Pot-stock euphoria appears to be wearing off, with a short-seller report targeting Aphria Inc. (APH.TO) raising broader questions about governance and financial disclosure in the adolescent industry.

Aphria’s stock price was chopped in half and several other pot stocks including Aurora Cannabis Inc. (ABC.TO) and Canopy Growth Corp. (WEED.TO) fell following the report from Quintessential Capital Management and Hindenburg Research, which alleged Aphria paid inflated prices for assets held by insiders.

The report is adding to concerns that the sector can’t justify the lofty valuations reached shortly before Canada legalized recreational cannabis in October. Since Oct. 16, the day before legalization took effect, the Horizons Marijuana Life Sciences Index ETF has lost 41 per cent, pressured by supply shortages and weaker-than-expected earnings.

Gabriel Grego, founder of Quintessential, alleged in his report that Aphria is a “black hole,” and that management overpaid for Latin American assets sold by companies with alleged links to Aphria.

The Leamington, Ontario-based company is vigorously defending itself, saying the purchase was a transaction negotiated at arm’s length and that both companies retained professional financial advisers. It called the allegations “false and defamatory,” and Chief Executive Officer Vic Neufeld told BNN Bloomberg that it will soon provide a detailed, line-by-line rebuttal of the short report. On Thursday, Aphria said it appointed a special committee of independent directors to review its recent acquisition of LATAM Holdings Inc., which was targeted in the short-seller report.

Embedded Image

‘Audited Hallucinations’

In the report, Grego said the short was not “a story about the cannabis industry and its commercial potential.” But it’s inevitable that the allegations raise questions about the health of the industry as a whole, said Al Rosen, founder of Toronto-based Accountability Research Corp., a forensic accountant and a long-time critic of the cannabis industry’s bookkeeping.

Rosen has criticized cannabis accounting in the past, saying it has produced “audited hallucinations.” One of the issues is the metric known as fair value, which measures the worth of plants as they grow, and requires management to make several assumptions about growing costs, plant yields and selling price. Because the unrealized value of the plants is factored into gross profit, pot firms can sometimes end up reporting gross margins of more than 100 per cent.

Permissive Frameworks

And he warns Canada’s regulatory environment and accounting standards are too lax. “Canada’s your perfect place to prey on investors,” Rosen said in a phone interview,

Still, the Canadian Securities Administrators issued a report in October, warning investors firms were failing to adequately disclose even basic financial information to shareholders. Of the licensed cannabis producers reviewed, 100 per cent needed to improve their disclosures, the regulators said.

“The cannabis industry has benefited from increasingly permissive legal frameworks and has grown significantly as an emerging public-market sector,” said the CSA, an umbrella group for provincial regulators. “Our review identified industry-specific disclosure deficiencies, which are notable given the recent rapid growth of this industry.”

The Ontario Securities Commission declined to comment on whether it was investigating Aphria.

Cannabis is like any young sector that’s faced with lots of investor scrutiny, said Greg Engel, CEO of Organigram Holdings Inc., a licensed producer based in Moncton, New Brunswick.

Rubber, Road

“This is like any industry, you’ve got to look at management teams, you’ve got to look at governance,” Engel said in an interview at Bloomberg’s Toronto office. “We’ve got a number of companies in this space where the CEO is the chair. From a governance perspective that’s not ideal, you need independence.”

Many pot companies are criticized for their frequent use of press releases in what appears to be a blatant attempt to boost their stocks, said John O’Connell, CEO of Toronto-based investment manager Davis Rea Ltd., which has been short Aphria’s stock since September.

“The rubber’s going to start hitting the road here pretty quickly in terms of who actually has executed on their business plan and not just promoted the stock,” O’Connell said.

Lingering Optimism

Five Canadian cannabis companies have now listed on either the New York Stock Exchange or the Nasdaq, including Aphria, and that brings extra scrutiny from the Securities and Exchange Commission, said Charles Taerk, CEO of Toronto-based Faircourt Asset Management, which runs the pot-focused Ninepoint Alternative Health Fund.

“I think an issue for these companies as they mature is the SEC has a more challenging set of rules with respect to disclosure,” Taerk said. “It’s a bigger challenge than I think some companies are really ready for.”

To be sure, there’s also plenty of lingering optimism in the sector. Cronos Group Inc. confirmed Monday it’s in talks with tobacco giant Altria Group Inc., sending its shares up by 16 per cent over two days. And as global stocks swooned on Thursday, pot stocks were a bright spot, with Aphria rising 6.7 per cent to us$5.28 at 10:00 a.m. in Toronto.

Looking ahead to 2019, it appears that the correlation between pot stocks will continue to break down as some companies successfully mature and others fail, said Rosen.

“There’s a small group of companies that will survive and a large number that are going to collapse.”

Cannabis Canada is BNN Bloomberg’s in-depth series exploring the stunning formation of the entirely new – and controversial – Canadian recreational marijuana industry. Read more from the special series here and subscribe to our Cannabis Canada newsletter to have the latest marijuana news delivered directly to your inbox every day.