No Cost Leadership, Oversupply, And Lack Of Brand Value Are The Terrors Of Aurora Cannabis

Nov. 14, 2019 11:49 AM ETAurora Cannabis Inc. (ACB), ACB:CA94 Comments21 Likes
Robbert Manders profile picture
Robbert Manders
2.22K Followers

Summary

  • Supply keeps increasing fast while demand increases slow. The market will press prices down, whether we like it or not.
  • Aurora seems to be a 'leader' when it comes to high operating expenses.
  • Even unrealistically high margins can't justify the current valuation of the stock.
  • Unless cash flows don't improve soon, the company needs the stock market to finance itself. Be aware of this as investor confidence fades.

Over the past weeks since I’ve published my previous article on Aurora Cannabis (NASDAQ:ACB), I have been reading a lot about what other people think about this stock. Often times, people who wouldn’t buy the stock themselves come up with a very nuanced story with the pros and cons of Aurora and the industry. There are several arguments that surface frequently:

  1. Supply concerns are exaggerated.
  2. Aurora is a cost leader and will therefore outperform.
  3. High margin cannabis 2.0 products will cause a revenue & profitability boom.

I will address these lines of thought one by one. First of all, investors must understand that the main activity of the company is farming cannabis, as I discussed in my previous article on ACB. This is what the company has invested most of its capital in.

Supply concerns

Some say that supply concerns are exaggerated. I have a different opinion and in this section I will present factual data that shows really how much supply is currently in the market and how much more is in the pipeline versus demand.

Most listed producers publish their production figures, sales volumes, production capacity and capacity under construction. The table below shows the data I have compiled from just 6 listed Canadian cannabis producers, whereby I only included Canadian production. As you can see, most companies aren’t ramped-up to produce at capacity; they sell less than they produce, and the planned capacity is double the existing (underutilized) capacity.

All figures are in kilograms. Source: company’s most recent reported figures, author’s own calculations, author’s estimates (in red). *Planned capacity includes only actual plans that will be carried out, preferably with that capacity already under construction. Canopy capacity estimate is based on company revenue (not weight) projections. Current capacity at Canopy (CGC) and Tilray (TLRY) is likely higher. Weight sold estimate of Supreme Cannabis (OTCQX:SPRWF) is revenue divided by $6.13 per gram, in line with company revenue per gram estimates for FV purposes by Supreme.

Aurora, as it seems, has removed its useful overview of production facilities including capacity from its investor presentation. My suspicion is that they realize that capacity expansion is not a selling point anymore. Perhaps they are feeling pressure in this very quarter. The problem is that legal production is rising exponentially but legal demand can’t keep up. Up until now, the market has absorbed this by increasing inventories, but this is bound to stop working.

Let’s go a level deeper and zoom in on Aurora. As the table below shows, Aurora managed to almost double production each quarter. Also, the company has done well by managing to sell a bit more than the previous quarter’s production in each quarter. Building inventory is logical when production is ramping up, but it can’t be an ongoing part of the business strategy. This means that even if production were to remain equal, sales would have to increase by 60%. But it is more likely that production grows by 45% to its quarterly capacity of 42,000 kilos, which requires sales to increase by 136%.

Source: ACB Q4 2019 MD&A. Red marks added by author for emphasis. Contrary to what the table leads the reader to believe, the data in the bottom part of the table reflects the Consumer segment too.

Another notable item in the figure above is average selling price, which tends to go down. At the start of the legalization, production was constrained and this resulted in high margins for legal producers. This is also why Aurora made a modest profit in fiscal Q1. Because capacity has been expanding rapidly ever since, the average net selling price has been dropping every quarter.

Consumer price data by Statistics Canada shows that the black market is defending its market share by lowering prices by over 10% since Q4 2018. At the same time, legal retail prices have not declined significantly, signalling that legal retailers are expanding their margins. This is clearly not working for the licensed producers that need the legal market to expand in order to take share from the black market.

As the table with the other producers has shown, Aurora is hardly the only producer in the process of increasing production and sales. If we stack up sales, production and capacity of just these 6 quite randomly selected listed companies against current consumer demand, it is obvious that a problem is on the horizon.

*Supply includes most recent quarterly figures group of 6 publicly traded companies, mentioned in the table below. The actual legal supply is higher as there are almost 200 licensed producers. Supply data source: company reports (MRQ), author’s estimates. Demand data source: Health Canada, BNNBloomberg.

Taking share from the black market will take time, just like it will take time to complete production capacity. The issue is that as things stand now, production is increasing at a faster clip than consumer demand. This is captured by the chart below, which shows that inventories increased at three times legal consumer demand in August.

