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How Marijuana Legalization Affected OrganiGram and Aphria's Latest Results

The Motley Fool logo The Motley Fool 4/20/2019 Todd Campbell

Marijuana companies OrganiGram and Aphria reported their most recent quarterly earnings earlier this week. One of the companies reported surprisingly strong sales, while the other delivered disappointment. Are these marijuana stocks buys?

In this episode of The Motley Fool's Industry Focus: Healthcare, analysts Shannon Jones and Todd Campbell explain how these companies are performing and what could be next for investors. Shannon and Todd also discuss why Abbott Labs is locking horns with Dexcom in diabetes and what the future looks like for Bristol-Myers Squibb, now that its acquisition of Celgene is official. 

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

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Shannon Jones has no position in any of the stocks mentioned. Todd Campbell owns shares of Celgene. The Motley Fool owns shares of and recommends Celgene. The Motley Fool recommends OrganiGram Holdings. The Motley Fool has a disclosure policy.

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This video was recorded on April 17, 2019.

Shannon Jones: Welcome to Industry Focus, the show that dives into a different sector of the stock market every single day. Today is Wednesday, April the 17th, and we're talking Healthcare. I'm your host, Shannon Jones, and I am joined by healthcare guru Todd Campbell. Todd, how are you?

Todd Campbell: I'm doing well up here in sunny New Hampshire. Happy to see that mud season hasn't yet arrived. Maybe we'll skip it this year and go straight to summer. 

Jones: Hey, you never know! It seems like that's happening more and more frequently. I think we'll probably hit 80, 90 degrees here in the next couple of weeks in Alexandria. 

Campbell: Wow, crazy!

Jones: It is crazy! For today's topic, we've got some less crazy updates to share with our listeners. Specifically, we've got news from across the sector, including merger updates, the diabetes stock wars, and, as always, marijuana earnings updates. Todd, let's dive right in!

We promised our listeners that we would be following up on the soap opera that has been Celgene, CELG, and Bristol-Myers Squibb, BMY. The news story here has been about the fate of this $74 billion merger, which came down to a shareholder meeting last week. There's been so much politicking on both sides of this debate and whether or not this deal should go through. You had a lot of very vocal shareholders saying that this was a deal that was very poorly conceived and ill advised. Todd, what was the final verdict on this huge deal last week? 

Campbell: Maybe this deal is crazy, right? Talk about things that are crazy. Maybe this deal was crazy! So, we talked on the show a few weeks back and we said OK, some big shareholders are really upset because they don't think the Bristol-Myers should be spending all this money on Celgene. They should just go it alone, and maybe even become an acquisition candidate rather than being an acquirer. When all was said and done, we ended up having over 75% of Bristol Myers shareholders vote in favor of the merger on April 12th. Virtually all of Celgene investors voted in favor of it. So the deal is done, the decision is made! These two companies will now combine into this massive behemoth with about $40 billion in combined annual revenue. 

Jones: Yeah, it's going to be a massive company. I think one thing to keep in mind is, there was a lot of back and forth on this deal. When you started to see these independent proxy advisors, ISS and Glass, Lewis step up to the plate and recommend that this deal move forward, that's when you started to see some of these activists like Starboard start to step back to actually make this deal happen. In the investment community, when you have especially Glass Lewis and ISS, when they speak, people tend to listen. I think that's what you saw with this deal. 

Campbell: A lot of these shares are held by passive funds, like the S&P 500 funds, etc. They pretty much just vote the way the proxy advisors tell them to vote. So, yeah, you have active managers like Wellington and Starboard and some that own meaningful amounts of shares. But with so many shares of big companies being held by these passive funds, once those advisors come out and say, yeah, go for it, it's good, it's pretty much a given that the deal is going to get done. I don't think it's necessarily a bad deal. I think this could be a very good deal. Shannon, not to bury the lede, I do plan on holding on to my shares of Bristol-Myers that I'm getting in this deal. As a refresher to listeners, as an owner, you're going to be getting $50 in cash, plus one share of Bristol-Myers Squibb, and then a chance, depending on whether or not some FDA approvals go their way, a shot at an additional $9 down the road from a contingent value right. 

