Aurora Cannabis Inc. (ACB) has received a lot of attention from analysts of late. However, no one has seemed to focus on a glaring red flag for the company. This article concentrates on the fact of costs and expenses outpacing revenues, which will in all likelihood lead to further massive dilution.
Note: All financial figures reflected in this article are in United States Dollars (NYSEARCA:USD) unless otherwise noted.
Cost and Expense Surges Outpacing Revenue Growth
No one wants to discuss operating expenses. In its Q3 2019 Report, the company reported operating expenses in the amount of $98.135 million ($130.239 million CAD). This was an increase over Q3 2018, $29 million ($38.492 million CAD) by $69.135 million, or 238%. Clearly, operating expenses are growing rapidly.
Moreover, the cost of sales increased YOY as well. (We address the decrease in production cost from Q2 to Q3 2019, and why it does not change our analysis, in the "What About the QOQ Decreased Production Cost" section, below.)
The cost of sales for Q3 2019 totaled $21.784 million ($28.914 million CAD), while the same figure for Q3 2018 was $5.143 million ($6.827 million CAD), amounting to a $16.641 million increase. Percentagewise, these costs increased by 324%.
Meanwhile, the net revenues only increased by $36.957 million. Specifically, Q3 2019 saw net revenues of $49.087 million ($65.145 million CAD), while the net revenues reported in Q3 2018 totaled $12.13 million ($16.1 million CAD). This was a 305% increase.
Bulls would of course view the above figures positively, noting that, percentagewise, the 305% growth in revenues YOY was higher than the 238% increase in operating expenses, and roughly on par with the 324% increase in cost of sales. This, however, would be shortsighted, in that it would ignore the actual dollar amounts.
The actual dollar amount is more important here than percentages because the amount of capital raises (or dilution) needed to keep the lights on is based on dollar amounts, not percentages. In other words, the percentages are irrelevant when calculating the difference between total costs and expenses, and revenues. That difference - $70.83 million - is the deficit, or the base amount the company will ultimately need to raise as a result of this particular quarter to avoid bankruptcy.
And remember, this tally increases with each quarter's deficit, meaning the year's deficit will be the sum of the quarterly deficits. Bulls of course will try to rebut this argument by referring to the company's cash on hand. We briefly address this point - cash on hand versus cash burn - in the "How Low Will It Go?" section, below.
In sum, the fact that the costs and expenses almost double the amount of revenues being generated is what should raise a red flag for investors. Indeed, the actual dollar amounts of the Q3 2019 costs and expenses grew almost twice as fast YOY than net revenues. Although percentagewise the company is slightly closer to breaking even (40.9% in Q3 2019 versus 35.5% in Q3 2018), the actual dollar amount of the deficit (which determines how much dilution is needed) is vastly greater ($70.83 million revenue deficit in Q3 2019 versus $22.01 million in Q3 2018). This means that, not only is more dilution coming, but it will be greater than the amount of dilution needed during the prior twelve months.
The Elephant in the Room
No one seems to want to address the surges in expenses. In the company’s transcript for its Q3 2019 earnings call, a word search for “expense” yields only one result. The context of the pertinent statement, “In addition, through the medical channel, patients can seek reimbursement for their expenses,” reveals that it had nothing to do with the company’s expenses.
Indeed, it was apparently not incumbent upon any of the conference call participants to ask about the expenses. No questions were posed as to the reasons behind the rise in expenses, and no one bothered to ask if expenses would decrease, slow down or be outpaced by revenues anytime soon.
Our analysis is very bearish. If there was good news regarding expenses, the company executives would have jumped to address it. One hour and 30 minutes worth of conference call, yet not one second devoted to discussing the rate of growth in operating expenses versus revenues. This leads us to believe that the problem will only get worse.
Which leads to the question, why is this such a red flag? Well, the base cost to keep the lights on (cost of sales plus operating expenses) for Q3 2019 was $119.92 million. And revenues, $49.087 million, only accounted for 40.9% of that amount – less than half. So the concern is one word (which is also absent from the conference call transcript) – dilution.
What About the QOQ Decreased Production Cost?
During the conference call, the company did spend a lot of time discussing their achievement in lowering the cost to produce their product. Interestingly, the fact that the executives discussed this cost cutting at length seems to prove our point that, if there was good news about cutting or slowing the growth of operating expenses versus revenues on the horizon, it would have come up.
In any event, the decreased production cost is insignificant to our thesis that further massive dilution is on the way. The earnings transcript shows that the company lowered the production cost from $1.92 CAD per gram in Q2 2019 to $1.42 CAD per gram in Q3 2019. As they produced almost 16,000 kilos in Q3, that amounted to a savings of roughly $8 million CAD ($6.03 million USD).
This is insignificant to our thesis for two reasons. First, it did not prevent QOQ overall expenses from outpacing the QOQ revenue gains. The Q2 2019 Report shows that Q2's operating expenses totaled $84.61 million ($112.332 million CAD), while the cost of sales was $19.43 million ($25.8 million CAD), for total costs and expenses of $104.04 million. Again, Q3's costs and expenses were greater as they totaled $119.92 million. Percentagewise, the costs and expenses increased QOQ by 15%.
