Few investors can argue Aphria’s stock hasn’t been left behind over the last six months.

It’s clear Aphria has suffered residual damage from the Quintessential short report even if all the findings and valuation arguments in the report have since been proven wrong.

The management team is gutted, a third party investigation found no wrongdoing, and a valuation review confirmed the market pricing of LATAM assets, yet the stock continues to trade at a huge discount to peers.

This investor apathy presents a compelling opportunity for management to force a re-rating of the stock using the extraction centre of excellence, we will call it Apha-Oil from now on, as the main ingredient.

 

Enter the Cannabis Extraction Stocks

Earlier this month Grizzle illuminated the potential and the challenges of the white-hot cannabis extraction industry.

Extraction stocks like MediPharm Labs and Valens GroWorks are the current darlings of the cannabis market due to investor expectations of exploding extraction demand to supply the growing infused product market.

Stock Performance of Extraction Stocks vs Cannabis Sector (HMMJ)

Source: Yahoo Finance

Investors are falling all over themselves to buy extraction stocks while forgetting that Aphria has 200,000 kg of internal extraction capacity starting up this year, on par with the largest pure-play extractors.

When we look at the value of the centre of excellence as a standalone company instead of just another division of Aphria, the possibilities start to look very interesting.

 

Aphria on a Sum of the Parts View

Aphria has a current market cap of 2.5 billion, which gets you:

  • 250,000 kg of total funded capacity in Canada, 100,000 kg of which is starting up in months.
  • Cultivation and distribution assets spread all over Latin America, Europe, and the Caribbean.
  • 200,000 kg of oil extraction capacity.

Aphria is competing effectively with all the big licensed producers yet it trades like an also-ran regional Canadian producer without an international footprint.

2020 Estimated EV/EBITDA

Source: Grizzle Estimates, SEDAR

If Aphria’s Extraction Centre of Excellence (Apha-Oil) were to trade as a public company it would be worth $700 million based on the trading multiple of MediPharm Lab’s extraction capacity.

This means Aphria’s cultivation assets and brands are actually trading for only $1.8 billion or only 4x 2020 estimated EBITDA at $5.50/gram retail.

Aphria’s multiple ex-extraction is 10x below the industry average and 20x lower than similarly sized peers Aurora Cannabis and Canopy Growth — a truly massive discount.

If Aphria management is listening, we propose three steps that would crystallize value for shareholders and offer a no brainer trade for Hedge Funds and other institutions.

 

A Step by Step Guide to 20% Upside at Aphria

 

Step 1: Create an Oil SpinCo (Apha-Oil)

Management should package the extraction centre of excellence into a standalone company, tentatively called Apha-Oil, and conduct an IPO.

An IPO allows the company to sells shares in exchange for cash, a better outcome for Aphria as it benefits from the valuation uplift of Apha-Oil on the public markets.

Step 2: Price Apha-Oil at a 30% discount to peer valuations and lock up 100% of capacity on a long term contract.

If Apha-Oil is priced at a big discount it would become an immediate buy for fans of extraction stocks.

Hedge funds would also be very interested in the arbitrage opportunity. They could short extraction stocks, buy Apha-Oil and profit as the valuation converges with higher-priced peers.

Secondarily, Aphria should sign long-term contracts for 100% of Apha-Oil’s capacity. Compared to peers Apha-Oil would be a much less risky play with future revenues largely assured.

Any investor who knows oil refiner stocks knows that earnings variability can be crazy. The stocks with the highest multiples are the ones with the most consistent earnings, not necessarily the highest earnings.

Fully contracted capacity for Apha-Oil would compare very favourably to 2020 contract coverage for Valens at 46% and Medipharm at only 7%.

100% Contracted Capacity vs Extraction Peers (2020E)

*100% capacity is for illustrative purposes only. Source: SEDAR Filings, Company Press Releases, Grizzle Estimates

Step 3: Use Proceeds from the IPO to buy back stock

An IPO of Apha-Oil should raise at least C$500 million, allowing management to buy back 50 million shares or 20% of shares outstanding.

Decreasing the share count makes Aphria immediately 20% more valuable as the same earnings are now spread over fewer shares.

Potential Share Count

Source: Grizzle Estimates

Conclusion: Oil Extraction is the Ultimate Value Hack

Aphria is clearly a very cheap cannabis stock that we believe will eventually close the valuation gap to peers.

Aphria management should jump at the chance to reward investors who have stuck by the company as they watched other stocks go up 30%+ since December.

Realizing full value for extraction assets can be done without impacting Aphria’s competitive positioning or ability to meet future cannabis oil demand.

Aphria is clearly a very cheap cannabis stock that we believe will eventually close the valuation gap to peers.

In the meantime, management can use the extraction assets to force an immediate re-rating of the stock which could go a long way to restoring investor confidence.