Since March 2019, Aurora Cannabis (NYSE:ACB) stock has been in a downtrend. The decline is broad-based with cannabis stocks correcting after a massive rally.
The correction has also been a result of surging inventory of dry cannabis, which is likely to put pressure on margins.
Amidst the decline, there are buying opportunities in the industry. If I had to choose stocks for the long-term portfolio, Aurora Cannabis and Canopy Growth Corporation (NYSE:CGC) are stocks worth considering.
I do believe that Aurora Cannabis is making the right moves towards value creation, but I don’t see profitability or free cash flows coming anytime soon.
I would therefore wait on the sidelines before exposure to ACB stock. Another leg of potential equity dilution and stock downside might present an opportunity to buy.
Aurora Cannabis Is Building a Strong Foundation
It is estimated that the global (regulated and illicit) cannabis market is over $340 billion. There are 50 countries that have legalized cannabis for medical use. Further, six countries have legalized cannabis for recreational use. It is also estimated that nearly 1.2 billion people globally are suffering from medical condition for which cannabis has shown therapeutic value.
Clearly, there is a big opportunity and Aurora Cannabis has been making the right moves. From a production capacity of 150,000 kg per year in 2019, the company’s production capacity will increase to 625,000 kg per year in 2020. The advantage with a scale up in production is that cost will decline and partially offset the margin compression due to dry cannabis inventory build-up.
The second positive is that Aurora Cannabis already has presence in 25 countries. Through the organic and inorganic route, the company has a first mover advantage in potentially big markets. This includes countries in the European Union where the company has two EU GMP-certified facilities.
Aurora has also been investing heavily on research and development to create high-margin medicinal and recreational products. This includes innovating products for the non-prescription wellness market. I believe that in the coming years, high-margin products will dictate the stock trend and valuation.
ACB Still Far From Positive Free Cash Flows
As a first step, Aurora Cannabis has been successful in making entry in several markets through the organic and inorganic route. However, negative free cash flow is likely in the coming years considering the following points:
- Selling dry cannabis is unlikely to be a cash flow growth trigger. Aurora Cannabis needs to invest heavily in the coming years to develop medicinal, recreational and non-prescription wellness products. These investments will imply stress on the balance sheet and possible equity dilution.
- Aurora has 40 clinical studies that are completed or underway. The company also has a pipeline of 27 clinical studies. There is a significant time lag from clinical studies to medicines gradually entering the markets. Therefore, the medicinal segment is unlikely to witness exponential growth anytime soon. At the same time, the pipeline is robust and successful trials would translate into diversified product launch in the coming years.
- ACB has a first mover advantage in several markets. However, establishing visibility for premium products would require investment in marketing. Therefore, even when value added product sales gain traction, the margins are likely to be subdued.
- The inorganic route has helped Aurora Cannabis accelerate market presence. I expect M&A to continue as the cannabis industry witnesses some consolidation. Funding inorganic growth would possibly imply funding in the form of debt or equity dilution.
Final Thoughts on Aurora Cannabis Stock
Aurora Cannabis stock has continued to trend lower since March 2019. This has been on the back of profit booking and industry concerns. At the same time, there is no free cash flow visibility in the foreseeable future.
However, Aurora Cannabis is working on a strong foundation before the take-off. I believe that high-margin products will be the game changer for the company.
As investment in new market entry, R&D, sales & marketing continues, investors will be concerned about further equity dilution or leveraging.
I would wait for a likely equity dilution to buy ACB stock. Levels of $5 to $6 can be interesting for some long-term exposure.
As of this writing, Faisal Humayun did not hold a position in any of the aforementioned securities.
