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3 Ways Marijuana Stocks Are Tricking Investors

Sean Williams, The Motley Fool

Early supply chain issues in Canada and California aside, the marijuana industry really has the feel of a once-in-a-generation growth opportunity. It racked up $12.2 billion in global legal sales in 2018, and Wall Street investment bank Cowen Group is calling for up to $75 billion in worldwide sales by 2030. For you math-phobes, that's a compound annual growth of almost 17% over the next 12 years.

But this potential isn't going unnoticed. Some of the most popular pot stocks have risen by a quadruple-digit percentage over the past three-plus years in anticipation of this revenue and profit growth. Finding value among cannabis stocks isn't easy.

But you know what else isn't easy? Weeding through marijuana stock income statements. While pot stocks announce headline sale and earnings-per-share figures like any other publicly traded company, there are a number of (perfectly legal) tricks they might be using that cloud a company's operating results, which are all that really matter. Here are three marijuana stock earnings tricks you need to be aware of.

An investor holding a magnifying glass over a company's balance sheet.

Image source: Getty Images.

1. Fair-value adjustments to biological assets

Arguably the wackiest of all legal accounting tricks comes courtesy of Canadian-based cannabis growers. Canadian-listed companies report their operating results using International Financial Reporting Standards, or IFRS accounting, which does differ notably from generally accepted accounting principles (GAAP) results that we're used to in the United States.

As it relates to marijuana growers, IFRS accounting requires that they regularly place a value on their crops based on the growing stage of their plants. For instance, a flowering plant is going to be more valuable than one that hasn't flowered, and growers will need to recognize this when adjusting the value of their biological assets (i.e., plants) from one quarter to the next.

In addition, growers also need to guestimate the cost to sell their cannabis, often weeks or months before they actually do. Eventually the actual cost is reconciled with the guestimate, leading to additional adjustments.

And just to make matters more confusing, these IFRS accounting fair-value adjustments are done above the line, before moving on to operating expenses. That means if the fair-value adjustment is positive and large enough, it can completely cancel out actual costs of goods sold and turn this normally negative figure into a positive number. This is how some pot stocks wind up with a larger gross profit than revenue.

An up-close view of flowering cannabis plants.

Image source: Getty Images.

As a prime example, Atlantic-based OrganiGram Holdings (NASDAQOTH: OGRMF) reported 14.5 million Canadian dollars in gross revenue (CA$12.4 million net sales) in the fiscal first quarter. Less cost of sales, OrganiGram sported a reasonable gross profit of CA$8.8 million. However, because OrganiGram is in the process of bringing a number of new grow rooms online during its phase 4 expansion, it recognized a substantially positive fair-value adjustment on its biological assets and inventories of CA$42.9 million, leading to a CA$51.7 million gross profit. 

OrganiGram isn't profitable on an operating basis yet. In fact, no pot grower is. But IFRS accounting sure makes it seem like OrganiGram -- and a select number of its peers -- are churning out the green.

2. Revaluing existing investments

A second perfectly legal accounting trick that marijuana stock investors need to be aware of is the revaluation of existing investments.

In the early stages of any high-growth industry, it's pretty common to witness consolidation, as well as cash-rich and major players making investments in smaller companies or potentially disruptive businesses within that industry.

Aurora Cannabis (NYSE: ACB), the projected leader in peak cannabis output in our neighbor to the north, has been an active investor over the past couple of years, and it's generally done pretty well for itself. At one time in 2017, Aurora held a 50% stake in the now-spun-out Australis Capital; a 17% stake in The Green Organic Dutchman (NASDAQOTH: TGODF), which projects as the fifth-largest grower by peak output in Canada; and a 25% stake in brick-and-mortar retailer Alcanna. As of the end of Aurora's fiscal first quarter (Sept. 30, 2018), it still held its same stake in Alcanna, but Australis Capital was divested, and the company had reduced its stake in The Green Organic Dutchman to 15%.

An accountant chewing on a pencil as he closely analyzes figures from his printing calculator.

Image source: Getty Images.

However, this seemingly benign reduction from a 17% stake in The Green Organic Dutchman to a 15% stake isn't so benign if you really dig into Aurora's first-quarter statement filed with SEDAR in Canada. Here's an excerpt directly from its first-quarter filing statement:

The Company's original investments in TGOD consisted of shares classified as investment in associates and compound instruments classified as derivatives at fair value through profit or loss. On closing of TGOD's IPO on May 2, 2018 and the conversion of subscription receipts into common shares and common share purchase warrants, based on the Company's initial 17% ownership interest and other qualitative factors, the Company concluded that it had obtained significant influence in TGOD. As a result, the aggregate $133,239 fair value of the 39,674,584 common shares was reclassified to investment in associates as of May 2, 2018.

On September 27, 2018, the Company no longer held significant influence in TGOD due to the resignation of its Board representative from TGOD's Board of Directors and other qualitative factors. As such, the $275,342 fair value of the shares were recognized as marketable securities and the $130,974 carrying value of the investment in associate at September 27, 2018 was derecognized from investment in associates resulting in a realized gain of $144,368.

Note, the monetary figures above are in thousands of Canadian dollars, so the realized gain was CA$144.4 million. Simply revaluing its investment resulted in a massive quarterly gain that didn't truly reflect the underlying state of Aurora's business. Investors must be mindful of investment revaluations, especially from pot stocks with large market caps.

3. Revaluing derivative liabilities

The third and final way marijuana stocks can legally try to pull the proverbial wool over investors' eyes without them realizing it is through the revaluation of derivative liabilities. The recent earnings release from Cronos Group (NASDAQ: CRON) provides the perfect example.

In December, the U.S. tobacco company behind Marlboro, Altria (NYSE: MO), announced that it would be investing $1.8 billion into Cronos Group for a non-diluted 45% stake in the company. In addition to finalizing this investment in March, Altria also received warrants that, should it choose, can be exercised at a later date to boost its stake up to 55%.

Two businessmen in suits shaking hands, as if in agreement.

Image source: Getty Images.

On the surface, this seems like a pretty standard investment deal where each party comes out a winner. Cronos Group gets a massive cash infusion that aids it in its efforts to expand capacity, move into overseas markets, and broaden its product portfolio. Meanwhile, Altria gets the opportunity to diversify away from the shrinking domestic tobacco industry.

But Altria also needs to ensure that Cronos Group doesn't dilute its stake by constantly issuing new stock. Since share-based dilution has become extremely common throughout the marijuana industry, Cronos introduced certain preemptive and top-up rights, collectively referred to as "anti-dilution rights" in the earnings release, which allow Altria to purchase Cronos shares and maintain its ownership percentage.

As a result of these issued warrants and anti-dilution rights, Cronos now needs to recognize these assets as derivative liabilities. As goes Cronos Group's stock, so will go the value of these derivatives in the quarters that lie ahead. In the fiscal first quarter, their introduction led to a CA$436.4 million realized gain, albeit Cronos lost more than CA$10 million on an operating basis if all the frosting were removed from the cake. 

The simple point being that investors can't take pot stock EPS figures at face value. You'll need to do some digging to see what sort of legal accounting tricks, if any, were used to arrive at a marijuana stock's bottom-line number.

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