From the highs of March 2019, Aurora Cannabis (NYSE:ACB) stock has slumped by 62% and the scenario is no different for other companies in the cannabis industry. The decline has been associated with industry- and company-related concerns and I don’t see any reversal in trend for ACB stock. This coverage will discuss the factors that can translate into sustained weak momentum for the stock into 2020.
From an industry perspective, the inventory of dried cannabis continues to swell. According to data from Government of Canada, inventory of dried cannabis was 96,822 kilograms in October 2018. Inventory surged to 289,902 kilograms in July 2019. Even the inventory of cannabis oil has been trending higher while cannabis oil sales remained stagnant in the last few months. There is a clear oversupply, which has impacted margins on sale of dried cannabis and cannabis oil.
Another interesting bit from the government data is related to the amount of cannabis sold for medicinal purpose. Some 1,941 kilograms of cannabis was sold for medical purposes by federally licensed sellers in October 2018. Sales have declined to 1,535 kilograms in July 2019. The sales of cannabis oil for medicinal purpose have also remained stagnant over this period.
The key point being — production of dried cannabis is not a concern. The major challenge is to expand the reach and demand for cannabis. Similarly, medicinal cannabis is unlikely to gain traction anytime soon.
Aurora Cannabis believes that the global market for recreational cannabis is $115 billion and for medicinal cannabis is $70 billion. However, it will take time to make inroads in the market. The stock is certainly discounting a relatively muted industry growth.
Expect an Extended Period of Cash Burn
There are important observations from the company’s 2019 results that lead to a conclusion on extended period of cash burn. The critical points are as follows:
- The company’s average net selling price of dried cannabis was $8.02 per kilogram in the fourth quarter of 2018. By the fourth quarter of 2019, the selling price has declined to $5.58. Even the selling price of cannabis extracts has declined from $13.52 to $10.37 for the same period. With an inventory glut, average sales price will continue to trend lower and margin compression will continue in 2020.
- Even with a 349% surge in revenue from 2018 to 2019, the company’s loss from operations increased from $95.8 million in FY18 to $314.2 million in FY19. Similarly, net cash used in operating activities increased from $81.7 million to $192.2 million. Clearly, cash burn has been accelerating as the company ramps-up sales and marketing efforts. Further, with margin compression, it is likely that cash burn will sustain in the coming years.
Plenty of Regulatory Challenges
Earlier this month, Aurora Cannabis provided a sneak peek of “next generation” cannabis products. The product pipeline includes vapes, concentrates and edibles. Within the edible segment, the company has a product pipeline of gums, candies and baked goods.
The positive aspect of this plan is that value-added cannabis products will command a higher EBITDA margin. This can accelerate profitability if the market gains traction.
However, the concerns are related to the regulatory side. According to Harvard Medical School psychobiologist, the legalization of cannabis is a “massive human experiment.”
Similarly, the National Institute of Drug Abuse has outlined the short-term and long-term impact of cannabis that includes “impact on brain development” and “lower IQ levels.”
The U.S. Food & Drug Administration is also concerned about the illness related to vaping since it has already caused more than 1,000 lung injuries.
The key point is this: There are an increasing number of voices talking about the health concerns related to recreational cannabis. It would not be surprising if the regulatory hurdles get higher. This would make introduction of new products relatively difficult and impact growth.
Final Thoughts on ACB Stock
Revenue growth for Aurora Cannabis has been stellar. However, the markets are looking beyond just top-line growth. Cash burn will continue for the coming years and the regulatory hurdles might increase. It’s therefore not surprising that ACB stock has been trending lower.
The downside in Aurora Cannabis stock might not be significant from current levels, but I don’t see triggers that can result in a sharp stock bounce back.
In addition, there is strong competition in the industry with several companies targeting entry into medicinal cannabis and value added products. This would imply the need for sustained investment in R&D.
Overall, ACB stock looks unattractive even after the big downside in the last six-to-eight months. While the total addressable market seems significant, it will be years before the markets can be penetrated meaningfully.
As of this writing, Faisal Humayun did not hold a position in any of the aforementioned securities.
