3 Things to Love About Emerald Health Therapeutics’ Q1 Report, and 2 Reasons to Worry

The legal marijuana industry is literally budding before our eyes. According to cannabis research firm ArcView, legal weed sales in North America surged higher by 33% in 2017 to $9.7 billion, and they’re estimated to grow by an average of 28% through 2021 to nearly $25 billion. It’s this rapid growth that’s been pivotal in attracting investors to pot stocks, as well as driving up their valuations.

Also helping is the fact that Canada is inching closer to becoming the first developed country in the world to legalize recreational marijuana. Opening the gates to adult-use weed is expected to add $5 billion to Canada’s legal weed industry, and it’s been the primary catalyst behind growers’ rapid capacity expansion throughout the country.

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Three reasons Emerald Health Therapeutics put a smile on investors’ faces

One such grower that’s aiming to place itself among Canada’s largest annual producers is Emerald Health Therapeutics (NASDAQOTH: EMHTF). The British Columbia-based grower reported its first-quarter operating results last week and updated investors on where it currently stands with its numerous projects and commercialization efforts. Let’s review three of the highlights of its operating results, as well as look at two aspects that should be reason for concern.

1. Pure Sunfarms is on track

The biggest sigh of relief from Emerald Health’s latest report won’t be found in its top- or bottom-line figures. Instead, it’s the fact that its partnership with Village Farms International (NASDAQOTH: VFFIF), which is seeing a 1.1million-square-foot tomato-producing facility be retrofit for cannabis production, is on track. Their joint venture, which is known as Pure Sunfarms, will feature 17 grow rooms and is expected to generate between 7,000 kilograms and 8,000 kilograms of cannabis this year, and 46,000 kilograms to 52,000 kilograms by 2019. Ultimately, the duo believes the Delta-3 facility could peak at 75,000 kilograms of annual production in 2020.

What’s more, Pure Sunfarms finalized a contract during the first quarter that’ll allow for the short-term rental of generating equipment to supply lighting during the 2018 and 2019 winter months. This allows time for the local utility to install the 24 MW of generating power needed to light the grow facility. Though this is an added cost to Emerald Health and Village Farms International, it’s a necessary step to boost upfront production.

Image source: Getty Images.

2. Emerald Health’s balance sheet is conducive to acquisitions

Secondly, Emerald Health’s cash position should be making a lot of people happy. The company ended the first quarter with $69.2 million in cash and cash equivalents, which was roughly double what it ended the subsequent fourth quarter with. Having more cash on hand means Emerald Health has the ability to complete the retrofit of the Delta-3 complex with Village Farms as well as continue the build-out of its 500,000-square-foot Metro Vancouver facility.

Furthermore, this cash has been pivotal in allowing Emerald Health to take part in the cannabis merger and acquisition craze. On May 2, 2018, the company announced a roughly $70 million cash-and-share deal for Agro-Biotech. The deal adds land as well as a 75,000-square-foot growing facility, 20,000 square feet of which has been built out. This facility is ultimately expected to boost its annual capacity by 10,000 kilograms.

3. Oils, oils, oils!

Although Emerald Health produced just a pittance in quarterly revenue — less than $289,000 — more than half of its first-quarter sales and 24% of its current inventory (expressed in dollar value) is made up of cannabis oils.

Whereas more growers are focused on dried cannabis given its large demand pool, there’s the likelihood that dried cannabis could be commoditized over time. This would mean a steady decline in dried cannabis pricing and, therefore, weaker margins, even for growers that are able to take advantage of economies of scale.

Meanwhile, cannabis oils are a considerably higher-priced and higher-margin product. Oils and extracts are far less likely to be commoditized or come under pricing pressure. Ergo, Emerald Health’s early focus on oils suggests that its management team recognizes the importance of expanding its product line beyond just dried cannabis.

Image source: Getty Images.

Before you get too excited…

However, before you get too excited about Emerald Health Therapeutics’ first-quarter results, you should also be aware that they contained a few red flags.

1. Metro Vancouver permitting has been delayed

Arguably the most disappointing aspect of the company’s first-quarter report — at least for those folks not reading between the lines — is the noted permitting delay for its 500,000-square-foot Metro Vancouver facility. This grow space, which will also house Emerald Health’s headquarters, is critical to potentially pushing this company above 100,000 kilograms in annual yield.

The reason the delay is concerning is simple: Emerald Health might miss out on lucrative long-term supply deals. When the proverbial green flag waves on legal weed in Canada, those growers who don’t have a lot of up-front production could miss out on these guaranteed long-term supply deals. The longer Emerald Health has to wait to get its Metro Vancouver facility permitted, the further it could fall behind the curve.

Image source: Getty Images.

2. Holy dilution, Batman!

The other issue, for those folks who are reading between the lines, and which seems to rear its head with all marijuana stocks, is dilution. With extremely limited access to traditional sources of capital, pot stocks have turned to bought-deal offerings in order to raise money for capacity expansion and acquisitions. In doing so, they’ve sold common shares, convertible debentures, stock options, and/or warrants. While these methods have been a success, they’ve also significantly raised the outstanding share counts of virtually all pot stocks.

According to Emerald Health’s first-quarter report, its Canadian listing ended the quarter with 115.2 million shares outstanding. Comparatively, in the prior-year quarter, Emerald Health had just 73.5 million shares outstanding. Mind you, the company still has more than 10 million stock options and over 7.4 million warrants outstanding as of the end of the first quarter. This outstanding share count is going to head higher, meaning the dilution of existing shares isn’t going to slow anytime soon.

For the moment, Emerald Health looks to be a work in progress, at least from the standpoint of this investor. Though it certainly has the capacity to be a major cannabis player, its late entry onto the scene could compromise its ability to secure easy-money supply deals. In other words, it’s a stock best observed from the safety of the sidelines.

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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.

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