For a company chasing a multi billion-dollar global industry, Aurora Cannabis (ACB) continues to spin wheels with decisions and statements that make me nervous. The company is still burning substantial cash and needs a big June quarter to get out of the hole. The oncoming supply flood remains problematic despite the claims of management, so my long-term investment thesis remains negative while cognizant that the stock can still rally in the short term.
Image Source: Aurora Cannabis website
Spinning Wheels
For FQ3, Aurora Cannabis still hasn’t made much progress in actually producing and selling cannabis, though most metrics did improve in the quarter. The company saw net cannabis revenue reach C$58.7 million, up from C$47.6 million in the prior quarter.
Source: Aurora Cannabis FQ3’19 presentation
One might expect much larger sales from a company with a nearly $10 billion market valuation based on 1.1 billion shares outstanding. Not to mention, a company with an at-the-market offering for $750 million on the books.
In the quarter, Aurora Cannabis produced 15,590 kgs, but the company only sold 9,160 kgs. The amounts are still very minimal in comparison to the funded capacity of more than 625,000 kgs plus additional capacity from ICC Labs in Uruguay.
The first real test comes with Aurora Cannabis having 25,000 kgs available for sale in the current quarter ending in June. How the market absorbs all of this additional supply will be an initial first test of where the market goes.
The other tests include the additional supply from the company suggesting yields are 20% above targets. As well, a small competitor like CannTrust Holdings (OTC:CTST) is quickly moving from 3,014 kgs sold in Q1 with a goal of growing quarterly production to 75,000 kgs by the end of 2020.
The good news for investors is that Tilray (TLRY) sees supply remaining constrained for 18-plus months. CEO Brendan Kennedy was one of the few reasonable voices in the Canadian cannabis sector. On the Q1 earnings call, he had this to say about the sector:
We now believe there could be a supply balance in Canada in the next 18 months to 24 months as the market finds an equilibrium between supply and demand. This is longer than our estimate just eight weeks ago, as the industry continues to struggle ramping production in the existing regulatory environment.
Path To Profits
The biggest promise maintained by management is the goal to reach EBITDA positive by FQ4. The company produced a C$36.6 million EBITDA loss in the last quarter so Aurora Cannabis has a huge step to make in the current quarter.
Due to a massive global expansion plan, the company has a relatively large operating expense base already. In FQ3, SG&A operating expenses were C$67.1 million, only up slightly from C$66.3 million in the prior quarter.
Source: Aurora Cannabis FQ3’19 MD&A
Management did an excellent job of maintaining SG&A costs in the prior quarter, but the company spends an absurd C$50.8 million on administrative costs. Aurora Cannabis spends a relatively small amount on sales and marketing for branding and research and development.
Even in a scenario of Aurora Cannabis becoming EBITDA positive in the June quarter, the company still spends over C$18 million on depreciation and amortization costs and almost C$40 million on stock-based compensation that’s contributing to the massive share count growth.
Source: Aurora Cannabis FQ3’19 MD&A
So even if the large cannabis company reaches EBITDA positive, Aurora Cannabis will still have sizable losses and share count dilution. First though, the company needs to hit these targets to reach EBITDA positive.
Using some basic targets of limited pricing pressure and constrained operating expense growth to C$75 million would produce a big EBITDA boost:
- Revenues – 25,000 kgs @ C$6 per gram = C$150M
- Gross Margins – 60% = C$90M
- OpEx – C$75M
- Adj EBITDA = C$15M
The question is whether prices can stay anywhere near C$6.00 per gram, down from C$6.40 in the prior quarter. A more logical target is C$5.00 per gram.
- Revenues – 25,000 kgs @ C$5 per gram = C$125M
- Gross Margins – 60% = C$75M
- OpEx – C$75M
- Adj EBITDA = C$0M
If prices dropped about 6% QoQ with only about 2,000 additional kgs sold, what’s going to happen when the amount explodes 170% in the current quarter to 25,000 kgs? Also, Aurora Cannabis plans to place some product in inventory for the consumables later this year so sales might fall short of the 25,000 kgs.
The production level will quickly expand again to 37,500 kgs per quarter for a ~300% increase in just two quarters. The difference here from the growth in 2018 is that these levels are going to be very material amounts.
The risk remains that prices drop more toward C$4, pressuring gross margins and ultimately keeping the company losing money and struggling to reach EBTIDA positive. What makes me nervous is these ultra bullish comments on demand from CEO Terry Booth on the earnings call:
I think I said last quarter that if there is one thing that I lose sleep about is our ability to supply the global demand for cannabis. But it is definitely something that still is at the top of our agenda, increasing our capacity to feed the global need. It took Canada five years to meet its demand for the population 33 million. So you just put that math into perspective with the EU, with Australia, Mexico and other countries that are coming online, it would take nearly 50 years to meet that demand. But we are not going to take that long because of the scale, we are now able to build upon.
The CEO seems to miss that relatively small companies like CannTrust are in the market boosting supplies 25-fold as well. Aurora Cannabis doesn’t need to supply the global markets alone and possibly at all to meet future demand.
Aurora Cannabis can argue all day that the company has lower production costs, but such a position won’t stop other companies from loading up supply to meet this demand as well. Making a statement suggesting a simple company in Canada needs to supply the global supply or it will take 50 years to feed the need already served by an illegal market just sounds tone death.
Takeaway
The key investor takeaway is that Aurora Cannabis is increasingly making us nervous that the company is blind to the oncoming flood of cannabis supply. The company appears far too bullish on the pricing environment under this scenario.
If we’re right, this market doesn’t end well for the stock. Tilray is pointing to a market that might hold up longer than expected, but any long position is just for a short-term trade.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion or consult a financial advisor. Investing includes risks, including loss of principal.
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