The market seems to be getting excited about cannabis stocks again with Aurora (ACB) bouncing hard off of its lows seen last year. However, investors need to step back and take a pragmatic look at the operations and risks in the company as a few red lights seem to be blinking such as high SG&A relative to revenues, ballooning goodwill, and excessive share-based compensation. The company recorded an $80.2M loss from operations for the three months ended December 31, 2018 which is quite a good deal higher than the same quarter's loss of $16.1M in 2017. With these latest quarterly results already reflecting Canada's cannabis legalization, in my opinion, it looks to be due time the company gets its expenses in check and settle into a sustainable operating model or else risk massive goodwill impairments.
Notably, last quarter's $80.2M loss from operations is before a $68.7M fair value impairment of their investment in Alcanna (OTCPK:LQSIF) and a $119.9M unrealized loss on stemming mainly from investments in The Green Organic Dutchman Holdings (OTCQX:TGODF) ($83.9M loss) and CTT Pharmaceuticals (OTCPK:CTTH) ($28.0M loss). Together, these losses helped push the net income loss for the quarter to a high $239.6M. Given all of these investments are in publicly traded companies, the fair value of Aurora's investments will fluctuate with the underlying security's market price and, that being said, calendar Q4 2018 was a rough quarter for a lot of companies in the cannabis sector.
Operating Leverage Not Being Achieved
With growing sales and legalization trends continuing to spread, the hope would be that revenue reaches that critical point where operations can start to turn a profit, or at least break even. Sadly, Aurora has been growing its SG&A as fast as revenues can keep up, meaning that the operating losses are continuing quarter after quarter as shown in the below graph.
Source data from Morningstar
To put things into perspective a bit more, Aurora's SG&A expenses of CAD$85.6M in the latest quarter are approximately 9.7% of tobacco giant Altria Group's (MO) CAD$833.3M SG&A expenses for its latest quarter ($USD 626M at 1.3311 CAD/USD average rate for the quarter). Already having 9.7% of Altria's SG&A should be digested along with the fact that Aurora's quarterly revenue of CAD$54.2M is only 0.7% of Altria's CAD$8,138.3M revenue from its latest quarter! With Aurora's latest quarter already reflecting Canada's cannabis legalization, in my opinion, it looks to be due time that the company gets its expenses in check.
Excessive Share-based Compensation
Aurora continues to dilute shareholders through excessive share-based compensation that amounted to $22.5M in the latest quarter. Share count has gone up around a staggering 428% in the past two years from 183 million in average shares outstanding in the quarter ended December 31, 2016, to 969 million outstanding in the latest quarter. This dilution from Aurora is far higher than the 147% increase in outstanding shares seen at Canopy Growth (CGC) during the same period.
Source data from Morningstar
Ballooning goodwill, mixed with negative Cash Flow from Operations, is rarely a good sign and the speed at which Aurora's CAD$3,056M worth of goodwill has piled up is concerning. The acquired goodwill needs to be tested annually for impairment and unless this acquired goodwill can start to live up to its economic value expectations at the time it was acquired, it might have to be written down eventually. The frenzy around the cannabis industry has led to rabid speculation from investors and corporations alike, resulting in acquisitions at inflated prices and goodwill being built up on the books of many companies in the industry.
Source data from Morningstar
Thinking about the fears in recent years of how the craft brewery frenzy will effect the brands and goodwill of the majors beer brewers is a theme that is highly applicable to the cannabis industry. Cannabis is far easier to grow compared to making beer and in countries where consumption is legal, such as Canada, the Netherlands, and Spain, residents are allowed to grow their own plants. This is a libertarian policy that is likely to continue as legalization spreads. The barriers to entry are low in my opinion as at the end of that day cannabis is just a crop.
Comparing the goodwill of Aurora to Canopy Growth, Aurora looks even more in danger of impairments. As of the most recent December 2018 quarter-end for both companies, goodwill as Aurora sits at 65% of total assets excluding cash compared to 40% for Canopy Growth respectively as can be seen in the graph below.
Analyzing the amount of revenue that this goodwill is helping to generate continues to paint both companies in a risky light, Aurora especially. If we take the calendar Q4 2018 quarters of both companies which included a full quarter of Canada's legalization and annualize revenue (a simple x4 for simplicity's sake), we see that goodwill is 28.2x revenues for Aurora and 10.9x revenues for Canopy. The companies would need to see an incredible improvement in revenues to make this goodwill economical.
Aurora might be continuing to make revenue gains but its operations leave a lot to be desired and the goodwill sitting on the balance sheet looks a little scary. The issues of high SG&A relative to revenues, ballooning goodwill, and excessive share-based compensation all raise a few red flags in my opinion. While I am not one to short stocks, as I believe the market can stay irrational longer than a short investor might be able to remain solvent, I will be keeping my distance from this company.
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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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