The best time to get into a market like the previously hot cannabis sector is after the related stocks are beaten down. Such is the case for Aurora Cannabis (ACB) now down over 55% from the double top at $12.50. As more and more areas legalize medical or recreational cannabis use, the market opportunity will only grow exponentially. The market dynamics of the cannabis sector are complex and the stock valuations are still stretched so the best way to derive the right valuation for Aurora Cannabis is the strong support at the current price.
Image Source: Aurora website
At this point, the global market opportunity in either medical or adult-use cannabis really isn't questioned. The opening up of the Canadian market in October to recreational use and the approval of at least medical applications in so many U.S. states suggests the tide on legalizing marijuana won't ever reverse absent changing facts surrounding safety.
Most industry players regularly use the $200 billion market opportunity figure for the global cannabis market. Some even suggest the cannabis sector will disrupt industries worth over $500 billion. Most research places the market opportunity in the $30 billion to $40 billion range over the next few years including this forecast that targets a $39 billion market by 2023.
The long-term key to success is not getting into a low-margin pricing war with supply outstripping demand. Aurora Cannabis plans to build at scale to lower costs while building strong brands that will offer higher selling prices. The goal is to replicate how beverage and tobacco companies rely on strong brands and distribution networks to control the market and sell commodity products at premium prices.
The company expects to dramatically increase production from 70,000 kg/year this year to over 500,000 kg/year in a time period of two years before including capacity of the pending ICC Labs acquisition. Again, this is good from the standpoint of Aurora Cannabis, but potentially bad for the cannabis market. When supply can be added so quickly, the market has the potential to quickly reach oversupply conditions outside of restrictions due to restrictions on licenses.
Source: Aurora Cannabis October '18 presentation
The key here probably isn't the ability to ramp up production. The more important aspect is the ability of the Canadian company to control market share via some strong initial brands. Aurora Cannabis already has the top 4 selling products in British Columbia.
A lot of these facts aren't disputable, the question is what the management team can do with this market opportunity to generate shareholder wealth. The recent FQ1'19 results provide a small hint into the operational capabilities of management.
Revenues surged by 55% sequentially and 260% over last FQ1 to $29.7 million. Due to so many moving parts, the key metric is likely to be the gross margin going forward. In this regard, Aurora Cannabis saw a small dip in margins to 70%. Source: Aurora Cannabis October '18 presentation
Selling prices are likely to fall in the next few years as production ramps up around the world. The Canopy Growth (CGC) CEO had previously predicted the supply and demand equation to normalize as soon as 2019.
For Aurora Cannabis, capacity will grow 5-10x in the next couple of years so the company will attempt to push the production costs down from $1.45/gram to below $1.00/gram. The question most in the market are worried about is whether the high-quality brands can maintain current selling prices.
Aurora actually saw their price per gram in the last quarter jump 15% YoY to $8.39. In these initial stages, one can't imagine a market where prices will rise further as capacity additions come online to catch up with legalization efforts.
Ultimately, the market will tell the story of the market dynamics. The cannabis stocks are trading at yearly lows while the big beverage and tobacco names are reportedly interested in the space now. This discrepancy suggests the big players are struggling with valuations.
* YCharts lists revenues in U.S. dollars while the other numbers in the article are based off the reports from Aurora Cannabis in Canadian dollars.
The ultimate question is what to do with the stock now after the major sell-off. Aurora Cannabis has had major support this year around the $5.40 level providing maybe the best way to play the stock for now.
At pro-forma revenue of ~$30 million (NYSEARCA:USD) based on inclusion of MedReleaf's business for the full quarter, Aurora Cannabis trades at about 50x annual sales.
Based on the reported numbers of $29.7 million in revenues, the company spent $65.3 million in operational costs leaving a wide operational loss of $35.6 million. A company spending $2 to make $1 can only be traded on a momentum basis even if the growth potential is astronomical.
With cash of only $148 million, Aurora Cannabis is likely to need an equity investment that would increase the market capitalization without likely adding additional revenues.
The key investor takeaway is that the market opportunity is enormous, but so is the likely competition when everything shakes out. The companies building a premium brand will likely survive and thrive, but market forces are very dynamic at this point.
Aurora Cannabis has a first mover's advantage, but the stock has a valuation to support such an investment thesis. The stock makes for an interesting momentum trade right around the current $5.40 level after the 55% dip. Further weakness below $5 would be a sure sign the cannabis company lacks institutional support and the beverage/tobacco industry backing sending a huge negative signal for the stock to not hold that level now listed on the NYSE.
The stock isn't likely to go up in smoke, but Aurora Cannabis is at a clear inflection point with high risk.
Disclaimer: 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.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ACB over 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.