This Top-Tier Pot Stock Just Snagged Another Supply Agreement

Few industries are as smoking-hot as the legal cannabis industry at the moment, and it's not hard to understand why. In less than three months, Canada will become the first industrialized country in the world to sell adult-use cannabis. The legalization of recreational weed could provide in the neighborhood of $5 billion in added annual sales once the industry is fully ramped up, and, suffice it to say, investors are eager to take part in this rapid growth.

As for Canadian cannabis growers, they've been doing their part by expanding their production capacity as quickly as their balance sheets will allow. A number of growers have seen their capacity double, triple, or perhaps even more than quadruple, just since the year began.

This top-tier cannabis growers' capacity has increased 150% since the year began

One such marijuana stock that has placed itself among Canada's top-tier producers is Ontario-based Aphria (NASDAQOTH: APHQF).

At the beginning of the year, Aphria was expected to produce around 100,000 kilograms of cannabis-equivalent production -- i.e., dried cannabis, plus alternative products, such as oils and extracts -- when at full capacity. This production was expected to derive almost entirely from its four-phase, more than $100 million project now known as Aphria One.

But since Jan. 10, the company (1) announced a partnership with Double Diamond Farms to retrofit existing facilities to grow cannabis, (2) acquired Broken Coast Cannabis, and (3) announced its intent to build an Extraction Centre of Excellence that's designed to produce cannabis concentrates. Its partnership with Double Diamond, known as Aphria Diamond, should yield 120,000 kilograms at full capacity, with Broken Coast Cannabis and its Extraction Centre adding 10,500 kilograms and 25,000 kilograms, respectively, when fully ramped up. All told, that's 255,000 kilograms in annual cannabis-equivalent production capacity by perhaps 2020.

Where does that rank Aphria in the grand scheme of things, you ask? Only Aurora Cannabis and Canopy Growth Corporation appear to be on track to produce more marijuana in a given year. Aurora Cannabis, should it be successful in acquiring MedReleaf, would be expected to generate 570,000 kilograms per year at full capacity. Meanwhile, Canopy Growth Corp. hasn't offered annual production estimates; but with an estimated 5.6 million in peak production capacity, around 500,000 kilograms of annual production isn't out of the question, in my estimate.

Aphria logs another supply agreement

With the capacity expansion craze likely beginning to wind down, the next step of the growth phase turns to finding ways to unload their crops. Even though initial demand for legal marijuana is expected to be high (pun fully intended), we're still talking about a lot of cannabis that needs to find a home.

At the moment, the outlook for supply and demand remains very fluid. Since no industrialized country has ever waved the green flag on recreational cannabis before, no one's exactly sure what to expect. Initially, since capacity expansion has been staggered, there's likely to be a cannabis shortage. But by 2020 or 2021, Canadian domestic oversupply could easily top 1 million kilograms. This excess is hopefully going to find a home in foreign markets where medical marijuana has been legalized.

With so much uncertainty surrounding the supply and-demand outlook, it's imperative that cannabis growers secure as many long-term supply deals as possible. These deals provide predictable cash flow that'll potentially help calm the nerves of skittish investors.

Last Friday, June 29, Aphria announced another supply agreement -- this time with the Manitoba Liquor and Lotteries Corporation. Under the terms of the agreement, Aphria will supply approximately 2,700 kilograms annually (a little over 1% of its yearly production) to Manitoba in the form of dried cannabis, cannabis oils, and perhaps even edibles and vapes down the road, assuming Parliament approves such products in the future. While not a big deal in terms of its annual production, it's yet another step in the right direction for Aphria.

For those who may not recall, Aphria finalized a three-year agreement for up to 12,000 kilograms annual with Quebec in April, and has export access to about a dozen countries, primarily because of its acquisition of Nuuvera, which has networks established in a number of foreign markets where medical cannabis is legal.

The unanswered question

There's no denying that Aphria's management team has done a good job forging long-term supply agreements and diversifying its product line beyond just dried cannabis, which has a high potential for commoditization over time. However, what remains to be seen is whether domestic oversupply can be completely dealt with via exports.

On the surface, demand for cannabis in overseas markets where medical marijuana is legal looks strong. But there are two unknown variables here. First, there are some foreign markets that simply aren't big purchasers of dried cannabis. They'd much prefer oils, softgel capsules, and other alternative cannabis products that aren't ingested by smoking. In this respect, Aphria looks to be in good shape since it's devoting a reasonable portion of production to oils and concentrates. The same can't be said for all of its competitors.

The second unknown is actual foreign demand. No one knows with any certainty whether foreign markets will be able to gobble up all of Canada's excess supply -- and we likely won't know for another two or three years. That creates a lot of per-gram pricing uncertainty and casts a cloud over pot stocks like Aphria.

While I do feel that the company is set up to succeed due to management's focus on profitability and its diversified product line, I'm still inclined to stay on the sidelines until there's a better feel for how the supply-and-demand picture plays out.

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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.