Aurora Cannabis: Justified

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About: Aurora Cannabis Inc. (ACB), Includes: APHA, CGC, CRON, HEXO, OGI, TLRY
by: Jonathan Cooper
Summary

Aurora has justified its second-place valuation with a great quarter in the Canadian recreational and international medical markets.

In Canada, Aurora sold approximately 5,400 kilograms of recreational cannabis, up 42% QoQ and in second place among peers.

Aurora increased international revenue 40% quarter-over-quarter and was one of three companies to with a tender application for a German cultivation facility.

Aurora expects to earn an adjusted EBITDA profit next quarter and to grow over 25,000 kilograms of cannabis - more than 20x what they grew a year ago.

Trading at about 17x estimated 2020 sales, Aurora will not impress value investors.

All dollar figures are in Canadian dollars unless otherwise noted.

Aurora Cannabis valuable compared to Canopy Growth, Organigram, Hexo, and Tilray

Summary

Aurora Cannabis (ACB) is the second most valuable cannabis company in the world and has retaken second position in Canadian recreational cannabis market share after a strong March quarter. Operationally, Aurora is growing in both Canada and internationally, including producing nearly twice as much cannabis this quarter as last (15,590 kg; up 99% QoQ) and being one of only three companies to win a tender to cultivate medical cannabis in Germany.

Aurora earned $65.1 million in the March quarter, up 20% QoQ although slightly below analyst estimates of $67.5 million. Gross margins ticked upward to 56%, far ahead of larger peer Canopy Growth's (NYSE:CGC) 22% gross margins last quarter. Aurora lost $76 million in EBITDA (ex-FV) this quarter and had a free cash flow deficit of $151 million, with about two thirds of that deficit due to capital expenditures. Perhaps owing to this deficit, Aurora has filed to raise up to U$400 million through an equity offering.

In my view, this was a strong quarter for Aurora with good growth in both the Canadian recreational cannabis market (revenue up 37% QoQ) and the international medical market (revenue up 40% QoQ). Those two markets are likely to be two of the largest drivers for Aurora's growth next quarter and Aurora's robust performance will give investors confidence the company will continue to perform well in all its key markets.

That said, value investors will still find little to like here. Aurora trades at approximately 17x its 2020 sales, based on analyst estimates. This valuation implies that Aurora will need many more strong quarters and continued growth in the Canadian and international cannabis markets to justify its $13 billion price tag.

For my part, I see Aurora as a reasonable investment in the Canadian cannabis sector, although not one of my favorite investments. Next quarter, Aurora anticipates growing more than 25,000 kilograms and cannabis and anticipates earning its first adjusted EBITDA profit on the back of increasing revenue. Aurora also is expected to announce U.S. CBD plans and Nelson Peltz-fueled partnerships with global companies over the next several months.

Resources

The Business

Aurora Cannabis is an enormous global cannabis company that intends to operate in every cannabis market where it's legally permitted. Aurora currently has operations in 24 countries across five continents (the Americas, Australia, Europe, and Africa) and is based in Edmonton, Alberta, Canada.

Among many other assets, Aurora has about 5,200,000 sq.ft. of planned cultivation capacity, with about 1,300,000 sq.ft. listed as being fully operational. This gives Aurora a production capacity estimated at about 150,000 kilograms/year of cannabis. That capacity will grow to 625,000 kilograms/year by the end of 2020.

Aurora Cannabis grew 99% more cannabis this quarter than last quarter.

Cannabis production and sales: During the third quarter, Aurora harvested 15,590 kilograms of cannabis (+99% QoQ, +1,193% YoY) and sold 9,160 kilogram equivalents of cannabis through all channels (+31% QoQ, +577% YoY). Quarterly results had a very small tailwind from the purchase of Whistler Medical in March 2019 while annual results have a larger tailwind from the purchase of MedReleaf in July 2018.

In both cases, however, the majority of the increases were due to Aurora building new cultivation facilities and the addition of the Canadian recreational cannabis market in October 2018. For example, Aurora's production increase in the March quarter was primarily due to increased cultivation capacity at facilities in Edmonton, AB (Aurora Sky), Markham, ON (MedReleaf Markham), and Bradford, ON (MedReleaf Bradford).

Aurora expects to harvest more than 25,000 kilograms of cannabis in their June 2019 quarter and will continue to ramp up production through the end of 2020.

