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Aurora Cannabis Is Compelling Over The Long Term

Aurora Cannabis Is Compelling Over The Long Term

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With the bulk of the attention of the Canadian cannabis market recently being on the legalization of recreational marijuana in Canada, the market has put the potential growth for medical cannabis on the back burner for now. I think that has, in general, temporarily put downward pressure on Aurora Cannabis (OTCQX:ACBFF) and other cannabis producers, but that is unlikely to continue on.

The major issues are the lack of certainty concerning when recreational pot will be available for sale, and what the final bill will look like once it goes through the political process.

Aurora Cannabis isn’t too concerned about this. On a recent webcast, Cam Battley, Chief Corporate Officer for Aurora, asserted the company, because of its variety of distribution options, “can sell every gram” it produces. If that’s proven to be true, it bodes well for shareholders as global and domestic pot demand ramp up.

One concern weighing on Aurora is the cost in share dilution from its aggressive move to increase capacity and become the market leader in cannabis production once its existing deals are finalized.

The dilution factor

With the market being increasingly concerned about the impact of bought-deal financing on the performance of the company, Battley commented on the webcast concerning the why behind it.

The major impetus behind its aggressive growth strategy initially, was the fact it wasn’t among the companies that originally received cultivation and distribution medical cannabis licenses in Canada. That resulted in that having to play catch-up to the 13 companies that received them first. Aurora has used its shares to enter into several partnerships, as well as acquire eight companies over the last year. The two largest and most well-known were the acquisitions of CanniMed Therapeutics and MedReleaf.

The latter should generate about 140,000 kilograms annually at peak capacity. That would bring the overall production capacity to about 570,000 kilograms a year for the company, once construction on existing projects is completed. I think Aurora is taking the right steps here. Over time the market will consolidate even further, and many of the smaller companies that aren’t acquired will end up going out of business. Those that are far behind the market leaders now, are going to struggle to compete.

That will reduce the number of competitors significantly and give Aurora an even larger market share.

Another factor concerning supply and demand is whether or not many of the companies providing estimates of capacity within specific time frames will be able to meet them. At this time, the market hasn’t shown much in the way of concern there. It appears that will change as demand starts to climb and some companies inevitably announce they’re behind schedule on building out their capacity.

I don’t think Aurora will be one of them, and that could give the company an upside surprise if it’s able to take even more share because of lower-than-expected supply.

As for dilution, this is one of the reasons why I don’t think it’ll do as much harm for Aurora as it may to others. I think the market will reward revenue before earnings over the next couple of years, and Aurora should either be the market leader in sales as the company stands today, once it finalizes its MedReleaf acquisition.

Since there were really no alternatives to financing in the cannabis sector, it’s hard to see why investors would punish a company that uses equity instead of debt to get financing they need. Yes, the dilution is there, but the other option would be to remain a small company that would struggle to survive. At this time, it’s the nature of the industry.

I would be more concerned if Aurora was the only company diluting its shares. As it is, most cannabis companies have participated in the same type of financing at different levels.

Further out, if Aurora isn’t able to generate positive earnings, it could become a factor, but it appears it isn’t too far away from producing a profit, which should change market sentiment concerning dilution.

Why Aurora Cannabis believes it can sell every gram

There are several reasons why Aurora believes it can sell every gram of cannabis it produces. They include increasing domestic demand, overseas sales, and supply not being as robust as believed because of the aforementioned expectations that some companies will fail to meet their target dates in completing construction that will add capacity.

While there’s no doubt Aurora will benefit from the legalization of recreational marijuana in Canada, one of its strengths is that it doesn’t need that to continue on its growth trajectory. That’s because it has focused strongly on the medical cannabis market, while building out an international production and distribution network.

With the market recognizing the rise in domestic demand and the probability supply won’t be at projected levels because of failure to meet estimated deadlines for capacity, which Battley noted in the recent webcast, saying he said it’s unlikely Canadian producers, which “are pretty bullish” on their projections, will all be able to meet them. He went so far as to say a number of the smaller players may not be able to bring their projects to fruition at all. Because of that, supply may be much more constrained than some following the cannabis market currently think.

I want to focus on the global medical cannabis market, which offers significant long-term growth for Aurora.

First, it needs to be mentioned that Aurora already has output capacity in place to sell into the recreational market once it becomes legal. It’s not like Aurora is ignoring that market, instead, it’s taking a more balanced view of the opportunities ahead, and isn’t laying everything on the line to battle it out for the lower margin recreational market at the expense of the more predictable and profitable medical cannabis market.

When taking into consideration the total global market, demand for medical pot is expected to exceed that of recreational marijuana, although that remains to be confirmed because of the lack of clarity on how large the Canadian domestic market is for recreational pot. Taking into account what most analysts are saying, it looks like the general consensus is it represents a $5 billion market.

