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Looking into the Financials of MedReleaf Corp.

Less than two weeks ago, shares of MedReleaf Corp. (TSX:LEAF) went through the Initial Public Offering (IPO) process and began trading on the stock exchange. Although investors did not aggressively jump at the opportunity to buy shares, the closing price for the first week was still at $9.20 per share.

Investing in the marijuana industry has been a very exciting endeavour since the beginning of the year. The challenges faced by investors have been (and remain) a lack of clear financial stability of any one of the companies in this category.

Canopy Growth Corp. (TSX:WEED) has traded on the stock exchange for approximately one year. Investors have ignored the obvious and invested in it anyways.

While Canopy Growth Corp. has reported a profit over the past year, the cash flow from operations (CFO) has remained negative due to the higher acquisition costs for each client. On the income statement, earnings have been positive due to the upward revaluation of the inventory grown by the company.

In the case of MedReleaf Corp., the good news for investors is that the company has reported both positive earnings per share and positive numbers from CFO as of March 31, 2017. Although these statements are now one year old, they are the most up-to-date financials available from the company. Earnings totaled $3.37 million, while CFO was approximately $1.4 million.

Looking at revenues and gross profits, the annual revenues from fiscal 2015 to 2016 increased drastically as the industry exploded. Revenues in 2015 were almost $3 million, which led to a per-share loss of $1.64. In 2016, revenues increased by over six times from the year earlier, and earnings per share turned positive to $4.40 per share. Things seem to be going in the right direction for the company.

When looking into the format of the income statement of MedReleaf Corp., investors need to be very careful and observant to understand where the increase in value (of inventory) is being placed. At the very top of every income statement is the revenue number, which is (in almost all cases) followed by the cost of goods sold amount and then the gross margin. This is the standard.

In the case of MedReleaf Corp., the gross margin is reported but is then followed by the “gain on fair value changes of biological assets,” which means that the company is accounting for the increase in value in inventory (in excess of the cost of production) as revenues. These are not revenues!

Although the gross profit number reported encompasses both the revenues and upward revaluations, the gross profit amount of 65% of revenues is simply too high. In the case of competitor Canopy Growth Corp., the gross margin is 173% of revenues (for the quarter ending December 31, 2016). These number simply don’t add up.

The saying “if it’s too good to be true, it usually is” comes to mind. Invest with caution.

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Fool contributor Ryan Goldsman has no position in any stocks mentioned.

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