Unfortunately, $4 may not be a bottom for Aurora Cannabis. Despite what looks to be an incredible value, when taking into account its international reach and peak production, a perfect storm could wind up sending the most popular pot stock with millennials below $3 per share.
To understand why high Goodwill concerns investors, you need to understand what Goodwill is. It is essentially the estimated value of the reputation and other intangible assets of a company. For example, suppose a company has total assets such as property and equipment that can be sold for $1 million. Now suppose another company pays $2 million to buy the first company. The extra $1 million, above the value of the actual assets, is considered Goodwill.
Admittedly, a lot would have to go wrong for Aurora to see a $2 and change share price, but the triggers are in place for it to happen. Heres what Auroras perfect storm would look like.
Canopy, Aurora Caught Up as MKM Expects Disappointing Cannabis Results
The 800-pound elephant in the room for Canadian marijuana growers has been the persistent shortage of pot products since day one of recreational legalization in Oct. 2018.
Part of this shortage can very well be blamed on the growers themselves, many of which waited until it was a veritable certainty that the Cannabis Act would be signed into law before shelling out big bucks to expand and acquire capacity. This has left most growers scrambling to complete production facilities nearly a year after the green flag waved on adult-use sales.
However, the bulk of supply issues to our north are the result of Health Canada being bogged down by cultivation, processing, and license applications. Even with procedural fixes in the works, this backlog isnt going to be resolved overnight, or possibly anytime soon. Couple this backlog with the snails pace by which some provinces have been approving physical dispensary licenses, and you have a recipe for ongoing supply shortages that could last into perhaps 2021.
Mind you, its not just dried cannabis that could be impacted. Derivatives, such as edibles, infused beverages, topicals, concentrates, and vapes, are set to launch by mid-December. These products are liable to face the same adversity that dried flower has been facing for nearly a year.
Theres no denying that Aurora Cannabis has an impressive international presence. Only three marijuana stocks have access to at least a dozen foreign countries from a production, export, partnership, or research perspective, but Aurora leads that list. These external sales channels should prove especially important if and when oversupply and commoditization of dried flower becomes a problem in Canada.
Aurora has made numerous acquisitions over the past couple of years. Some analysts argue that it has made too many. As a result, it has an excessive amount of Goodwill that is included in the valuation of ACB stock.
The concern is that Canadian growers are unlikely to push into international markets until domestic demand has been satisfied. And, as noted, it could be numerous quarters, if not years, before supply issues in Canada have been resolved sufficiently to ensure that domestic demand is being met. Aurora has hinged its future on overseas markets; however, these markets are unlikely to deliver much in the way of returns for perhaps two or more years.
Maybe the most direct threat to Auroras valuation is its gruesome balance sheet, which is currently lugging around 3.17 billion Canadian dollars in goodwill. Goodwill being the “premium” that an acquiring company pays above and beyond tangible assets for the company it purchases.
While its not terribly uncommon for goodwill to be recorded when one company buys another, Auroras is out of control. Over the past three years, the company has made well over a dozen acquisitions, with anywhere from 50% to 80% of the value of these deals often being recorded as goodwill. The hope is that Aurora will develop the assets of the businesses its acquired, as well as monetize any patents, and recoup the value of this goodwill. But lugging around CA$3.17 billion in goodwill is going to be difficult to recoup.
Aurora Cannabis stock has been in a freefall over the past three weeks. ACB stock is oversold, so it may bounce or undergo a relief rally soon.
Whats more, CA$3.17 billion in goodwill represents 58% of the companys total assets. Sure, Aurora might look dirt cheap at less than 1.3 times its book value, but understand that CA$3.17 billion is goodwill and another CA$688 million is intangible assets. Thats CA$3.86 billion of CA$5.5 billion in total assets thats built on hope rather than fact. If Aurora takes a sizable writedown, its share price could tank.
Auroras acquisition spree has also led to an ongoing problem with share-based dilution. The company has financed practically every acquisition entirely by issuing its own stock as capital, thereby ballooning its outstanding share count and diluting the value of existing shares. Between June 2014 and June 2019, Auroras outstanding share count rose by 1 billion. Yes, billion.