Figure 1. Total Inventories and Sales - Dried Cannabis (Kilograms). Text version below.

Source: Health Canada.

It is also noteworthy that medical sales in August were down to their lowest point of the last 12 months, while recreational sales were up. Part of it could be seasonal, but it is probable that people are seeing better pricing or quality in the recreational market. Note that medical sales are usually seen as higher margin.

Aside from just gathering production and capacity data from random listed producers, we can also take data from Health Canada to estimate production capacity. The ministry reports 1.55m square metres of cultivation area. That equals to 16 million square feet in use, or the size of 20 Aurora Sky facilities. Aurora Sky’s production capacity is >100,000kg per year according to Aurora. This means that if the cultivation area by Health Canada is as productive as Aurora Sky, legal supply is 2m kg/year, more than double the (estimated) size of the Canadian legal and illegal market demand combined. Of course, it is more than likely that the cultivation area does not only include highly efficient greenhouses such as the Aurora Sky facility, but we should also be aware of the fast capacity increases. Cultivation area doubled in less than three months leading up to June.

Figure 2

Total cultivation area of licensed producers in Canada. Source: Health Canada.

Plants grow over time, so production is obviously lagging cultivation area. But at a point in the near future, companies will have to find ways to sell what they produce.

Some say the international market is a way out. However, the international market (international trade) is extremely limited due to regulatory constraints. As you can see in the table below, exports are 10% of licensed medical sales at best (while medical sales are less than recreational sales).

Source: Health Canada. Red mark added by author for emphasis.

A last clue as to where the market is heading is in the latest earnings and press releases of LPs. Organigram (OGI) seems to have had a disappointing quarter with pressure on sales and pricing to the point of a Q-o-Q net revenue decline of 34%. The company did not quantify how unit sales and average selling prices affected revenue, but it did say the following:

[Adverse effects from Ontario retail network size] were further exacerbated by increased industry supply.

Press release Organigram, November 11.

The latest reports of other peer companies also show weakness. Tilray (TLRY) did quite well on sales, but experienced very weak pricing, as net revenue per gram was down 24% Q-o-Q. In a way, lower pricing is healthy as it is the path to take share from the black market, but sales multiples show none of these Canadian cannabis stocks are priced for modest margins.

Aurora will release earnings after close. Given the supply/demand data and the weakness experienced by its peers, it is hard to see how Aurora will beat expectations it set in the previous quarterly earnings call, when it said it saw no pressure on pricing. Yet, the analyst revenue consensus, which forecasts a modest Q-o-Q decline, shouldn’t be that hard to beat.

The only logical conclusion from this is that production growth and volumes are unsustainable. Capacity rationalization cannot be avoided. Because a lot of capital is invested in production capacity, this will be a painful process and there will likely be producers that go bust. So supply concerns are very real and in no way should we downplay what is going on.

Aurora’s (questionable) cost leadership

An argument is that Aurora is a cost leader and will therefore perform well during the shakeout that I made the case for in the previous section. The company itself reports a cash production cost of $1.14 per gram. The company is large and it is reasonable to believe that larger facilities and facilities that are closer to producing at capacity have the best cost profile. However most other producers don’t publish their expenses in the same format as ACB does, and even if they do, it is hard to tell if it is a fair comparison as companies can choose what costs to allocate to production in their own non-GAAP analysis. I have gathered consolidated cost of sales figures from four companies whose operations overwhelmingly rely on cannabis production and sales to distributors, or companies that have segmented well. Beside Aurora, this left me with Aphria (APHA), HEXO (HEXO), and Supreme (OTCQX:SPRWF).

A nice starting point is consolidated cost of sales. This is fair, because it excludes gains from growth in biological assets, which can distort inventory valuation. As you can see in the table below, Aphria seems to be the least efficient producer, while HEXO is the most efficient. There is some logic here, as Aphra had a low capacity utilization of just 37% in the quarter, while the others were between 60% and 70%, by my calculations. Also, HEXO had the lowest revenue per gram at C$3.20, while the others ranged between C$5.16 (APHA) and C$6.13 (Supreme, author’s estimate).

Source: consolidated cost of sales divided by grams sold according to the latest quarterly report published before November 2019.

In addition to cost of sales, a company has many other expenses. In the case of these stocks, operating expenses are quite substantial. I calculated OpEx for four companies in the table below (OpEx included marketing & sales, general & administrative, R&D, stock-based compensation, and D&A).