Aurora is building out its Aurora Polaris facility for products like edibles and vape pens.

Aurora Polaris rendering, via Aurora Cannabis.

Aurora Polaris: In October 2019, Canada is expected to legalize a variety of processed cannabis products including edibles, beverages, and vape pens. These products are currently not allowed in Canada for either recreational or medical use. These products will expand the Canadian cannabis market and bring in new legal users who prefer these form factors over the currently available dry flower and cannabis oil products. These products are likely to have higher margins than dry flower because they allow for much more product differentiation (flavors, appearance, type of food, texture, potency) and therefore better branding.

Aurora is preparing for these new products with the construction of their 300,000 sq.ft. Aurora Polaris facility in Edmonton, AB. This facility was announced in February 2019 and will serve as Aurora's hub for production of higher-margin, value-added products. Aurora expects to use the facility for products "including edible products such as baked goods, chocolates, mints, and infused beverages, in addition to concentrates such as vape products, cosmetics, and softgels."

These processed products are likely to be created using cannabinoids and terpenes extracted from cannabis rather than from dry flower itself. Aurora is using Radient Technologies (OTC:RDDTF) for cannabis extraction, with the first delivery of cannabis derivatives from Radient in May 2019. Aurora and Radient signed an agreement to work together in November 2017 with a five-year term that Aurora can extend a further five years. Aurora has an equity position in Radient including a $12 million investment in December 2017. After that investment, Aurora has 37.6 million Radient shares and 4.5 million Radient warrants. Those warrants expire this December and are out of the money (at $1.71/share), but the shares are worth about $38 million and represent about 14% ownership of Radient based on the latter's Dec. 31 filings.

March Quarter Results - Revenue and Gross Margins

Aurora Cannabis released its third quarter results of fiscal 2019 on May 14 with the earnings call on the morning of May 15. To avoid confusion, I will refer to Aurora quarters by date rather than their fiscal quarters.

Aurora Cannabis revenue increased to $65 million and gross margins ticked up to 56%.

Revenue: During the March quarter, Aurora Cannabis generated $65 million in net revenue (+20% QoQ, +305% YoY), which was $2.4 million below analyst estimates of $67.5 million.

Gross margins for the quarter ticked up slightly from 52% to 56%. This increase was caused by a drop in growing costs. During the March quarter, cash cost of sales per gram dropped 21% QoQ to $2.05/gram and cash cost to produce per gram dropped 26% QoQ to $1.42/gram. This decline is due to economies of scale as Aurora's largest facilities come online. Those facilities are expected to have a cash cost to produce under $1/gram.

Gross margins already were significantly ahead of Aurora's largest peer, Canopy Growth although slightly behind Nasdaq-bound Organigram (OTCQX:OGRMF):

Aurora Cannabis has among the highest margins in its peer group.

Segments: Aurora's net revenue of $65 million was made up of $29 million (45%) from medical cannabis, $30 million (45%) from recreational cannabis in Canada, and $6 million (10%) from other sources. Aurora's revenue growth this quarter was primarily due to increased recreational cannabis sales and growth, with recreational cannabis growing from $22 million (40%) last quarter.

By weight, Aurora sold about 5,400 kilogram equivalents of recreational cannabis at an average price of $5.48/gram compared to 3,807 kilograms at $5.67/gram last quarter. These sales place Aurora second among Canadian cannabis producers, behind Canopy Growth but ahead of Organigram:

# Company Rec. Cannabis Sales Quarter
1. Canopy Growth 8,288 kilograms (equivalents) Dec 31, 2018
2. Aurora ~5,400 kilograms Mar 31, 2019
3. Organigram 4,658 kilograms Feb 28, 2019
4. Hexo (HEXO) 2,537 kilograms Jan 31, 2019
5. Tilray (TLRY) ~1,900 kilograms Mar 31, 2019

Top five recreational cannabis sales. Estimates by the author based on company filings.

All sales here are in kilogram equivalents since a portion of these sales are sold as cannabis oils and sprays.

Aurora earns most of its revenue from dry cannabis, but its international segment is growing quickly.

European Sales and German Tender Win: The vast majority of Aurora's cannabis sales are in the Canadian market, but international medical cannabis sales are growing.