Making matters worse, the company has a CA$230 million convertible note offering that comes due in March 2020. As my colleague Keith Speights notes, the conversion price is nowhere near where Aurora is currently trading, meaning no debtholder in their right mind is going to opt for the conversion. That means Aurora Cannabis is going to need to come up with CA$230 million to pay off its noteholders in less than six months time.
How will it do this? Despite having some cash on hand, the logical answer is to again issue more stock, or possibly offer new convertible notes that could be converted into stock at a later date. No matter what actions Aurora takes, it typically results in shareholders getting the short end of the stick.
Lastly, theres built-up hope among investors that Canadian growers like Aurora Cannabis are going to benefit from a softening of the U.S. federal governments stance on marijuana. Its currently a Schedule I drug in the U.S., meaning its entirely illegal, prone to abuse, and has no recognized medical benefits. Any sort of reform would be viewed as a major positive for the global pot industry.
However, its looking unlikely that well see any sort of serious progress made before 2021, at the earliest. Even the recent passage of the Secure and Fair Enforcement (SAFE) Banking Act should be taken with a grain of salt given the likelihood that itll stall in the Republican-led Senate. Pretty much all cannabis legislation is dead as long as Mitch McConnell (R-Ky.) remains Senate Majority Leader.
With the U.S. marijuana market pretty much off the table for Aurora, and the potential for a goodwill writedown exceptionally high, the perfect storm may be brewing that could push this popular pot stock below $3 a share.
Cannabis stocks reversed their early losses to move higher in afternoon trade Wednesday, after a report found that most Americans favor decriminalizing all drugs.
The report by libertarian think tank Cato Institute found 55% of 1,700 adults polled want drug offenses to be treated like civil infractions that do not carry jail time, compared with 44% who disagree. While polls have long found Americans in favor of legalizing cannabis, support for overall drug policy has mostly been lacking, as advocacy site Marijuana Moment reported.
The report came as the broader markets were under heavy selling pressure from recession fears with the Dow Jones Industrial Average DJIA, -1.87% down more than 500 points and the S&P SPX, -1.82% own 2%.
The Horizons Marijuana Life Sciences ETF shed its early losses to trade up 1.6% with 24 of its constituent stocks trading higher. The ETMFG Alternative Harvest ETF was flat. The ETFs have fallen for the last four trading sessions.
Valuations on a select group of cannabis companies are starting to look appealing at these levels, said Korey Bauer, portfolio manager at the Cannabis Growth mutual fund CANNX, -3.09% from Foothill Management. But investors should be very selective in the sector at this time, he added.
Sentiment clearly is negative, he said, citing the vaping-related lung disease that has sickened people across the country and the increasing difficulty in accessing capital.
The sector is (being) driven purely by retail investors. Retail panic is creating opportunities for active managers like us, he said.
The market was pressured early in the session by losses for the big Canadian licensed players, after an analyst said earnings expectations are unrealistic and told investors to brace for more bad news.
MKM Partners analyst Bill Kirk outlined his forecasts for when companies will report positive EBITDA, or earnings before interest, taxes, depreciation and amortization, a metric that is more of a measure of cash flow than actual profit.
Even on that basis, Kirk said he expects market leader Canopy Growth CGC, +2.45% WEED, +2.43% will not be EBITDA positive until the first quarter of 2022, a full year later than the current consensus estimate. For Aurora Cannabis ACB, +3.52% ACB, +3.31%, the most widely held stock, Kirk expects positive EBITDA by the first quarter of 2021, compared with the current consensus of the third quarter 2020.
For Tilray Inc. TLRY, +1.49%, his forecast is the first quarter of 2022, a year later than the consensus. For Cronos CRON, +0.56% CRON, +1.10%, its the first quarter of 2023, compared with consensus for fourth quarter 2021, and for Hexo Corp. HEXO, +0.00%, his date is second quarter 2020, matching the consensus.
With Aurora warning of slower buying from provinces in July and August (warning Sept. 12), and little indication new retail locations are opening in Ontario in October, we believe the next reported quarter will not show meaningful net sales acceleration, Kirk wrote. Increased costs, without the hoped for sequential revenue growth, results in profitability that is likely to disappoint.