Source: author’s own calculations based on MRQ reported before November. Miscellaneous expenses were added to G&A. Segment results were used to adjust OpEx and revenue for Aphria.

Strikingly, net (cannabis-related) revenue typically can’t even keep up with operating expenses. On a side note, stock-based compensation is quite a significant part of operating expenses. The C$27.5m at Aurora is almost C$1 per gram of cannabis produced. We must not forget that the stock price has plummeted. If the company is to continue to reward employees with shares, it will have to issue more of them. So this problem of dilution stacks on top of dilution that will happen when Aurora issues equity to raise cash.

In the next step of this analysis, we divide OpEx by grams sold, grams produced, or by capacity. Trying each of these three methods provides us with the following data.

Source: author’s own calculations. Capacity is current capacity in KG/year as reported by the company. Grams sold are an estimate for Supreme.

As one can observe, the sizable discrepancies based on the relative level of sales, capacity and production causes wild swings. As an alternative, I divided sales & marketing by grams sold and other expenses by grams produced.

Source: author’s own calculations. Grams sold are an estimate for Supreme.

If we take this new measure of all-in operating expenses per gram, it looks like Aurora is among the least thrifty spenders among these peers. Surprisingly, it is Supreme, the smallest peer, that has the lowest cost base. That said, Aurora has the most ambitious expansion plans and is probably anticipating faster growth than its peers, while the ambitions of Supreme are to sell a high quality niche product. Either way, there is no evidence that Aurora is in any way more efficient than its peers. This high cost base will come back to haunt ACB if competition is tougher than anticipated. To complete the puzzle, I subtracted OpEx/gr as calculated in the table above from gross margin per gram. The result in the table below is quite telling.

Source: author’s own calculations.

Based on actual expenses incurred, it is not right to argue that Aurora is the lowest cost or most profitable producer. After all, marketing, sales, G&A, stock-based compensation and many other expenses that are conveniently left out of presentations, are actual costs incurred with the goal of delivering value to the company. Of the four, only HEXO has a worse EBIT per gram than Aurora.

To get the EBIT margin positive is important. When excluding working capital movements and stock-based compensation, the company had a negative cash flow from operating activities of C$55m. The company also spent about $C168m on CapEx. This total illustrative financing need of C$223m in just Q4 looks really bad compared to the cash balance of C$172m. The company continuously has to get financing from either banks or the stock market. The stock market is losing confidence, and banks will certainly take notice of that and also of market developments, especially oversupply. Management has remained bullish in its communications to the market because it knows that this can turn into a very slippery slope in a very short period of time.

To me, it is very telling that Aurora removed its capacity overview from investor presentations. They are worried, and its investors should be too. This idea that I have is not unique. Short sellers also have this view, which is why fees to short this stock are over 60% at Interactive Brokers (image below).

Source: Short Stock Availability within the account management tool of Interactive Brokers.

It appears as if current shorts are willing to take an annualized loss of 63%. To put that into perspective: The Coca-Cola company (KO) has a current fee rate of just 0.25%. To institutional investors, the most viable long case consists of lending the shares to others to short. Yet, this enormous tailwind doesn’t entice many of them.

Brand value, edibles and vapes

One argument that is always raised is that somehow Aurora will profit from its brand and high margin products. Let’s think for a minute how this will work. The company has to create brand value without advertising. In that context, deep advertising budgets or a superior size are not necessarily advantages. The company does, however, need to sell high volumes due to its high production capacity and ambitions. Quality and price are the main levers it can pull to sell more product. There are always consumers who are willing to pay extra for high quality products. But the fact is that most people care a lot about price. This is especially true in a market without brand value created by advertising. So my best guess is that Aurora needs to compete on price to push its product. The most viable investment case remains that of low-cost producer.

And no, cigarettes are not a fair comparison because tobacco companies established their brands decades ago by advertising when it was legal and thereby profit from the fact that barriers to entry are enormous. The Canadian cannabis industry clearly doesn’t have many issues with barriers to entry as there are enough producers willing to sell their products at a current loss just to sell their production and operate at maximum efficiency.

The hope is on vapes and edibles that will start selling by mid-December. In that context, it is good to take a look at how these products do in the US. The chart below shows market share of different cannabis products in legal US markets. Over 56% of demand is still the ‘old-fashioned’ dry flower. Concentrates, pre-rolls and vape pens take second, third, and fourth place, respectively. The high margin edible and vaping products that people have high expectations of captured a total market share of only 15% to 18% in legal US markets. So the opportunity in Canada is perhaps a lot smaller than many hope.