During the March quarter, Aurora generated $4 million of revenue from European medical cannabis sales, up 40% QoQ and 72% YoY. This growth is significantly faster than the growth of the Canadian medical cannabis market, which is a mature, slow-growth medical cannabis market.

Aurora's European revenue is likely to rise in future quarters. In April 2019, Aurora Cannabis was awarded the maximum number of lots in a German cannabis production tender. Aurora received five lots as did Aphria (APHA). After that award, Aurora will build a cultivation facility in Leuna, Germany. Construction is set to begin this month and is expected to be completed within 12 months. That facility will produce a minimum of 4,000 kilograms/year of cannabis beginning in October 2020.

Oil and extract sales made up 18% of Aurora's sales in the March quarter, as shown above. The majority of these sales (80%) are in the Canadian medical cannabis market with the Canadian recreational market consuming the remainder. These oil and extract sales are particularly lucrative for Aurora since they fetch an average price of $11.0/gram (+10% QoQ) while dry cannabis sells for $5.86/gram (-6% QoQ, due to a higher proportion of lower-revenue recreational sales this quarter).

Thanks to a recent Health Canada licensing of Aurora's partner Radient Technologies, Aurora expects oil and extract-based sales to increase in Aurora's September quarter. Radient received a Health Canada license in February 2019 and began producing at commercial scale in March 2019, according to filings.

Operational Costs and Profitability

During the March quarter, Aurora's sales and gross margins trended upward. At the same time, costs continued to mount as Aurora continues its build-out.

Aurora operating costs rose to $130 million this quarter including $39 million in share-based compensation

Aurora's operating costs rose $18 million in the March quarter from $112 million up to $130 million. Rising share-based compensation contributed the most to this increase, with Aurora paying out $39 million in share-based compensation (+104% QoQ, +147% YoY). General and administrative costs also increased $7 million to $51 million while sales and marketing costs fell $6 million to $16 million.

Aurora EBITDA dropped to a $76 million loss with a $151 million free cash flow deficit.

Profitability: Aurora is not profitable. In my view, the best metrics for tracking the profitability of companies are EBITDA excluding fair value adjustments and looking at operating cash flow. (Fair value adjustments are non-cash adjustments which are required under Canadian accounting standards but would not be used under U.S. GAAP accounting. However, Tilray is the only major cannabis company that reports its earnings using GAAP.)

During the March quarter, Aurora's EBITDA fell to a $76 million loss from a $65 million loss last quarter. This decline was due to higher operating costs, especially the $20 million increase in dilutive share-based compensation.

Meanwhile, Aurora's operating cash flow improved slightly from last quarter, improving to a $55 million deficit from a $64 million deficit last time. Operating cash flow does not include share-based compensation, as that's not a cash cost. Aurora also spent $97 million on their various infrastructure projects as they build up to a 5,200,000 sq.ft. cultivation footprint. Because of higher capital expenditure, Aurora's free cash flow declined to a $151 million deficit, up from $142 million last quarter.

Adjusted EBITDA: Aurora itself reports an adjusted EBITDA figure to track profitability. This figure is nearly identical to EBITDA ex-fair value, but Aurora's adjusted EBITDA excludes share-based compensation. Share-based compensation does not cost Aurora money - so that metric may be useful for Aurora debt holders looking to see if Aurora can cover its interest payments. However, share-based compensation dilutes equity holders, making EBITDA a better metric for shareholders than adjusted EBITDA.

During the March quarter, Aurora reported an adjusted EBITDA loss of $37 million, an improvement from last quarter's $46 million loss. However, if share-based compensation is included, this quarter's adjusted EBITDA inc-SBC loss was $76 million compared to $65 million last quarter.

Why I ignore net income: Net income is not a good way to track cannabis company earnings. Among other factors, net income includes the non-cash fair value adjustments that I'm excluding from EBITDA and that Aurora itself excludes from adjusted EBITDA. This quarter, for example, those adjustments added $16 million to Aurora's net income, but those are non-cash gains based on the estimated carrying value of inventory and biological assets rather than based on actual sales or costs.

Aurora net income includes things like a $101 million adjustment on the value of derivative contracts Aurora will never pay.

Source: Aurora Third Quarter Financial Statements.

Net income also includes a significant number of below-the-line (below operating earnings) adjustments which are non-cash and will have little-to-no impact on Aurora's business yesterday, today, or tomorrow.