For Canadian LPs to improve profitability would require that pricing holds up, that new products due at year-end when derivatives come on line succeed and are margin-accretive, that export markets demand product grown in Canada and that brands start to resonate across regions.
Read: Canopy Growths remaining CEO talks about pot companys shake-up, and the search for his replacement
Rather than be wildly profitable in two years, we expect the Canadian LPs to be roughly break-even, said Kirk. They would need to keep their sales, general and admin. costs flat — which is unlikely — and that would barely produce the P&L leverage to reach consensus estimates. Companies would need to move from about C$500 million ($377 million) in EBITDA losses in the current year to a C$900mn EBITDA gain in two years.
By comparison, the U.S. government has calculated that Mexican cartel chief El Chapo (Joaquin Guzman) made over $12 billion from his illegal drug trade, while the top Canadian growers have cumulatively lost $1.4 billion, said Kirk.
Canopy stock was last up 2.4%, Cronos was up 1.9%, Aurora was up 3.9%, Tilray was dup 2% and Hexo was down 0.4%.
Canaccord analysts named three picks in the sector that are showing improving fundamentals in a tricky time for the industry. Ayr Strategies AYRSF, -1.60%, a multi-state operator with its main operations in Massachusetts and Nevada, will benefit from a shift away from vapes following a short-term ban in the Bay State, according to analyst Bobby Burleson.
Rising wholesale spot prices are likely to become more evident in coming weeks and could serve as a near-term catalyst for AYRs shares, he wrote in a note to clients.
Planet 13 Holdings PLTH, +0.47%, a Las Vegas-based cannabis dispensary, is expected to benefit from continued strong sales and falling costs as its ramps production, said the analyst. Plus Products PLPRF, +8.57%, a leader in CBD-infused gummies, is expected to benefit from a shift to non-vape consumption, said Burleson, which he said is already evident in channel checks in California.
From Marijuana Business Daily comes the news that the wholesale cannabis market has remained largely unmoved by the current outbreak of severe lung disease that is believed to be tied to vaping. The disease, which has killed 12 people and sickened more than 800, according to the Centers for Disease Control and Prevention, was expected to discourage consumers from vaping cannabis products and move them to flower and pre-rolls instead. But wholesale cannabis growers said pricing has not moved dramatically during the crisis, and the percentage of flower being purchased has barely changed.
See now: Cannabis stocks mostly lower as euphoria over banking bill fades in face of tricky U.S. Senate path
In California, for example, the percentage of flower purchased as of Sept. 22 was 40.7%, down from 41.1% on Sept. 1. In Colorado, the percentage has climbed to 50.1% from 45.3%.
In company news, Tilt Holdings TLLTF, +39.58% said it has negotiated an agreement with six of its remaining founders, under which they will forfeit all 60.2 million stock options granted at the time of the reverse merger of four companies that created Tilt last year.
Tilt stock was last quoted at the stock trading at 31 cents, up about 44%. The company reported stock-based compensation expense of $47 million in the second quarter because of the stock options.
Adjusting for the subsequent forfeiture, TILTs Q2 2019 net loss of $48.9 million would have been almost entirely reduced, bringing the company close to break-even, it said in a statement. Tilt made headlines in May when it booked a goodwill impairment charge of about $500 million in its first quarterly report after going public. That led to a massive loss of $554.5 million on sales of $5.7 million.
Chief Executive Alex Coleman told MarketWatch at the time that the charge was because the company used one methodology on Dec. 6, 2018, to value the companies that merged to form Tilt Holdings, and a different set of standards on Dec. 31.
For more on this, read: How a freshly grown cannabis company managed to lose $500 million in less than a month
Elsewhere in the sector, Organigram OGI, +2.82% was up 2.3%, Green Growth Brands GGBXF, +6.22% GGB, +7.26% was up 4% and Aleafia Health ALEAF, -1.22% ALEF, +0.00% was down 0.9%. Aphria Inc. APHA, +4.70% APHA, +4.63% was up 5%, MedMen MMNFF, +6.07% was up 7% and GW Pharma GWPH, -2.12% was down 2.5%.