It’s been a great time to be an investor in weed stocks for the past few years. If you bought nearly any pot stock in 2016, you’re probably sitting on some handsome gains right now. But the market is bracing for a shake-up in the next few years.
This month, Canada will become the first G7 nation to federally legalize the use of marijuana for recreational purposes. However, the Canadian government has decided to regulate the market tightly and offer licenses only to a handful of big players. With high barriers to entry, wide margins, and a product with centuries of proven demand, these few players are on a precipice of a drastic transformation of their balance sheet.
In the hopes of sharing in the windfall, investors have poured billions into these stocks, sending some of them to absolutely ludicrous valuations (I’m looking at you Tilray). In a previous article, I mentioned that the gold-standard for the weed market is Canopy Growth Corp (CGC). With $4.6b in cash, a partnership with one of the world’s largest alcoholic beverage companies, branches abroad, and supply arrangements with various Canadian provinces, CGC is in a much better position than Tilray to dominate this market over the coming decade. In fact, some readers mentioned how silly it was to even consider comparing the two companies.
I guess with that in mind, it’s time to take a closer look at CGC’s closest rival – Aurora Cannabis (ACB, OTCQX:ACBFF). With a market cap of just over $9.1b and sales of over $42.6 million (year ended June, 2018), Aurora is most comparable to CGC.
Like Canopy, Aurora has supply arrangements with nearly all (9 out of 10) Canadian provinces and territories. This gives it access to over 98% of Canada’s population. With 63,000 kilograms in contracted volumes over the next year, the company has more contracted sales than its current production rate (45,000 kgs/year). By the end of 2018, operations are expected to be expanded to a production run rate of over 150,000 kgs/year.
The company has already funded a capacity boost that will bring the total number of production facilities to 11 and the total annual production capacity to 570,000 kgs/year by the end of 2019.
Unlike CGC, Aurora doesn’t have a blockbuster deal with a major consumer goods company like Constellation Brands, but there are rumors Coca Cola may be exploring a strategic deal. Through partnerships, joint ventures, and subsidiaries, the company has a presence in over 18 countries. Unlike CGC, it doesn’t have a consumer brand yet, although it does plan to launch one soon.
All these factors make Aurora one of the largest players in the global cannabis market. For investors, there are two key questions about Aurora that underlie the investment thesis – what’s the growth potential and is it already priced in?
Sales have been on a tear for the past two years. Since 2016, the revenue generated from selling medical cannabis across Canada has grown from $1.1m to 42.7m, an incredible rise of 39x over two years. It’s important to note that the company sells exclusively medical cannabis. Gross margin was a whopping 88% in 2017 and 78% in 2018.
Aurora’s net profit for this year is a one-off. The company admits that the profit can be attributed to the unrealized non-cash gains on derivatives and other marketable securities. Without these exceptional items, the net loss from operations this year was $74m, up from $8.67m a year ago. That means operational losses grew by 8.45x. In other words, losses are growing slower than sales.
The rise in production from 45k to 500k annual kgs is fully funded, while the company holds nearly as much cash and cash equivalents ($116m) as long-term debt ($154m). In fact, long-term debt is surprisingly low, at just 13% of equity. Aurora seems to have a strong balance sheet serving as a base for immense growth.
The company continues to power growth in three key ways – investing in production facilities, acquiring companies spread across the marijuana supply chain for vertical integration, and partnering with companies for wider reach. Only two of these are capital intensive. However, there is little doubt that Aurora has managed to ramp up production efficiently so far, and could cement its position as the second largest weed company in the world by 2019. With such a great position in the market, the only remaining hurdle for investors is the valuation.
Trying to value a weed stock is often an exercise in futility. There’s simply a lot of known unknowns in the market, ranging from the eventual price per gram of legal weed to the fragmentation in the international market. But that doesn’t mean investors shouldn’t at least try to place Aurora’s valuation in context.
I think two reasonable ways to value the company is to compare it to other similarly-sized weed stocks and place a reasonable value on the growth potential of the company.
For the comparison, I’ve picked Aphria (OTCQB:APHQF) and Canopy Growth. Price-to-sales is the best metric considering none of them make a profit at the moment. Here’s how they compare:
Legal Weed Stocks Price-to-Sales Ratio
As of Sept 29th 2018
Aurora may be reasonably priced based on this comparison with its peers. If you assume the market will eventually level off at a price-to-sales ratio of 5x for market leaders (similar to the ratio offered to the world’s leading alcoholic beverage companies), Aurora will have to expand sales 20x to justify its valuation. Considering sales are up 39x in the past two years alone even before Canada has legalized recreational sales of marijuana, I think this is clearly possible. In fact, the increase in funded production capacity by the end of 2019 alone is 11x the current rate.
Another way to value Aurora is to calculate its justified PS ratio. According to an estimate by Grand View Research, the global medical marijuana market will be worth $55.8 billion by 2025. I’ll assume the market is at least 30% smaller than that by 2025 and that Aurora manages to capture only 15% of it despite its clear first-mover advantage at the moment. On that basis, the company is likely to have sales of nearly $6b by 2025, implying a CAGR of 102% from current levels.
The question I think any investor eyeing Aurora stock at the moment is whether it’s worth paying 100x last year’s revenue for a chance to experience an estimated sales compounding rate of 100% for the next five-seven years.
Doubling sales every year may seem preposterous for any other industry, but for a substance with proven demand and wide margins facing the end of a centuries-long prohibition, I don’t think it’s unreasonable.
However, there is one critical cloud hanging over Aurora’s prospects – the cash on Canopy’s books. Any company that wants to dominate the legal marijuana industry (medical or recreational) will need to either invest in production plants or acquire companies to fuel growth. Aurora has done both of these in recent years with considerable success. But going forward, the valuation of any small marijuana company it wishes to acquire will be considerably inflated. Meanwhile, the company only has roughly $200m in cash, compared to Canopy’s arsenal of over $4.5b. Without a major cash infusion or a strategic partnership with a major company like Coke, I think Aurora may struggle to keep up in the global marijuana arms race that is just getting started.
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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