Cannabis stocks have been on a tear in 2019. We called it in Q4 that we thought the tax-loss selling season in the US could well be the driver behind the dramatic (read bloodbath) sell-off in Q4 of last year. But most of the cannabis stocks have regained these losses big time in 2019.

Although still lagging the highs of late August 2018, many of the cannabis stocks have recovered and have been displaying bull-like strength in the past 30 days. And the Canadian LP's have really come out strong with numbers from the pubescent recreational market in Canada.

Yes – Day One was a disaster – but capacity is increasing, shops are being restocked, and finally, new licenses are being granted and stores opening.

And so, to the two giants of the industry. The undisputed #1 and #2 in the cannabis market, Canopy Growth and Aurora respectively. The analysts have been predicting massive numbers for their quarterly earnings reports, with revenue increases of 300% and more the 'expected'.

Aurora reported first, so let's start with them and then we'll cover Canopy's results.

### Aurora Cannabis

Aurora pre-announced their sales, giving a range of $50 to$55 million for the quarter. In addition, they stated that they would be EBITDA positive in Q4 (ending June 30, 2019).

In Q1, their revenue was $29.7 million (year-on-year growth of 260%), with$0.6 million of that coming from the recently legalised Canadian market. Their Gross Margin came in at 70%, up from 58% for the previous year, but down from 75% achieved in Q4 2018. They also reported an operating loss of $112 million. Analysts were expecting revenue of$51.8 million, EBITDA of $34.7 million and EPS to come in around -$0.06 per share. One of the things most analysts were unanimous on, was that Aurora's portfolio of investments could lose significant value, given the downturn in stock prices in the latter end of 2018. This couldn't have been more on point.

On Tuesday Aurora announced their Q2 2019 results, for the period ended 30 December 2018, after the markets closed for the day.

It was the top line revenue that really had mouths wagging. Aurora reported sales of $54.8 million for the quarter, marking the very high end of their previously-announced range of$50 – $55 million. This marked an increase of 363% over the previous years revenue and an 83% increase in revenue over the previous quarter. Recreational sales accounted for$21.6 million, which Aurora stated on their earnings call, meant they had captured 20% of the Canadian recreational market. An astounding result. Medical sales accounted for $26 million, a 9% increase over the previous quarter, and their EU sales (mostly to Germany) amounted to$3.2 million.

There is no doubt that Aurora crushed its sales, but once you move further down the line, you start to notice some significant issues. Aurora's Gross Margin of 52%, down from 62% in the previous quarter, was significantly lower than the all-time high of 72% achieved in Q4 of 2018.

#### The Bottomless pit

During the quarter, Aurora's loss from operating amounted to $80 million. Free cash flow for the quarter was$142 million, but in their defense, a huge amount of capital is being put to work building out their production capacity. For the 6 months ended 31 December, their operating loss amounted to $133 million. Their overall loss for the quarter came in at a mammoth$240 million. Yup – you read that right. However, you need to take a closer look to better understand this number. A $190 million of the$240 million was a write-down of the value of their derivative investments. Essentially all of Aurora's investment portfolio is currently in paper format, and hence will rise and fall with the market.

The last quarter of the 2018 calendar year was a bloodbath for cannabis stocks. Some stocks lost almost 70% of their value in just 3 months. In Q1, Aurora quoted the value of its investments as $700 million. In Q2 that number was reduced by just over 50% to only$318 million. Primarily this was as a result of its investments in Alcanna and The Green Organic Dutchman falling, as the respective share prices themselves got hammered.

That's why we are not really paying attention to it. When the market moves in a bullish direction (as it did in Q3 last year), then the value of Aurora's investments will rise with it (as it did in Q1 when they announced an $83 million gain on their investments. Chances are that Q3 (ending 30 March 2019) will include a gain given the way the market has performed year to date. Aurora once again reiterated their commitment to being profitable in Q4 2019 (for the period ended June 30, 2019). They explained that their key driver for growth in the coming 18 months is their increase in production capacity. Their current annual production capacity os 20,000 kilograms and is expected to increase to 150,000 by June 2019, and over 500,000 by Q2 2020. However, on the back of a successful raise of$300 million in convertible notes subsequent to the quarter, Aurora has just over $600 million in cash, cash equivalents, and short-term instruments. This is more than enough to cover the currently quarterly burn of$140 million, but not forever. Aurora needs to move the needle significantly when it comes to profitability.

#### The Bottom Line

Aurora cemented its status as the second biggest cannabis company in the world by delivering stellar revenue numbers. To grab such a large and meaningful share of the recreational market is very promising, and the fact that their International revenue is also rising shows that they are indeed executing on their global expansion strategy.

However, the company is still significantly overvalued if you consider that with $54.8 million in quarterly sales, and with a current valuation of$9.5 billion, they are trading at 43x EV to Sales. This is a huge number, no matter what the company or industry.

With significant pressure on their gross margin and significant cash burn from operations, Aurora is really going to have to scale their revenue and match their margin and cost targets to even start to grow into this valuation. But having said that, they have all the ingredients to do so, and we remain very bullish on their prospects for 2019.