For example, this quarter Aurora recorded a $102 million loss on derivative liability which is included in net income. This loss is a paper loss that Aurora will never have to pay. As explained in Note 13(c), this "loss" is related to Aurora's January 2019 issuance of U$345 million in convertible notes. Those notes carry an interest rate of 5.5% and Aurora expects to repay those notes in cash rather than in stock. However, each quarter Aurora must value those notes and record an unrealized loss or gain on derivative liability based on the changing value of the equity conversion option embedded in those convertible notes. The changing value of these options is recorded in Aurora's income statement each quarter and is included in Aurora's net income.

But Aurora will never need to pay this cost. Those notes will either be repaid in cash - for U$345 million plus interest - or will be repaid in equity, with a conversion price of U$7.23/share. The changing value of the equity conversion options in these notes (which is based on the changes in Aurora's stock price and the volatility of Aurora's stock price, among other factors) will not be relevant to Aurora's business at any point in the future. Thus, net income for Aurora or for most cannabis companies includes a significant amount of noise, which I try to reduce by relying on more meaningful metrics like EBITDA ex-FV and operating cash flow.

Aurora filed to offer up to U$400 million worth of equity.

Source: Aurora Cannabis on Sedar.

Capital position: Aurora's capital position is a bit complicated.

As of March 31, Aurora had $347 million in cash. Including restricted cash, short-term investments, and marketable securities (such as their investment in Radient above), Aurora had $579 million in current cash-like assets.

This was offset by about $639 million in loans and convertible debt. However, this figure excludes the value of the equity conversion option embedded in Aurora's convertible debt. That is on the balance sheet at $270 million, but this is after the $101 million increase highlighted above (which is a non-cash cost). Without getting into too much detail, if Aurora repays its debt in cash, it will work out to approximately $810 million in repayment.

Thus, Aurora sits on a net debt position of approximately $230 million but has enough cash on hand to pay for a little over two quarters at their current free cash flow deficit of about $150 million/quarter.

On May 14, Aurora filed a prospectus to raise U$400 million through issuing shares of the company. This prospectus would allow a share offering any time in the next 25 months. Net proceeds from this share offering would be used to help Aurora continue to grow its global footprint. Given Aurora's free cash flow and net debt position, it would be unsurprising if Aurora pulled the trigger on an equity funding round during the next quarter or two.

Market cap/enterprise value: As of May 13, Aurora had 1.0 billion shares outstanding with an additional 160 million shares worth of options, warrants, restricted stock units, and convertible debt. On a partially diluted basis at a share price of $11.67/share, this gives Aurora Cannabis a market cap of about $13.1 billion. Aurora has a net debt position of $230 million, putting its enterprise value at $13.3 billion.

This makes Aurora the second most valuable cannabis company in the world after Canopy Growth:

# Company Market Cap (C$) Enterprise Value (C$)
1. Canopy Growth $24 billion $20 billion
2. Aurora $13 billion $13 billion
3. Curaleaf (OTCPK:CURLF) $8 billion $8 billion
4. Cronos (CRON) $8 billion $6 billion
5. Tilray $7 billion $7 billion

Source: Author's estimates based on pro forma figures.

Looking Forward

Aurora has never posted an adjusted EBITDA gain - but they plan to do just that next quarter.

Aurora expects to deliver positive adjusted EBITDA in their June quarter. Aurora first stated this goal in February 2019 and has reaffirmed this goal in their May 14 earnings release. This would be the company's first positive adjusted EBITDA quarter in at least two years - longer than the company has been using the metric. Aurora also has suggested that it will produce at least 25,000 kilograms of cannabis in the June quarter, compared to 15,590 kilograms this quarter and 1,206 kilograms one year ago.

Prior to these earnings, analysts expected Aurora to generate $282 million in revenue in fiscal 2019 (ending June 2019), which implies expectations for about $130 million of revenue next quarter - an almost 100% increase over the current quarter. Analysts also expected Aurora to generate nearly $800 million in revenue next year, implying sequential growth rates in the high teens during all of next year.

The largest driver for Aurora's growth over the next year is likely to be the Canadian recreational cannabis market. According to my research, cannabis sales have been approximately flat through February 2019. However, they are likely to increase meaningfully beginning in April 2019 as Canada's largest province has opened its first batch of retail stores. Even adding 25 stores in Ontario could increase retail sales by up to 60%, according to some estimates.