Jones: That $9 contingent value right, that's dependent upon approval across three different products. That is a contingent value right that requires all three to get approved. Certainly adds a bit more risk to see in that one play out. But I think all in all, to your point, Todd, this is a deal that two companies combined do make sense. Again, in the biopharma space, a lot of these deals just don't make sense and they seem to fall apart. We'll have to see if this deal will go the same way. But what you're getting here is a combined company that will be, among other things, a dominant player in the oncology space in particular. 

Campbell: Biggest one. I think they'll be No. 1. $23 billion roughly in sales just from Opdivo, which is a Bristol-Myers drug with about $6.7 billion in annual revenue last year. Sprycel, Urivoid, two more drugs that Bristol-Myers brings to the table in oncology. Then, adding in Celgene's Revlimid, a $10 billion drug. Pomalyst, another drug with $2 billion in sales. And Abraxane, a pancreatic and breast cancer drug with another $1 billion in sales. So yes, a very large player in oncology. Also, Shannon, a pretty big player in autoimmune disease. They're going to be able to now market both Orencia, which is Bristol-Myers' drug that had about $2.7 billion in sales, treating RA and psoriasis, and then the psoriasis drug Otezla from Celgene, which had sales about $1.6 billion last year. So a pretty big player there as well.

The other reason that I like this deal is because you do have all these multiple shots and goals fast approaching potential approvals for drugs that arguably address multibillion-dollar indications. You have Ozanimod for multiple sclerosis; Fedratinib in myelofibrosis; bb2121 in multiple myeloma. We've talked a lot about that on the show in the past. Liso-cel, Luspatercept, all these drugs have billion-dollar-plus opportunities ahead of them if they can get across the finish line. 

One of the reasons that I'm holding on to my shares is that Bristol-Myers says that this isn't a dilutive deal. Their earnings are going to grow every year from here through 2025. They have a chance for over $2 billion in synergies from cost savings. And, they think they're going to generate $45 billion in free cash flow for the first three years. That's good for Bristol-Myers' dividend, because remember, Bristol-Myers pays a dividend where Celgene didn't. I think that yields probably somewhere north of 3% right now. 

Jones: Yeah. Looking forward, you're looking at six product launches, five coming from Celgene specifically. That's $15 billion in potential total revenue over these next few years. I think one thing I'll be watching, of course, is the contingent value right. That is something that is tradable. But more importantly, those three drugs, I think the longest timeline is maybe 2021. 

Campbell: Yeah, March 31, 2021.

Jones: 2021 there. So, we'll have to wait some time on that. The other thing I'll be looking at is, now that this deal is moving forward, what programs will ultimately be kicked to the curb, be put on the shelf? With a lot of these mergers, even promising drug candidates sometimes just don't fit into the meshed organization and in terms of what they're looking for pipeline-wise. So it'll be interesting to see how that plays out as well. But Todd, I'm glad that you mentioned it because you knew I was going to ask, are you going to hold. It sounds like that's definitely a yes. 

Campbell: Yep, absolutely! I'll stick around and see what happens. 

Jones: Great! Let's turn our attention to the second big story. It's really all about the diabetes war. Competition is heating up in the diabetes space, specifically among CGM players. Two heavy hitters, Dexcom, DXCM and Abbott Labs (NYSE: ABT), ABT. Todd, Abbott Labs is looking to step up the competition with a new product that could launch in the U.S. later this year. Before we dive into that, though, I think maybe for our listeners who are new to the space, what exactly is a CGM and what is Abbott actually looking to do? 

Campbell: CGMs are continuous glucose monitors. To understand continuous glucose monitors, it's helpful to understand diabetes. In diabetes, the pancreas either doesn't produce enough or any insulin. Insulin is necessary to break down and turn glucose in the bloodstream into stored energy. So in type one, you're not producing any insulin; in type two, you've developed a resistance to the insulin that you do produce. If you're not producing enough insulin and your blood sugar gets heightened because of it, it can lead to all sorts of life-threatening complications. You can have nerve damage, you can develop cardiovascular disease, you can have vision loss. In fact, Shannon, of people who are turning 50, who are also diabetic, on average, the life expectancy is shortened by about nine years. 

