My investment thesis on Aurora Cannabis (ACB) has long held that the cannabis stock might have another rally left based on sector momentum. In the short term, the market cares more about price than fundamentals and a move above $8 has been a signal for another test of previous highs. A big analyst call sealed the likely rally in the stock.
Image Source: Aurora Cannabis website
Bold Analyst Call
On Tuesday, Cowen Equity Research analyst Vivien Azer shuffled her cannabis top pick of Canopy Growth (OTC:CGC) with Aurora Cannabis. The analyst slapped a $14 price target on the stock and Aurora Cannabis surged over 7% to top $8 on the news.
The catch that the market originally missed is that the bullish call was C$14 or only ~$10.50. The target price is actually far below the $12.52 high from last October. In part due to this reason, the stock is back below $8 for a likely short term.
The major points of the analyst call are actually not the best reasons to move out of Canopy Growth and into Aurora Cannabis: out performance by Canopy Growth over the last year and Aurora Cannabis obtaining 20% market share in the Canadian recreational use market.
From the above chart, one can't deny that Canopy Growth outperformed Aurora Cannabis over the last year. The chart doesn't make any statements about whether the outcome is based on an irrational market or contributing factors justifying the move.
The biggest reason for the opposite moves is that Canopy Growth sold a large portion of the company for cash to Constellation Brands (STZ). Aurora Cannabis has spent the last year buying firms via diluting shareholders with shares that will be sold in the future. One move boosted the stock to a premium price and the other holds down the stock due to paying a premium to buy other companies.
The other issue is the market share, where Canopy Growth is expected to control over 30% of the market share with Aurora Cannabis down around 20%. In that last quarter, Canopy Growth reported revenues from Canada of ~C$80.3 million and a total of C$83.0 million in comparison to only C$54.2 million in total from Aurora Cannabis.
Aurora Cannabis is ramping up production along with a lot of other players in the current Canadian market, so market share based on December numbers are relatively meaningless. The company will more than triple production by the June quarter and likely catch up with Canopy Growth.
Where This Goes
With about 1.1 billion shares outstanding, Aurora Cannabis has a market value of about $8.8 billion now or C$11.6 billion. Canopy Growth is up at a market value of $16.4 billion or C$21.2 billion. Due to the large net cash balance of C$4.1 billion, Canopy Growth has an enterprise value of $13.4 billion. At the $10.50 price target, Aurora Cannabis would have a similar enterprise value ~$11.5 billion considering the company has a limited cash balance.
My point in the whole analysis is that valuation metrics should matter far more than where a stock has been. Aurora Cannabis is in a massive growth phase that positions the company to catch up and potentially surpass Canopy Growth.
The forecast is for Aurora Cannabis to exit 2020 or so with cannabis production in the range of 1.2 million kilograms with Canopy Growth at only 560,000 kilograms or roughly half of ACB's production levels. Though, Canopy Growth has the financial firepower to ramp up production levels.
Analysts actually have both companies reaching FY21 revenues in the $1 billion range so again, the justification is probably for similar stock valuations. Aurora Cannabis has an extra quarter of recreational use in Canada included in the FY19 results providing the misleading numbers for the current fiscal year. By FY20, analysts project both companies having similar revenues.
These revenue estimates are interesting considering the Stats Canada data on Q4 annualized spending on cannabis. The government report has the household spending on cannabis at C$5.9 billion with only C$1.2 billion coming from legal source. About 4x the revenues were still coming from illegal sources due in part to lower prices. According to the report:
Data collected on the Statistics Canada crowdsourcing website StatsCannabis indicate that the average all-in market price paid for legal cannabis flowers was C$9.70 in the fourth quarter of 2018. The corresponding average price of illegal cannabis was C$6.51, lower than the price of legal cannabis by 32.9%.
The upside for Aurora Cannabis would be a substantial portion of the revenue still in the illegal market to capture via legalization. The downside is that the market is already flooded with supply and illegal sources need to undercut prices of legal options.
One can easily take the Q4 revenues for Aurora Cannabis of C$50+ million to C$200 million annualized. Further, one can gross up the total based on the Statistics Canada market size and Aurora Cannabis would reach at least C$1 billion target in a few years. Add some international revenues and Aurora Cannabis would reach the above revenue targets and the market will probably reward the stock with a big rally.
The big hiccup is pricing as the market is flooded with new supply. Aurora Cannabis is alone going from 7,822 kilograms produced in the December quarter to 25,000 kilograms in the June quarter and production isn't stopping there with a target of over 100,000 kilograms of quarterly production in Canada alone.
Cannabis pricing was already under pressure in the December quarter with the implementation of the excise tax in Canada and all of the illegal supply. Remember that the illegal market can avoid these taxes and sell at a cheaper price while maintaining similar profit margins.
Aurora Cannabis averaged a net selling price of C$6.23 per gram for dried cannabis in the December quarter due to wholesale pricing and the absorbing of the excise duty tax of at least 10%. As more legal supply hits the market, Aurora Cannabis could be looking at net prices of C$4 to C$5 a gram.
A simple financial model for FQ4 with the above pricing pressure:
- Net cannabis revenue: 25,000 kg x C$5.00 gram = C$125.0 million
- COGS: C$1.50 gram = C$37.5 million
- Gross profit: C$3.50 kg gross margin = C$87.5 million
- Operating expenses: C$75.0 million
- Depreciation: C$25.0 million
- Operating loss: C$12.5 million
The key to these estimates is that the numbers are probably a best case scenario. The cannabis costs aren't likely to be down at C$1.50 with the startup of several facilities. The FQ4 costs per gram might actually approach the C$2.00 level of FQ2. In addition, the huge ramp could push operating expenses and depreciation costs much higher than the estimates for modest increases from the C$66.4 million and C$19.3 million levels from last quarter.
The actual biggest risk might be a lower net selling price towards C$4 a gram as illegal sources fight against a flood of legal supply. Such a scenario of lower net selling prices becomes highly problematic as Aurora Cannabis expects to further ramp up even more production into an oversupplied market.
Path Of Least Resistance
The initial path of least resistance for the stock appears a break above $8. The company has a cheaper market value than Canopy Growth and a forecasted path to similar revenues by FY20. The recent chart of lower lows and higher highs should push the stock higher.
The stock would clearly have a stretched valuation at $10.50 while the more likely outcome is a test of the $12.50 high for a market valuation of $13.8 billion. An enterprise value matching Canopy Growth doesn't appear so out of the realm of reality regardless of the fundamentals.
Momentum traders are still eating up the production growth and revenue forecasts to remain ultra bullish on Aurora Cannabis. This initial path will likely be followed by the reality of disappointing results come the FQ4 report in August.
The key investor takeaway is that the Canadian cannabis stocks trade at sky-high valuations that could get even higher. Aurora Cannabis appears on a path to break key resistance at $8 and head to the Cowen target of $10.50 and previous highs of $12.50.
One can't really make a fundamental case for such valuations so a rally to $12.50 is the ideal opportunity to exit this stock. A market valuation approaching $14 billion with revenues likely to struggle to reach $1 billion is problematic in the future. The supply/demand data in Canada continues to suggest the market is going to be flooded by mid-year for a cannabis market already fully supplied via illegal sources undercutting legal prices.
My best projection is that Aurora Cannabis misses revenue targets by the end of calendar 2019 and the stock ends up back below $8. Investors should enjoy this last squeeze higher before normal supply/demand dynamics wreck the sector.
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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