Aurora's Canadian recreational cannabis sales also will increase as the company adds more cultivation capacity and as new cannabis products - like edibles and vape pens - are legalized in fall. Those products may entice new users into cannabis stores, but even more so, they will add more existing cannabis users into the Canadian legal market from the slowly diminishing black market. It's likely to take several years for the legal Canadian recreational market to reach maturity, based on my previous research in Colorado and Washington state.

Thoughts

Value investors won't be impressed: With an enterprise value of $13 billion and expected 2020 sales of perhaps $800 million, Aurora trades at about 17x 2020 sales. It's very speculative to extrapolate EBITDA margins (and Aurora may not be profitable in FY2020, which starts in only one quarter) but at a long-term steady-state 30% EBITDA margin, this implies Aurora may trade at 56x 2020 EBITDA.

This price is very unlikely to attract value investors. Instead, Aurora investors are interested in the long-term growth of the company and significantly more than one year's worth of growth already is priced into Aurora's share price. The same could be said for other Canadian cannabis companies: It will take many years of good execution and the growth of global cannabis markets for these companies to justify their current valuations.

Aurora's performance this quarter: That said, Aurora did well this quarter. Aurora's two most important growth markets in the near-term future (barring legal change in the United States) are the Canadian recreational cannabis market and the European medical cannabis market. Aurora improved its standing in both markets this quarter.

This quarter, Aurora's Canadian recreational cannabis revenue grew 37% quarter-over-quarter and their recreational cannabis sales (by weight) grew about 42% QoQ. After Organigram's exceptional February quarter, I did not know whether Aurora could hold on to their second-place position in Canadian recreational cannabis market share. However, Aurora surpassed Organigram's February sales by 16%.

As of this writing, Stats Canada has not released March 2019 sales figures, so it's premature to estimate Aurora's market share of the Canadian market (since we don't know the size of the market). That said, it's likely that Aurora has passed a 20% market share after hitting a 14% market share last quarter - a substantial improvement and a solid justification for the market's choice to make Aurora the second most valuable cannabis company in the world.

Aurora also had a good quarter in the European medical cannabis market. Aurora increased their European cannabis revenue by 40% QoQ, up to $4 million this quarter. More importantly, Aurora secured a great win in Germany, gaining the right to build a cultivation facility in Leuna that will produce a minimum of 4,000 kilograms/year. Only two other companies can claim a similar victory and larger rival Canopy Growth is notably not one of those companies.

Looking forward, Aurora is exploring strategic partnerships with Nelson Peltz and will unveil its US strategy. That strategy is likely to include a CBD program and will also include Australis Capital (OTCQB:AUSAF), a small multi-state cannabis company that Aurora spun out September to gain its NYSE listing. In the interview above, executive chairman Michael Singer noted that Aurora will look to add multiple partnerships rather than give control of the business to an outside firm, perhaps in reference to the Canopy Growth/Constellation Brands (STZ) and Cronos/Altria (MO) deals.

Aurora's approach to the United States looks thoughtful and raises interesting questions about what part of the cannabis value chain will be the more profitable in the future. Long term, it's probable that the highest margin segments in cannabis are likely to like in branded consumer packaged goods in the same way that owning the Budweiser brand is more valuable than owning a chain of liquor stores.

Overall, this was a very solid quarter and Aurora performed well in both the Canadian recreational and the international medical markets. That said, large losses and negative cash flow will continue to provide ammunition to Aurora's detractors. As with nearly all Canadian cannabis stocks, Aurora's valuation looks very optimistic at perhaps 17x 2020 sales, meaning that Aurora will have to continue to execute extremely well to provide meaningful long-term returns to its shareholders. The optimistic valuations mean that investors will be exposed to significant risks if the market loses confidence in Aurora, such as if we fall into a bear market or if the cannabis sector falls out of favor.

For my part, I see Aurora as a reasonable investment in the Canadian cannabis sector, although not one of my favorite investments. I remain fully invested in the cannabis sector but do not currently have a position in Aurora. That said, Aurora performed well this quarter and its performance justifies its position as the second most valuable cannabis company.

Happy investing!

Disclosure: I am/we are long CGC, HEXO, OGRMF. 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.