Meanwhile, Q2's net revenues totaled $40.81 million ($54.178 million CAD). Again, Q3's net revenues were $49.087 million. Percentagewise, the revenues increased QOQ by 20%. Yes, this 20% growth in revenues QOQ is greater, percentagewise, than the 15% increase in costs and expenses. However, as this article has pointed out, that is irrelevant when discussing the amount of dilution that will be needed, which turns on actual dollar amounts, to the detriment of shareholders.
Specifically, the company's Q2 revenue deficit was $63.23 million. And the company then increased its distance from the breakeven point in Q3, with a revenue deficit of $70.84 million. In other words, our analysis is that the company is offsetting any revenue gains with even greater surges in total expenses. Considering the prior two sections of this article, the gist is the same for both YOY and QOQ. This quarterly trend means even more dilution no matter how you look at it.
Second, and more importantly, the company's ultimate goal of getting the cost of production “well below $1.00 [CAD] per gram” by “Q1 2020” is insignificant given their simultaneous goal of increasing production from the present 16,000 kilograms to “a rate in excess of 150,000 kilograms per annum by the first quarter of our fiscal 2020.”
In order to find out the future cost of sales per quarter, if we assume that “well below $1.00 [CAD]” by Q1 2020 means roughly $0.95 CAD (another Seeking Alpha contributor analyzed Canadian pot stocks and determined that the lowest cost of production was $0.95 CAD), then we multiply that amount by their anticipated Q1 2020 production rate of 150,000 kilograms per year, and then divide by four financial quarters. That result is $35.63 million CAD ($26.84 million USD) per quarter. Thus, the cost of sales will continue to increase.
In sum, our analysis is that the decreased cost of production is insignificant because the company’s production increases will actually increase the cost of revenue further. This is all while operating expenses are also increasing. Bulls who believe in this stock are of course now wondering, “Yeah, but what about increasing revenues?” We are not confident that revenues will match or outpace the costs and operating expenses anytime soon.
Here, the problem is demand. In the chart below, Health Canada provides market data showing that Canadian marijuana sales have remained stagnant. Indeed, sales for March 2019 were roughly the same as sales for December 2018. Meanwhile, the chart further shows that cannabis companies are saturating the market with supply at significantly increasing rates.
Our analysis, therefore, is obvious – ACB’s increase in production in no way correlates to an increase in actionable demand. Not to mention any chance of any increase in future revenues outpacing the increasing costs and expenses. In fact, our analysis is that it will be impossible for revenues to outpace expenses unless and until the company establishes a firm footing in another country with strong demand for the product, and brings their operations up to speed.
This would again cost a lot of money, and take a lot of time. As to how much time, during the earnings call, CEO Terry Booth stated:
It took Canada five years to meet its demand for the population 33 million. So you just put that math into perspective with the EU, with Australia, Mexico and other countries that are coming online, it would take nearly 50 years to meet that demand. But we are not going to take that long because of the scale, we are now able to build upon.
Our conclusion is obvious – the company needs to issue its common stock to keep the lights on. Further massive dilution is inevitable for the next few years, at minimum.
How Low Will It Go?
Our above analysis shows that the cost to keep the lights on will continue to increase at a higher rate than any increase in revenues for years to come. As such, further dilution is inevitable. Unfortunately, it is impossible to tell how much lower the stock price will drop. Our analysis is only able to point out that further drops are inevitable, and now is not a good time to be in the stock.
However, we can provide some further guidance. The Company's 2018 Cash Flow data shows that, in 2018, the company needed to raise a whopping $162.48 million ($215.6 million CAD) from common stock issuance. The company further offset expenses by issuing $259.96 million ($345 million CAD) in convertible notes/short-term debt to raise cash.
So, the company needed to raise $422.44 million to keep the lights on (meaning a revenue deficit in that amount) in 2018. And as outlined above, costs and expenses continue to surge more than any gains in revenues. Thus, unless ACB intends to issue another $259.96 million or so in debt, we conclude that the company will need to raise even more than $162.48 million from issuance of common stock over the next twelve months. Therefore, the dilution effect will be greater over the next twelve months than it was over the prior twelve months, to the detriment of shareholders.
We know that bulls would be quick to point out the $261.24 million in cash on hand reported for Q3 2019. This does not change our assessment because of the detailed analysis provided by another Seeking Alpha contributor, who concluded that the cash “will have been entirely exhausted by Q2 2020.”
The takeaway is that management is on a path that is not shareholder-friendly. To put it more bluntly, the stock is presently a train wreck in progress. Investors should exit their positions immediately, and not buy back in until there is hard evidence of the company nearing full production capabilities in other countries that have real and strong demand for the product.
Recently, in mid-March, this pot stock had a nice high for 2019. Unfortunately, it has since turned into a bad trip for investors. And, it is only going to get worse. Maybe the dilution will stop and this stock will get a good buzz going again sometime in - best case scenario - a few years, if it proves able to establish a real presence after getting up to speed in other countries, depending on demand. But for now, sell before any gains from your portfolio go up in smoke.
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.