When considering the global medical market, there are already over 24 countries that legalized cannabis for medical use. By 2025, medical marijuana global sales are estimated to reach $100 billion in revenue, according to a recent report released by Grand View Research, Inc., with all legal sales expected to reach $146.4 million by the end of 2025.

There have been a number of estimates made for global medical cannabis sales over the last several months, with a very wide projected ranges across the various reports. Some I’ve seen have sales at about $22 billion by 2022, and about $28 billion by 2024. I’ve seen one that has medical cannabis sales estimates reaching as high as $180 billion. The $100 billion mentioned above is somewhat between the extreme deviation in estimates, which is why I chose that one as a baseline to work from.

Battley noted that the medical cannabis segment represents extraordinary growth opportunities for the company. He pointed out, rightly in my opinion, that many smaller producers are going to struggle to compete at the international level with medical pot.

That was also a reference to many companies that have focused on the recreational pot market in Canada, which for the most part, won’t have the excess capacity to sell in overseas markets.

Another strength in medical cannabis is it forces companies to produce the oils and extracts that come with wider margins and stronger earnings. Many countries don’t allow dried cannabis because of laws that don’t allow smoking marijuana as a means of consumption.

One of the steps Aurora has taken to address that was to take a 9.14 percent interest in CTT Pharmaceutical Holdings Inc. What CIT does is supply “fast dissolving oral thin film wafers that provide a quick release, smoke-free delivery of medical cannabis or other active ingredients.”

It has also entered into an agreement with Heinrich Klenk GmbH & Co. KG, a German-based company, to introduce a new brand dubbed “Cannabis Klenk.” Aurora will supply the product and Pendanios will import it and sell it through the distribution network of Klenk to German pharmacies.

Aurora also owns a 51 percent stake in Aurora Nordic, which will construct a 1 million square foot greenhouse in Odense, Denmark, which will further enhance its medical cannabis footprint in the giant EU market. It is expected to produce about 120,000 kilograms annually.

An interesting picks and shovels play

In November 2017, Aurora announced it had acquired greenhouse design firm Larssen Ltd. By acquiring Larssen, Aurora brought the costs it had paid out to the company for various projects, in-house. It had worked on most aspects of the design and construction aspects of greenhouses worldwide, and it should provide a nice income source for Aurora in the years ahead.

With the number of competitors in the cannabis segment expected to soar over the next few years, Aurora is now positioned to be a consultant, designer and builder of greenhouses in the cannabis sector.

Aurora stated that with the acquisition comes a high-margin revenue and earnings opportunity that should rapidly grow with the sector.

In the 12-month period ending on September 30, 2018, Larssen is projected to generate about $6 million in revenue with an EBITDA margin above 40 percent.

Besides its work with Aurora, at the time of the announced deal, Larssen was developing greenhouses for The Green Organic Dutchman and Cann Group.

Not only does this give a new and significant revenue stream for Aurora for the long term, it also reduces expenses it would have spent on Larssen with its own development projects.

This is probably going to be a great deal for the company, especially when the market starts looking past revenue to earnings.

Conclusion

It’s possible the latest communication from Aurora Cannabis could be an attempt to manage expectations for the company. The reason for that in the very near term could be from recreational cannabis taking longer to implement than originally thought. Aurora suggested it may take until September before sales begin.

When considering it may take a quarter to get the process streamlined, it could mean sales could be less than the market is looking for. If that’s how it works out, it may mean it won’t have a strong impact on company revenue and earnings until the first quarter of calendar 2019.

At the same time, the company obviously wants investors to see the more predictable and visible medical cannabis market that has so far made the company what it is. That means margins and earnings from that segment of the market should exceed that of the recreational market, and while it is unlikely to grow at the pace of the recreational cannabis market over the next year or so, further out it could account for not only a higher percentage of revenue, but a much higher percentage of earnings.

Add to that the high-margin one-stop-shop greenhouse-building business, and it provides a potentially strong foundation for the future of the company.

All that said, recreational pot sales should still be a meaningful part of Aurora’s performance, as it opens up an entirely new revenue stream for the company.

If management is correct and the projected capacity for production is less than thought at this time, it could be a surprise catalyst for Aurora, which could then boost prices on the recreational side of the business if supply is more constrained than the market is looking for.

Under that scenario, the company could exceed expectations on both revenue and earnings, giving shareholders a surprise return through at least the next twelve months or so.

Further out, overseas medical pot sales and the potential of its greenhouse unit are going to be major factors in the overall performance of Aurora Cannabis.

For these reasons, even with the dilution factor, they should bring some solid results for investors.

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.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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