overnight. It's taken its first steps in the right direction, but it has a long way to go.

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Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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