Is Accounting Exaggerating Marijuana Profits?
In Canada, public marijuana companies follow the same accounting rules as agriculture. At first glance this may seem logical, it is a crop after all. However, the marijuana business right now is nothing like the potatoe business. It's a brand-new industry (legally), that is starting off with massive demand. Because of this, companies are starting and growing at an extraordinary pace. But agriculture accounting was not designed for this growth and the result is some pretty inflated financial numbers.
Gross Margins of over 100%
Gross margin for a company is equal to it’s revenue less the cost of those sales / total revenue.
It’s essentially an indicator of how profitable a company is just from the products it sells, ignoring the back end (admin, marketing, etc.).
Marijuana stocks have been showing crazy high gross margins, even before the plant was legalized. Canopy growth Corp. for example, reported a gross margin of 164% all the way back in the third quarter of 2017. That means that for each $1 of cost there was $2.6 of revenue showing. Unheard of for agriculture. However, a big portion of these gleaming numbers are completely estimated, and naturally ripe for exaggeration.
Agriculture Includes Estimates
Under the accounting standards (IFRS), inventory – harvested product, as well as biological assets – living plants, are measured under the ‘fair-value model’.
Meaning that plants are measured at estimates of what the current selling price of it would be, less the costs to sell. This includes every plant. From full producing plants to seeds just starting to sprout.
Estimates are required for eventual selling price, costs to grow, costs to harvest, crop yields and selling costs among other factors. The companies must also consider other unknown factors like potential of bugs, disease and mold. For potatoes and other agriculture, they’ve been doing this for a long time, not so for the emerging Cannabis industry.
The amount of estimation required is the highest when plants are at early stages of growth. And this industry is planting seeds furiously.
Seeds = profits
Inventory is not the only area effected. When a company shows that their crops are valuable. More valuable than the costs that will be put into them; than that increase in value is recorded as revenue. Even just a newly sprouted seed, can add revenue for a company. With so much planting, the result is that a very large portion of a companies’ revenue can be coming from just these estimates, before any money is made at all. If you take out all of these estimates and just look at actual sales, some of those fantastic gross margins could be knocked down by as much as 100% (eg. 160% to 60%).
What’s an industry to do?
The big Marijuana companies have been showing more detail and clarification over time. However, the structure of these clarifications is inconsistent and likely not fully understood by the average investor.
Many are suggesting and pushing for regulators to step in and set standards specific to accounting for Marijuana. In the end however, it is still agriculture. Once the industry is matured there will be much less estimation and what is estimated will be more reliable. Any regulations put in place this year might be unnecessary in a few years time.
Do the numbers matter?
Stock values have exploded for marijuana companies, in September total value of the public stocks in the industry hit a high of over $60 billion (market cap). These stock values are so much higher than revenues and profits, that it’s hard to imagine if people are really looking at the numbers that closely.
So maybe the hype of potential growth is the only thing that matters at this stage. But if you’re thinking of investing in the industry it’s probably a good idea to keep the numbers in check too.