Aurora Cannabis: Predicting Bankruptcy
- Aurora's Altman Z Score has fallen once again, and it's currently in the distressed zone along with its peers.
- The company's bankruptcy risk is quite high but its management can still turn things around before it's too late.
- The stock may fall further to more reasonable trading multiples.
Aurora Cannabis (NASDAQ:ACB) has performed poorly over the last year. Its quarterly revenues have continuously dropped across multiple end-markets, there's no action plan in sight to trigger its turnaround and its shares have, consequently, plunged by about 85% over the period. There's now speculation floating across various investing forums that the company would file for bankruptcy in the near future, which, given its financial health, seems like a highly probable outcome. Let's take a closer look to have a better understanding of it all.
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The Bankruptcy Predictor
Let me start by saying that credit rating agencies across the globe use various kinds of stress tests to measure a company's financial health before eventually assigning it a rating. While some tests may over exaggerate its underlying issues, others might provide false positives or completely miss the issues altogether. So, this isn't a fool proof method.
One of these stress tests is the Altman Z Score. It's a linear formula that involves five business ratios and it's internationally used to predict the bankruptcy risk for both manufacturing and non-manufacturing firms. It basically assesses a company's existing financial health, based on events that have already taken place, which means that it's a lagging indicator.
The formula goes as:
Z = 1.2*A + 1.4*B + 3.3*C + 0.6*D + 1.0*E
Here, each of the variables are defined as:
A = Working Capital / Total Assets
B = Retained Earnings / Total Sales
C = EBIT / Total Sales
D = Market Cap / Total Liabilities
E = Sales / Total Assets
The final Z score gets classified into three zones.
- If the Z score is above 2.99, it's considered to be the safe zone
- If the Z score is between 1.81 and 2.99, it's considered to be in the grey zone
- A score under 1.8 is classified as the Distressed zone, where companies have the highest risk of defaulting
Calculating for Aurora Cannabis
Having defined the formula and its variables, let's do some math and calculate Aurora's Z score
Consolidated Z Score
A score of 0.87 puts Aurora Cannabis in the distressed zone, meaning it has a high risk of filing for bankruptcy. This shouldn't come across as a surprise for readers and investors closely following the cannabis producer. The company had to slash its capital expenditures and sell one of its greenhouse facilities earlier this year to keep the cash burn at manageable levels.
Having said that, I back-calculated the Z score for Aurora and some of its peers to put things in perspective and to confirm the findings. As it turns out, Aurora Cannabis and its peers registered a major drop in its Z score over the last 5 quarters. As a consolation, at least Aurora's score isn't the worst amongst its mentioned peers.
(Source: Business Quant)
But the Z score does lend credence to bankruptcy-related concerns and the bearish narratives surrounding Aurora Cannabis. The score suggests that all the mentioned companies are financially frail, including Aurora Cannabis, and we could see a number of bankruptcies within the Cannabis production space in the coming quarters.
What Lies Ahead
First, I'd like to clarify that a high risk of bankruptcy doesn't mean imminent bankruptcy and it definitely doesn't translate into a call to short the stock. I believe Aurora Cannabis can still pivot as a business and its management can still turn things around for the company and its shareholders by way of asset divestments, capital expenditure cuts, streamlining operating expenses and targeting lucrative end markets that offer higher margins.
For instance, its wholesale and medical cannabis sales sport higher margins than its consumer cannabis sales. So, for now, Aurora Cannabis may be better off by targeting wholesale and medical cannabis sales opportunities. Similarly, it can scale back on its expansion plans and temporarily shut a part of its production capacity to maintain optimal utilization rates.
(Source: Business Quant)
One might argue that the Z score is just a stress test to measure a company's financial health. While that's true, we must also remember that borrowing rates vary with the creditworthiness of applicants. So, a continued decline in its Z score may trigger credit downgrades and increase Aurora's cost of borrowing. Consequently, Aurora's board may look to further dilute the company's share count to raise cash, if the cost of borrowing increases significantly. So, it's in the best interest of Aurora's management and its shareholders that the firm's risk of default reduces over time.
This improvement won't happen overnight. It may take several quarters for Aurora's creditworthiness to materially improve, its risk of default to subside and its Z score to rise to the safe zone. Creditors won't see just one quarter worth of data and forget about the prior earnings. So, I believe the company would have to show consistent improvement and its management would have to come up with a robust restructuring plan to reassure investors and creditors that their money is safe.
But if Aurora's management is unable to pivot, then I foresee the company's share price declining further, its management undertaking a reverse split (as discussed here) and its Z score worsening in coming quarters
Also, the mentioned cannabis companies are trading at lofty sales multiples in spite of their high probability of bankruptcies. Sure, Aurora Cannabis isn't the priciest of the lot, but a forward sales multiple of 6.5x is quite high for a company that's seemingly experiencing a cash crunch. So, I'm of the opinion that Aurora and its peers' sales multiples will temper down to more reasonable levels as the market continues to factor in their high risk of bankruptcy.
(Chart compiled by author, Data from Ycharts)
The key takeaway here is that Aurora Cannabis has a high risk of bankruptcy but it's not a surety. Its management can still turn things around and steer the ship on the path of recovery. But, the cannabis producer does seem a bit overvalued given its bleak financial health. So, readers and investors looking to accumulate Aurora's shares may want to wait for its shares to fall further. Risk averse investors, on the other hand, may be better off by staying on the sidelines due to its frail financial positioning. Good Luck!
Author's Note: I'll be writing another report on Aurora Cannabis next week. You can stay updated by clicking the "Follow" button at the top. Thanks!
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