Aurora Cannabis (ACB) announced its exit from a 10.5% ownership position in The Green Organic Dutchman (OTCQX:TGODF), an organic cannabis producer out of Ancaster, Ontario. While the move stirred up a range of opinions, including those of an increasingly bleak future for TGOD (I disagree), supported by a more than 15% slide in stock price during the trading day, I would like to offer a write-up on why I think it’s an excellent business decision on Aurora’s part, and simultaneously, in no way a death sentence on TGOD’s stock.
In some ways ACB’s decision to sell reflects its sentiment toward TGOD’s prospects compared to Whistler (Whistler Medical Marijuana Corporation, a private producer of certified organic cannabis, acquired in January 2019 for $175 Mm). But that’s not the news in focus. Aurora has divested TGOD before (recently, 5.7 Mm shares in October 2018), and the Whistler purchase was announced half a year ago.
The timing of today’s announcement reflects a necessity that goes beyond sentiment. Let’s follow the money.
1. Cash burn
As of last reported quarter (March 2019), Aurora has the following liquidity:
- C$ 390 Mm in cash available,
- C$ 210 remaining in the credit facility (offered by a bank syndicate led by Bank of Montreal, which was recently increased from C$ 230 Mm to C$ 360 Mm, due to mature in August 2021, increase announced on August 15th 2019), and finally,
- C$ 86 Mm of gross proceeds from the sale of TGOD shares.
That’s a total of C$ 686 Mm on the sources of liquidity side.
On the uses of liquidity side, there is:
- C$ 398 Mm cash burn expected during the three coming quarters (June 2019 through March 2020),
- C$ 230 Mm of outstanding unsecured convertible 5% debenture due CQ1 2020 (March), which is currently out of the money.
A side note for those of us who don’t have daily experience buying and selling debentures:
At the time the debenture matures, debtholders can convert their shares of debt into shares of equity at a predetermined price, in ACB’s case, $13.05 per share, or treat their shares of debt as bonds and receive $1,000 for each $1,000 invested.
Option 1 – If an investor exercises the conversion feature, they will receive 76.6 shares per each $1,000 invested. If March 2020 was today, and the debenture had matured, with current price of ACB stock being $5.59, an investor would receive back just $428 for each $1,000 invested, a terrible deal for the investor.
Option 1 could be useful in a different scenario – If the current price was $15, debtholders would convert their shares at $13.05 and immediately sell on the exchange for $15, at a profit to the investor and no loss to ACB.
Option 2 – Debtholders could redeem their debenture at par value, and the company, in order to pay off the debt, would effectively have to come up with $571 per debenture, out of its cash reserves. This is the likely scenario if ACB’s stock price does not rise above 13.05 by March 2020.
Uses of liquidity add up to C$ 628 Mm.
Source: Sedar.com, company filings
Without the sale of TGOD, Aurora would run a risk of being around C$28 Mm short to meet its liquidity needs (not including the additional expense on debenture under unfavorable market scenario). In my opinion, this fact was pivotal in creating urgency about the recent sale.
As can be seen from the liquidity discussion, the decision to sell does not reflect so much on the outlook for TGOD as on the business rationale of ACB. I’m of the opinion that the huge swing in TGOD price will soon revert to the recent average.
2. Other financing options available but less desirable
Aurora has secured a provision (called “shelf prospectus”) to issue $750 Mm in common shares and other ownership instruments such as debt securities, warrants, etc., at a future date (called “shelf stock” – a commonly used way to accelerate a partnership negotiations when a partner is found). So far no partnerships have been announced, but this facility can be used without a partner as well, in either case, however it may result in dilution of common shareholder rights.
The management has mentioned on several occasions that the company will try to avoid structuring future deals in a share-diluting manner (although the Whistler purchase was an all-stock deal), as it causes criticism from common shareholders.
3. 50% realized return on TGOD
According to the management’s announcement, ACB realized 50% internal rate of return on the investment. There might have been a few better opportunities to sell (at a higher price, for example, mid-March, see price chart below), but as with any real option, there was a risk of missing out on further appreciation of TGOD stock. At this time, however, with several delays in licensing and delivering a harvest (finally expected in September of this year), the risk of upside is small. Namely, TGOD and the underdeveloped Canadian recreational retail channel would have to jointly beat their respective estimates in the next quarter or two. In that unlikely scenario, ACB still has warrants to purchase 16.6 Mm shares in the future, until January 2021.
Source: YCharts
4. No pressing supply constraints
Aurora purchased another organic medical cannabis supplier, Whistler, mentioned in the beginning of this article. Whistler is further along in its life stage than TGOD, has had positive cash flow since 2015 and is currently delivering more than 5,000 kg of certified organic cannabis on an annualized basis, with a potential to expand to 15,000 kg.
(Just a quick reminder, there’s no difference in producing medical vs. non-medical marijuana, the difference is in the way it is sold – with a prescription vs without – so there can’t be a bottleneck in producing it, other than an extraordinary demand for organic certified produce, which so far we have not seen.)
Thus, ACB’s current ability to supply Canadian and international medical markets is not at risk given Aurora’s 50,000 kg/quarter production capacity, of which only 20-30% gets sold. At the same time, near-term capacity to sustain liquidity is, in fact, at risk. And this reason helped justify the company’s exit out of TGOD from a position of strength at this time. Even if ACB gave up the option to purchase 20% of its future produce at 10% discount.
Summary
In summary, I will restate that Aurora’s divestiture of TGOT is a reasonable business decision at this time, given liquidity needs, possible delays in finding other sources of financing, sufficient current supply of cannabis, and a strong realized return on the TGOD investment. The decision should not depress the stock price of The Green Organic Dutchman, as it does not reflect on the entirety of its business success long term.
Aurora is set to report results on September 11 and to host an earnings call on September 12 (likely containing the positive results which the company already pre-announced a few weeks earlier), but the transaction will not be reflected on the books until next quarter.
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.
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