US cannabis product use. Source: headset.io.

An obvious problem for vapes are the many lung-related illnesses related to THC vape use. Not only is the FDA is investigating this, Health Canada also has concerns. Whatever they find can directly affect policy. It also seems like conservatives in Canada have growing concerns, such as this columnist from the Toronto Sun. Politicians already feel pressure to act. Just last month, the Ontario government decided to ban vaping ads in convenience stores.

Though expecting an overnight regulatory overhaul is a stretch, penciling in many years of growing THC vape sales does not seem prudent at this point either.

But let’s suppose that Aurora will make it work to create a brand, and that Canadians are more willing to use vapes and eat edibles than Americans. Let us also assume that Aurora will sell all of its products at a high margin. I think that Aurora in this hypothetical scenario would be quite comparable to branded consumer staple producers like Proctor & Gamble (PG), which makes wellness and consumable products for the mass market. Their returns and margins are high because they don’t farm, but that we can also ignore.

As a thought experiment, I created the overview below which shows hypothetical EV/EBIT multiples using the current EV of Aurora and the EBIT margin of consumer staple companies displayed, coupled with Aurora sales volumes under different scenarios. For example, current production capacity is 168,000 kilos; if the company produces and sells its full capacity, this equals an annual revenue of C$934m. I casually took last quarter’s average net selling price per gram of C$5.56 because the price of dry flower will decrease due to lower production costs, which will offset absolute revenue gains from ‘2.0’ products. If ACB would achieve the same EBIT margin as Proctor & Gamble (PG) - which is 21.9% - on this C$934m revenue, that would result in an annual EBIT of C$205m. Given that the current EV is C$5.5bn, the EV would then be 27 times EBIT. Interestingly, P&G is only trading at an EV/EBIT of ~21 (ttm as of November 9, SA data).

Source: author’s own calculations. EV used is C$5.5bn CAD, no adjustments were made for capacity construction costs. Annual sales assumptions in CAD from current sales, capacity and planned capacity are 396m, 934m and 2,825m, respectively. Sales are scenario sales volumes, multiplied by the current average net revenue per gram sold of C$5.56. EBIT margins (from left to right) are 16.5%, 21.9%, 24.8%, and 28.1%.

I think the only case in which the current valuation looks compelling, is when ACB can reach the planned capacity scenario by growing sales by 600% while making a PepsiCo (PEP)-like EBIT margin of 16.5%.

Based on the evidence presented in this article, an attentive reader will see that it is at best very challenging for ACB to drastically increase quarterly sales. It would mean that in order to sell its full capacity production of 508,000kg, Aurora should capture a market share of 328% within the current legal market which is about 175,000kg (author’s estimate, based on Health Canada August data). Of course, we can assume that the black market will lose share. But it is irrational to assume that Aurora can take a market share towards 100% without radical changes to the competitive environment.

Achieving these 20% EBIT margins while taking over the market is essentially the squared difficulty of both of these objectives. At this moment, Aurora couldn’t be further away from where it should want to be. At the same time, it doesn’t have significant brand value but does have numerous competitors and a price-conscious consumer. We must also not forget that Aurora is primarily an agricultural business, like I argued in my previous article on ACB. There is a reason why listed consumer staples companies don’t farm the input products they need: because it is extremely low-margin to begin with.

Conclusion

The case presented is clear: the industry will have to deal with severe supply issues shortly. These issues are of a structural nature and can only be solved by painful capacity rationalization. In this process of survival of the fittest, it is highly doubtful that Aurora is the fittest. Aurora does (or did) have the greatest ambitions when it comes to expansion, but this also bloated its cost structure. The company has to sell big volumes in its upcoming fiscal quarters to utilize capacity and capture the market share it wants to have. This will put pressure on pricing, as undercutting the competition is the only viable way to capture that much market share in absence of advertising. Meanwhile, the investor community seems to have a long-term view of the opposite: more sales at not just a positive operating margin, but also a high one.

The bottom line is that industry supply concerns are real, while the company is burning cash and new product types are just as competitive and unlikely to save the day. Even if the company survives long enough to profit from edibles and vapes, it is highly unlikely that it will become the P&G of cannabis. If I were a shareholder today, I would sell while I can and stay away.

This article was written by

Robbert Manders profile picture
2.22K Followers
Dutch speakers can now also follow me on Twitter.Besides being a fundamental value investor, I have a master's degree in Finance, have been investing myself for over 10 years, and have equity analyst experience at a top Dutch buy-side institution. I live in the Netherlands and will share my European perspective on stocks worldwide.
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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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