One of the ways that people think that we might be able to improve upon those outcomes for diabetics is by better monitoring their blood sugar levels so that smarter decisions can be made about their insulin. Continuous glucose monitors allow you to do that. You take a sensor, you put it on your body, and then you're able to get really close to -- not exactly, but close -- real-time readings of your blood sugar levels that can then be used to theoretically make decisions about your insulin that could prevent highs and prevent lows that may contribute to or speed up disease progression. 

Jones: The other important point is related to finger sticks. A lot of diabetics rely on frequent finger sticks to determine the appropriate insulin dosing. What these CGMs have been able to do is not only cut down on the number of finger sticks, but also there's an accuracy and even just a convenience factor that plays into it as well. 

But Abbott and Dexcom have been dueling in terms of technology. I'd have to say probably Dexcom the more innovative of the two when it comes to CGMs. But ultimately, Abbott is set to release what could be one of the more innovative approaches to the CGM market. Todd, what should listeners know about their product? 

Campbell: Abbott already has something on the market called the FreeStyle Libre. This was their first generation of their latest CGM. What's remarkable about this device is it does significantly reduce the finger sticks that you're talking about. Remember, in the olden days, if you wanted to check your blood sugar, you had to keep sticking your finger to get a blood sample to put in the little testing thing to find out if you needed some insulin. That's a very inefficient way of doing things. You no longer need to do finger sticks for calibrating Abbott's machine or for very extended long warm up times or to confirm that you need to dose your insulin. That's a huge advantage. 

The problem with the FreeStyle Libre 1.0, as I'll call it, is it didn't include alarms that could highlight short-term highs or lows in your glucose. That's something that Dexcom's G5 and G6 incorporate. G5 and G6 from Dexcom have always been thought to be the premium product. They carry a premium price. The FreeStyle Libre is much cheaper. Last year, they launched version 2.0 of the FreeStyle Libre. It includes those alarms I was just saying were missing from 1.0. That FreeStyle Libre 2.0 is not available yet in the U.S. However, the application has been filed with the FDA for approval. If it is approved, then you're going to have a really big market share battle here as people try to decide, there are still less features in the FreeStyle Libre 2.0, but it'll save them a lot of money; or, do I want to stick with the Dexcom that I've been used to? And I think that's created a lot of excitement for Abbott and concern about Dexcom. Will Dexcom be able to hold on to its status as the premiere player from here?

Jones: With the FreeStyle Libre 2.0, some analysts are saying it could come at potentially an 80% discount to what Dexcom's offering. So price I think is going to be a huge factor. I think the premium for Dexcom's products probably won't matter as much to those that require more intensive insulin therapy, and really do want the best of the best in terms of innovation and monitoring. But ultimately, I think for those patients that require less intensive forms of therapy, and are price sensitive, are probably going to go for Abbott. 

One of the things that I think is important to note, though, and correct me if I'm wrong here, Todd, I really don't think this is a winner-takes-all market. I do think that there's space for multiple players just given the massive opportunity for diabetes right now. 

Campbell: So stoked that you brought that up. Absolutely! Massive market. 30 million diabetics here in the U.S. alone. 400 million globally. One million plus type one diabetics who are insulin-intensive here in the U.S. alone. This is a big, big market!

Abbott, I listened to their conference call this morning. Their diabetes sales grew 34% globally worldwide to $566 million in the first quarter. That's huge! U.S. sales were up 77% to $152 million. They only have about 1.3 million users. So think about the size of this addressable market and where Abbott is right now, and where Dexcom is right now. You're still talking about significant runway that I think could support both of these players. 

Dexcom's already guiding conservatively for 2019. They grew very fast last year. I think they're up like 50% revenue. This year, they're saying they'll grow about 15%. I guarantee that's building in some of the threat that's approaching from the FreeStyle Libre 2.0. But Dexcom also plans to roll out their G7, their next generation one, in 2020, which could even be cheaper, and theoretically that kick-starts the war all over again. This is going to be something that investors are going to want to watch for the next at least two years. 

Jones: On May 1st, I believe Dexcom is set to report their current quarterly earnings. I'm sure management will be addressing the competitive dynamics and landscape even more. We'll definitely have to tune in and keep our listeners up to date on all the latest on this war that continues to play out. 

