Aphria's Problems Could Prove Toxic to All Pot Stocks

The marijuana industry has had a remarkable year, highlighted by the legalization of recreational marijuana in Canada on Oct. 17. Ending nine decades of prohibition, Canada rolled out the red carpet for an industry that could generate $5 billion in added annual sales by the early part of the next decade.

It was also a year of firsts for the U.S. cannabis industry. The U.S. Food and Drug Administration approved a cannabis-derived drug, more states legalized medical and recreational pot, and Tilray (NASDAQ: TLRY) became the first Canadian-based pot stock to go the initial public offering route on a major U.S. exchange.

The grass isn't always greener

However, it's been anything but a perfect year for marijuana stocks. The Horizons Marijuana Life Sciences Index ETF, the very first cannabis exchange-traded fund to begin trading publicly last year, is down 29% year to date through Dec. 5. With the exception of a strong rally between mid-August and mid-October leading up to the legalization of adult-use weed in Canada, it's been anything but a green year. And by the look of things, it may get a whole lot worse.

On Monday, Dec. 3, Ontario-based Aphria (NYSE: APHA) was rocked by allegations from noted short-side firm Quintessential Capital Management and forensic analysis firm Hindenburg Research that it had knowingly acquired three assets from SOL Global Investments (previously known as Scythian Biosciences) at an egregiously overinflated price.

According to the co-authored report, Aphria acquired three assets in Latin America and the Caribbean from SOL Global for what amounted to nearly $300 million a few months ago. The report suggests that these assets were purchased by SOL from three separate Canadian shell companies for considerably less.

And the report connects Andy DeFrancesco, the chairman of SOL Global and an adviser to Aphria, as a vested party to these three assets.

Making matters more troublesome, this is the second time this year that an Aphria acquisition has been called into question. In March, after it paid 425 million Canadian dollars ($319 million) to buy out Nuuvera, which expanded Aphria's presence into eight new markets, it was disclosed that Aphria CEO Vic Neufeld and other insiders held positions in Nuuvera. While it's not unheard of for insiders to hold equity stakes in a company that they're acquiring, it's something that Wall Street and investors would like to know about more than a day before a deal closes!

Since the report by Quintessential and Hindenburg went public, Aphria's shares have lost more than half their value.

Aphria's problems could prove endemic to the entire marijuana industry

As for the company, it has rigorously denied the allegations and stands by its Latin American properties. It defends the purchase price paid, noting that it received a fairness opinion and financial advice before completing the deal. Aphria also points out that it noted in its initial acquisition announcement a "de minimis" ownership stake in shares and warrants of SOL Global Investments.

Nevertheless, at least for now, Wall Street and investors aren't buying the company's defense. In fact, it could take a long time for Aphria to fully disprove these claims, and to rebuild investor trust.

But what investors need to understand is that this bombshell isn't just an Aphria problem, it's an industrywide problem.

To be clear, I'm not suggesting that pot stocks haven't been truthful with investors, or that Aphria had misled its shareholders. Only time will give us that answer. But it's hard to deny that there's little substance behind existing marijuana stock valuations. The allegations levied against Aphria could make it very difficult for investors to trust marijuana stocks until we begin to see the tangible results of legalization efforts in Canada and the United States.

Take a closer look at the recent quarterly operating results for practically any pot stock and you'll see what I mean. Canopy Growth (NYSE: CGC), Tilray, and Aurora Cannabis (NYSE: ACB) are currently the three largest marijuana stocks by market cap -- $10.9 billion, $9.3 billion, and $5.4 billion, respectively. Yet in their most recent quarter, Canopy Growth produced just CA$23.3 million in sales, Tilray generated $10 million in sales (Tilray reports in U.S. dollars), and Aurora Cannabis brought in CA$29.7 million. That's peanuts compared with their current market caps.

Meanwhile, excluding a number of one-time benefits tied to asset-sale gains, derivatives, and fair-value adjustments to biological assets, pot stocks are losing an awful lot of money on an operating basis. Canopy Growth reported a whopping CA$214.6 million operating loss in the fiscal second quarter, Aurora Cannabis lost CA$111.9 million on an operating basis, and Tilray's operating loss totaled $20 million. Even taking into account that none of the earnings reports factor in legalized adult-use sales, investors could have difficulty supporting these valuations.

Investors should also realize that emotions have played a role in driving marijuana stocks higher. With sentiment clearly pointing lower following the allegations against Aphria, it could be difficult to once again instill confidence in investors.

Aphria is just one company, but it's exposed a few key weaknesses of the entire marijuana industry.

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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.