You might not think that Aurora Cannabis (NYSE:ACB) would need additional production capacity. After all, the company is already on track to have an annualized production run rate of well over 500,000 kilograms by the middle of next year. With its funded capacity of over 625,000 kilograms per year, Aurora ranks in a strong first-place position among Canadian marijuana growers.
But thats apparently not enough for Aurora Cannabis. The company announced on Wednesday that its increasing capacity at its biggest facility even more than planned. What in the world was Aurora thinking?
Aurora is in the process of constructing its facility, dubbed Aurora Sun, in Medicine Hat, Alberta. The facility is expected to be ready for cultivation by the middle of 2020.
Cronos Group (NASDAQ:CRON) has been one of the stocks to add to the “avoid list” due to its weak quarterly report. The company benefited from a CAD $2.4 billion Altria (NYSE:MO) investment, which closed in March 2019. The bad news is that the company’s average selling price fell from $6.43 in full-year 2017 to $5.74 for 2018. It blamed the falling ASP on an excise task. Operating expenses also ballooned from $9.3 million in full-year 2017 to $29.4 million.
Its probably an understatement to refer to Aurora Sun as an advanced cannabis-growing facility. Aurora Sun will have a glass roof along with a system to recapture rainwater and melted snow to irrigate cannabis plants. It will have sophisticated automation systems that allow total control over environmental conditions.
Originally, Aurora planned for Aurora Sun to have 1.2 million square feet of growing space. That would have enabled at least 150,000 kilograms of cannabis to be produced at the facility annually.
On Apr. 5, the CEO of Constellation Brands (NYSE:STZ) told CNBC that Canopy Growth (NYSEQ:CGC) could make more than $1 billion in revenue by the end of its fiscal year. Constellation reasoned that Canopy can sell $5 billion to $6 billion worth of goods in Canada alone. Beverages and other edibles would add to the company’s addressable market potential.
Now, though, Aurora intends for Aurora Sun to have 33% more growing space — a whopping 1.62 million square feet. Instead of 150,000 kilograms per year, the facility will be able to produce more than 230,000 kilograms.
If youre keeping score at home, Aurora currently has only one facility, Aurora Sky, that can grow more than 100,000 kilograms of cannabis per year. The company is constructing the Aurora Nordic 2 facility in Denmark, which when complete in 2020 should be able to produce over 120,000 kilograms. In addition, Aurora has bought land and a building in Exeter, Ontario, that will have an annual production capacity of 105,000 kilograms.
But Aurora Sun will be in a league of its own. It will nearly double the capacity of Auroras next-largest facility. At full operation, the facilitys 37 different growing rooms will house more than 1 million cannabis plants at varying stages of growth.
You can ask pretty much any observer of the Canadian marijuana market and theyll tell you that a major supply glut is inevitable. Some might think that glut will arrive sooner than others do, but hardly anyone would argue that supply isnt going to surpass demand in the not-too-distant future.
The obvious question is: Why is Aurora increasing its capacity in Canada? It provided a straightforward answer to this question. The company said that additional growing space is being added at the Aurora Sun facility “to support rapidly growing global demand for high-quality medical cannabis in Canada and abroad.”
CannTrust (NYSE:CTST) could trade in a wide range after the company reported weak fourth-quarter results in the end of March. Revenue grew to 132% from last year to CAD $16.17 million. The company lost CAD $0.26 a share.
CEO Terry Booth provided a little more color on the decision: “Particularly in newly opened markets, establishing first-mover position and embedding Auroras market share and brand requires a stable and reliable supply of high-quality cannabis for these markets. The increased scale of Aurora Sun reflects our expectations for the long-term growth in global demand, especially the higher margin international medical markets, which will be faced with significant supply shortages for the foreseeable future.”
Although Aurora Sun is in Canada, it appears that the real target for the additional capacity is the international market. And Aurora clearly thinks that these markets arent in jeopardy of having a supply glut anytime soon.
Does Auroras plan to boost capacity at the Aurora Sun facility make sense? I suspect some will think its a bad decision. After all, most international medical-cannabis markets are still in their infancy. Theres no guarantee that these markets will grow as quickly as projected.
But Aurora could very well be right that there will be supply shortages for quite a few years in international medical markets. And the company is absolutely correct that these markets provide higher profit margins than the Canadian adult-use recreational market does.
I also think that Aurora is prioritizing production costs and flexibility. Aurora Suns advanced technology should enable Aurora to drive down costs per gram compared with older facilities. In addition, Booth noted that the facility is “designed with flexibility in mind to enable us to quickly meet changing market demands, particularly as breeding and cultivation technologies evolve and as customer preferences and requirements change.” The bottom line is that capacity at Aurora Sun will be more valuable to Aurora than capacity at many of its other facilities.