[Now,] we've got more marijuana earnings, this time from two big players. The first is OrganiGram Holdings, ticker OGRMF, and the second is Aphria, ticker APHA. OrganiGram right now is the second best performing Canadian marijuana stock so far this year, up 81% since the start of the new year vs. the S&P up about 16%. On the other hand, we've got Aphria. It's up about 8% on the year but fell pretty steeply after earnings came out on Monday. Let's dive into both of these companies, Todd!

Let's start with what sales and revenue look like for both of these. What were the headline numbers there? 

Campbell: OrganiGram delivered net marijuana revenue of $26.9 million. That's excluding excise taxes. Just as a quick sidebar, Canada put excise taxes on marijuana last year. All of the major providers have decided to absorb those costs. All the numbers that you see when you see net marijuana revenue in their press releases, that's what they're talking about, not including the excise taxes they collected and are absorbing. $26.9 million. Of that, recreational adult use sales were $24.5 million and medical marijuana sales were $2.4 million. That's OrganiGram. 

Over at Aphria, Aphria put up sales of $73.6 million, but huge asterisk associated with that sales figure. In the quarter, their recreational sales actually declined to just $7.2 million. That's down from $11 million in the previous quarter. Their medical marijuana sales fell 2% to $10.6 million. So, why did Aphria's sales jump if their medical and their recreational sales were flat. That's because they went out and they bought a couple of drug distributors last year, one in Germany and one in Argentina. Incorporating those drug distributors' sales onto their statements has caused that big spike up in its revenue in the quarter. 

Jones: Yeah. Some detail on that, Aphria acquired CC Pharma. That was the drug distributor in Germany. And then in Argentina, APB was the one they acquired. That added $56 million in distribution revenue to their results for the quarter. So we did see a boost in terms of sales related to that, but that actually put a bigger dent on margins, which brings us to the topic of profitability for both -- or, as you can say, lack thereof of profitability. What did that look like, Todd? 

Campbell: OrganiGram is unique in the industry because most of the big players have shifted away from indoor growing, which is typically associated with being a more expensive way to grow marijuana, to either greenhouses or outdoor growing. OrganiGram is sticking with indoor growing. They do it a little bit differently. They handle it like a three-decker bus. They have a three tier-indoor grow system that they use. As a result, they have some of the lowest cultivation costs per gram in the industry. Last quarter, cultivation costs per gram were $0.85 per gram on an all-in basis. $0.85, that's crazy, down from $1.48 in the previous quarter. The lower production costs did translate into a bigger gross profit. The gross profit was $16 million on an adjusted basis, not including the changes in the fair value of biologics, something that I don't think is important to consider, so I cross that number out. Their gross margin was 60%, which is just really good compared to what we've seen from these other marijuana stocks who've been investing heavily into their businesses, and as a result have seen their gross margins fall dramatically. They still lost money in the quarter, though. They lost $6.4 million.

Jones: For Aphria, granted, it's not a true apples to apples comparison with OrganiGram, but when you're looking at that cost per gram, they came in right at $3.76. Ended up with a gross profit of $13 million. But going back to talk about the distribution companies that they acquired, even though it was a boost to sales, you did see pressure on margins. Matter of fact, I wouldn't even call it pressure, they just collapsed. It went from 47% in terms of gross margins down to 18% because these distribution companies operate at a much lower margin. I do have to wonder, I know Aphria is a company in transition right now. They're going through management changes and really trying to become much more of a global business. But that was definitely something that stood out to me when you're looking at profitability for Aphria. They ended up net loss on the quarter $108 million, or $0.43 a share. Also the other big story here was packaging costs. Management in their conference call did talk about expensive sourcing, just to make sure that they had enough packaging on hand when adult use sales began. Also labor costs. Sounds like a short-term issue, but something we certainly want to keep an eye on as well. 

Campbell: Yeah, those packaging costs doubled to $1.98, which is huge. That's a big chunk of that all-in cost per gram that you mentioned earlier on. They do think that they have a plan that's going to take care of that. But there is still some inventory that's left over that has to get worked through. They're getting a little bit more careful in the way that they package their products to use less materials. They're sourcing them from new vendors to try and save some money. So there should theoretically be some tailwinds that will help profitability further on. You mentioned those acquisitions and the fact that they carry such lower margins. The margins are 10-15% in that distribution business. The combination of declining marijuana revenue, which is high-margin, that tilted of course, the revenue mix toward these low-margin businesses. That should theoretically be temporary as well. As more production ramps up, and we'll get to that in a second, as production ramps up, then hopefully, this company's profitability will get better. 