### Canopy Growth

Their Q2 2019 results were average, to say the least. Sales of $23.3 million (which represented a 33% Year on Year increase) meant that Canopy was actually outsold by its closest rival – Aurora. Most concerning to analysts was the fact that Canopy had seen declining numbers in both their top line revenue numbers and associated gross margins. Gross margin of 28% was significantly down from the 43% achieved in the previous quarter, and sales had declined nearly 10% from the previous quarter. In short, Canopy had not performed well, and management's commentary on the matter was that sales were down as a result of inventory stockpiling ahead of the demand that was forecasted for the legalization of adult use in October 2018. Overall operating expenses grew 552% and resulted in a net loss of$214.6 million for the quarter. Big things were expected of Canopy Growth in Q3 with Canaccord Genuity predicting sales of $74 million. So how did they do? We all expected their revenue number to be big, but not this big. Canopy delivered Gross Revenues of$98 million for the period ended 31 December 2018, and net revenue of $83.0 million, smashing Canaccord's estimates and producing year on year growth of 282% In the quarter, Canopy sold 10,102 kilograms of cannabis, with 8,288 kilograms sold in the recreational market. This is more than double Aurora's sales and gives Canopy a 30% share of the recreational market in Canada. This is simply phenomenal and confirms their 'best-in-class' execution reputation. Recreational sales accounted for 70.1% of revenue, and international sales (primarily to Germany increased ever so slightly from Q2 – albeit with a much higher average selling price per gram). The also reported positive net income of$74 million ($0.22 per share) primarily as a result of changes in the fair value of their investment assets. Although this came as a welcome surprise, one should not read too deeply into it, as it is linked to the rising and falling values of their underlying financial assets. #### Far from profitable However, this report card was not without its faults. Canopy is still nowhere near to making a profit. Free cash flow deficit for the quarter came in at -$289 million (as opposed to -$270 million in the prior quarter) and brings the free cash flow total from the trailing year to a massive -$907 million.

These numbers are being driven by their uber-aggressive global expansion strategy, and a closer inspection reveals they are indeed reducing their operating loss. Operating losses came in at -$157 million for the quarter, an improvement on the -$211 million in the previous quarter. Although operating losses have grown – year on year – they have been significantly reduced in the quarter, which might indicate Canopy is on their right track.

Margin, however, is a glaring issue. Just like Aurora before it, Canopy's gross margin declined in the quarter, on the back of sequential declines in previous quarters. Canopy reported a gross margin of just 22%, down from 28% in the previous quarter and well below their 58% achieved in Q3 2018.

Management explained that this low margin was as a result of the cost of sales including the impact of operating costs of cannabis cultivation subsidiaries not fully commissioned, including their Delta greenhouse, a number of zones at their Aldergrove greenhouse facility, as well as Edmonton and Fredericton.

#### Forward-thinking

What was interesting to note is management's comment on the fact that margin was also impacted by costs associated with developing edible and beverage products for the looming extracts market – due to open up in Canada in October 2019.

Extracts, oils, and edibles command higher margins and premium pricing. This is the reason for this market being deemed "real legalisation" by some, given the fact that current estimates put the Canadian black market for vapes and extracts at over $2 billion a year. This is going to be a big market, and Canopy seems to be preparing for this. Excluding the costs associated with these non-cultivating subsidiaries and absorbing medical excise taxes of$2.1 million in order to ease the burden imposed on patients, the gross margin would have been 40% of sales. However, this is still well below Aurora's 52% and Organigram's 71%.

#### The Bottom Line

Canopy Growth's results were simply amazing. With recreational sales totaling over 30% of the entire market, and at an average selling price higher than any of its peers, Canopy delivered a set of results that showed exactly why they are considered the division's heavyweight champion. This was simply best-in-class execution, but with the future in mind.

"I truly enjoy our quarter ends, because taking time to reflect on what actually has occurred in a prior period only happens when we do the preparation for this call, because normally we're kind of busy thinking about the next seven quarters."

– Bruce Linton, Canopy Growth CEO

With Canopy having entered the US with a starting bet of $150 million to establish a Hemp cultivation facility in New York, their 32 issued and 160 pending patents, and their recent purchase of Hemp-IP specialist, Ebbu, Canopy is planning, building and executing on a forward-thinking global strategy. Yes, they burnt cash, but they also have a whopping$4.1 billion in the bank (thanks to Constellation Brands) and thus have more than enough growth capital. Their margins are low, but no doubt will continue to rise as their production capacity opens up and economies of scale take hold. And they are well set to capitalise on their recreational market share and reach once edibles and extracts become legal in October this year.

#### The judge's decision

Ladies and Gentlemen, after 3 months of grueling action in the cannabis industry, the scorecards have been completed, and the results are in. The winner is…

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###### Mark Bernberg

Mark Bernberg is a long-time cannabis investing enthusiast and founder of The Green Fund, Asia Pacific's preeminent media house, positioned at the forefront of the global cannabis industry.