Its possible that a few years from now, well look back and be able to say that Auroras move to boost capacity was crazy. However, I wont be surprised at all if, in retrospect, the decision instead will appear to be crazy like a fox.
My previous research has made me believe that Aurora Cannabis (ACB) has outrageous plans to expand production in the face of a market set for far too much supply. The Canadian cannabis company always tops lists for cannabis production plans and has made the odd decision to announce a further increase in production capacity by 2020. All of the data points suggest this move is unwise until some existing supply is removed, but the company keeps making these moves because the stock rallies every time.
As mentioned in the introduction, on Wednesday, Aurora Cannabis publicly stated it would further expand cannabis cultivation facilities. The company already had an aggressive expansion plan in the works and was just entering a period of additional inventory hitting the market to test the supply/demand equation. The question is why the company felt the need to rush into even more future expansion.
The Aurora Sun facility was already forecast as a massive facility with 1.2 million square feet and the size of 21 football fields. Aurora Cannabis decided to expand production space by 33% to 1.6 million square feet.
The facility goes from the listed 150,000 kg goal to a new production capacity plan of in excess of 230,000 kg. Investors need to take note that the forecast capacity went up over 50% on only a 33% increase in additional space.
The company has consistently discussed plans for cannabis production capacity going from 120,000 kg currently to over 500,000 kg by mid-2020 or only one year away now. Aurora Cannabis has funded capacity in Canada and Europe actually listed at over 550,000 kg with an additional 450,000 kg planed in Latin America via the ICC Labs acquisition last year. The key to the story being that the company only sold about 7,000 kg last quarter and the company doesnt forecast reaching the 100,000 kg per annum finished inventory rate until the current quarter.
One cant really view how the cannabis market will play out with supply/demand balance and pricing impacts until some of the initial capacity jumps reach the market. After this quarter, Aurora Cannabis now expects production capacity to jump 6 fold to reach over 625,000 kg per annum of dried cannabis.
The lack of push back by the market only encourages more capacity expansion. Basically, the momentum feeds on itself until finally hitting a wall. The stock gaining over 3% suggests the wall hasnt been hit yet.
My constant thesis of a cannabis market on verge of being flooded with supply got recent confirmation from the CEO of a competitor to Aurora Cannabis along with industry research on the illicit markets. The market has chosen to ignore those negative headlines as well.
The most damning news was the Tilray (TLRY) CEO Brendan Kennedy on the Q4 earnings call suggesting investments in Canada were no longer attractive:
Over the next 18 months, we believe there will be oversupply, just as weve seen in certain U.S. states as operators and newly legal markets race and government regulators catch up to find an equilibrium between supply and demand. We will not purchase or invest in what we believe to be overpriced supply assets in Canada, which we believe will erode in value in the medium to long term, as the market normalizes.
Media research continues to show that the illicit market isnt going away. The black market in Canada was still strong in the initial sales period according to an article in the Washington Post. Now, High Times suggests the more developed California market (similar population as Canada) still faces a strong black market.
The crux of the article is that legal weed is overtaxed and over regulated allowing the black market to sell at lower prices. Canada faces the same issue as regulators imposed excise taxes and license fees that increase the cost of the legal weed. In most cases, the producers actually had to take a sales price hit by absorbing the excise tax in a clear sign that pricing power doesnt even exist when the legal market lacked supply.
If these issues werent bad enough, Aurora Cannabis faces a market that still wasnt showing much in the way of sales growth all the way through January. Yes, after about 3.5 months of recreational-use sales, the Canada market is still only consuming about 7,000 kg of cannabis each month.
The number is problematic as sales actually declined in January from the November and December levels while finished inventory was growing. The big looming issue supporting the theory the market is going to be flooded with supply is that the unfinished inventory is surging having reached 115,000 kg in January or nearly 20x monthly sales.
More importantly, the data points dont provide any logic for expanding production. Especially when other competitors like Village Farms (VFF) and Emearld Health Therapeutics (OTCQX:EMHTF) plan to double capacity in B.C. to 150,000 kg with further plans that could easily convert existing greenhouses to reach 330,000 kg of annual cannabis supply.
The key investor takeaway is that about every week a major cannabis producer in Canada inexplicably announces plans to boost cannabis production. Despite any data points supporting a scenario where demand will exceed supply when all of the already planned capacity expansion reaches market, especially with a still strong black market, Aurora Cannabis is investing even more into their farming operations.
The ultimate risk now is a collapse in market prices due to the flood of new supply in the next year. When the stock quits rallying on the never ending expansion news, investors will know the time exist to take any profits in the stock.
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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