The $108 million loss they reported in the quarter also includes $58 million in impairment charges, including an $50 million impairment charge associated with acquiring some assets in Latin America last year. They decided that they were carrying those on the books at too high a price, so they locked that down by $50 million. 

Jones: With the legal marijuana market still in its infancy, many of these growers still ramping up in terms of capacity. Obviously, funding is a key area to watch and the sources of that funding. What do we see in terms of balance sheet? What did cash and debt look like across these two companies?

Campbell: They're both fine. They are spending a lot of money. But neither of them worry me too much. OrganiGram has $63 million in cash. It had $13 million on the books in debt exiting the quarter. But they just signed a letter of intent to borrow $140 million. Some of that is going to be used for expansion programs that boost production. We'll talk about that again in a second. Aphria has $135 million in cash and about $77 million in debt. I think both these companies are OK when it comes to having enough cash to accomplish what they need to accomplish within the next one to two years. Then we have to reevaluate. 

Jones: Speaking of the next few years, when it comes to what the future looks like for both of them, really comes down to production capacity at the most foundational level. This last quarter, both of these companies were actually pretty much in lockstep in terms of production capacity, looking at around 35,000-kilogram production capacity. What are they eyeballing in terms of future capacity though?

Campbell: One of the reasons that Aphria's marijuana revenue declined is because they held back some harvesting to be able to have enough mother plants for an expansion they're doing on their big greenhouse, Aphria One. Aphria One, massive expansion program, just got approved by Health Canada in March. They're now starting to cultivate marijuana in that expansion program. That increases their capacity to about 115,000 kilos run rate right now, which is a huge jump up. Last quarter, their production was about 20,000. They have capacity of 36,000. But they held some back, produced about 20,000 run rate. Now, they're jumping, like I said, to 115,000.

At OrganiGram, because of the expansion that they just got approved, they look like they're going to get to 62,000 run rate this month, growing to 89,000 kilos in September and 113,000 kilos in December. Theoretically, both of these companies will exit 2019 roughly similar to one another at the 115,000 area. 

The one wild card, Shannon, is another greenhouse Aphria is working on trying to get approval from Health Canada on. That's Aphria Diamond. If that comes online, Aphria's capacity is going to jump to 255,000. That should solidify it as the third largest grower in Canada. 

Jones: Yeah. Production is really the name of the game here, especially for OrganiGram. They just signed a letter of intent to supply cannabis to Quebec, which is the last of the Canadian provinces that they didn't already have a supply agreement in place with. Now, this will basically make OrganiGram one of the three growers with a supply deal in place across all of the provinces. That'll be huge. 

In addition, of course, October of this year will mark when Canada is expected to legalize edibles. OrganiGram, of course focusing on the edibles, really building out automated equipment and production to be able to jump right into that. They're also looking at cannabis-infused beverages. They believe they've got a proprietary formulation that could basically make the effects of these cannabis-infused beverages happen a lot faster. We'll have to see how all of that plays out. I know they're looking for a partner in that particular deal. We'll see if that happens. 

For Aphria, the name of the game for them moving forward is all about getting that product mix and cost in line. Because they are a company in transition, because you've got a new management team, this is a company that's gone through so much, really just over the past few months. They dealt with short sellers attacking them, a hostile takeover bid, and now you've got new management that is trying to become a much more global operation. We'll have to see what plays out with Aphria. But, to know that they're ramping up in the right ways is certainly an encouraging sign there. 

Campbell: Yeah. I think that the one takeaway on Aphria, if you listen to their conference call, one of the things they said over and over again is, if you take price per gram where it is today and you look at what we have right now, we're approved for peak production capacity, that gets us to a billion-dollar run rate exiting 2020. That's pretty remarkable from where we are today. 

Jones: Exactly! That will do it for this week's Industry Focus: Healthcare show! Thanks so much for tuning in! As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Todd Campbell, I'm Shannon James. Thanks for listening and Fool on!

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