Canopy Growth Corp (TSE:CGC): Is it Misunderstood?

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Canopy Growth Corp has not yet actually generated a positive net income

Motley Fool Canada | December 8, 2016: Canopy Growth Corp (TSX:CGC) has rallied over 300% this year, making it the best-performing stock on the TSX. But before you jump on the bandwagon, I want to clear up the biggest misconception about the stock; namely, the fact that Canopy has not yet actually generated a positive net income.

Canopy makes no net income. That’s right; the oft quoted figure of .05 per diluted share the company reported in its Q2 2017 filings is not entirely accurate. Moreover, the company also did not generate an incredible 186% in gross margins during the same quarter. The reason for this misconception is due to the fact that Canopy reported the unrealized gains in biological assets on its income statement and netted it against its cost of sales.

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For those unfamiliar with International Financial Reporting Standards (IFRS), the unrealized gains in fair value of biological assets refers to the non-cash gains a company makes on their plants and animals as they mature through their life cycles. Generally, this type of reporting is common among agricultural entities. When it comes to Canopy, the unrealized gains in fair value, of course, refers to their marijuana plants as they go through their life cycle up to the pre-harvest period.

Upon harvesting, the biological assets are then moved to the inventory at fair value (the price the company would receive for the assets during an orderly transaction between market participants), which becomes the cost for the inventory. After which, upon sale of the assets, the inventory is expensed as cost of sales and netted against the fair value gains.

Sounds confusing? It is.

Although what Canopy is doing is completely within accounting guidelines, this type of reporting creates significant earnings volatility and anomalies, such as 186% gross profits, potentially throwing off investors who are unfamiliar with IFRS complexities. Unlike, say, a manufacturer whose cost of sales would be incredibly straightforward, Canopy’s cost of sales is contingent upon the strains being grown, the life cycle stage of the pre-harvest plants, and, of course, significant management judgement in determining fair value of marijuana assets.