I’m more than a little skeptical towards the market rally we’ve seen since October. And I’m more than a little skeptical towards Aurora Cannabis (NYSE:ACB) stock. Those two sentiments are not unrelated.
Since late October, we’ve seen huge rallies by small-cap stocks in general and “hot” sectors favored by retail investors in particular. Whether it’s electric and autonomous vehicles, online gambling, or cannabis, the gains by such sectors have been enormous.
The surge of optimism has benefited ACB stock, which is up more than 200% just since late October. And, to be fair, there is some reason for the optimism. Aurora’s operating losses continue to narrow. Meanwhile, Aurora has improved its balance sheet, and sentiment towards the cannabis sector has improved.
But there’s also a sense with Aurora and the market in general that investors simply are overlooking risks. We’re seeing basically every stock in entire sectors not only move higher, but in many cases double or even triple. For cannabis in particular, the rally seems tied to U.S. election results that simply weren’t as bullish as some investors seem to think and probably were roughly in-line with expectations.
Simply put, I don’t trust these rallies by Aurora or its sector.
The Case for ACB Stock
As I noted earlier, there are reasons to be upbeat about Aurora.
Under its new CEO, Miguel Martin, Aurora at least looks like it’s heading in the right direction, as its losses have narrowed tremendously. In its most recent reported quarter, Q1 of fiscal 2021, its EBITDA loss, excluding one-time costs, was just 10.5 million CAD. The company’s adjusted EBITDA loss during the same period a year earlier was 39.7 million CAD.
Aurora’s balance sheet has also improved. The company has converted some of its debt into ACB stock, selling $125 million in equity in a so-called “bought deal financing” last month.
Aurora’s bankruptcy risk was heightened just a few months ago. But as the credit markets show, that risk has been minimized, as Aurora’s bonds have rallied sharply, if not quite to the same extent as its shares. The 5.5% convertible senior notes due 2024 traded below 35 cents on the dollar as recently as May. They recently changed hands for more than 84 cents.
Meanwhile, Aurora has remained the leader of Canada’s medical-cannabis sector, despite its aggressive cost-cutting. Its facilities have been closed and its employees have been laid off to reduce its expenses and match Canadian demand. At least over the last few quarters, Aurora has been very adept at the latter task.
And with its risk of bankruptcy down, Aurora has the ability to position itself for renewed growth. The U.S. market, of course, looms large for the sector. It’s no coincidence that ACB stock and the sector have soared since the U.S. elections, which gave Democrats control of the White House and Congress. According to some observers, that development is likely to lead to cannabis legalization at the federal level at some point.
Hold on a Minute
The problem with ACB stock, particularly after its recent rally, is that, upon closer inspection, the shares don’t look as attractive.
Take the company’s profit increases. Aurora has made progress. But that progress was created by massive cost-cutting. Its sales, general, and administrative expenses have plunged from their record high above 100 million CAD. The company’s SG&A expenses dropped from 66 million CAD to 43 million CAD in a single quarter between Q4 and Q1.
There’s the obvious concern that Aurora’s cuts are going to go too far. That aside, the problem is that there’s simply not much more Aurora can do, but work still needs to be done. A 10 million CAD quarterly loss still leaves the company in a hole.
Once its operations break even, it will still lose money due to interest costs and minimal capital expenditures. And it still needs to support its market capitalization which is nearing $3 billion. Further, an awful lot of further improvement by the company already looks priced into the stock.
And there are still concerns about its operations. Martin, Aurora’s CEO, himself admitted after Q4 that the company had lost its market-share lead in the Canadian consumer market. Rivals like Canopy Growth (NASDAQ:CGC) and Cronos (NASDAQ:CRON) have enough cash to invest in customer acquisition and take more share from Aurora. Aphria (NASDAQ:APHA) and Tilray (NASDAQ:TLRY) will be a more formidable rival once their merger is complete.
Aurora isn’t out of the woods. In fact, it’s nowhere close to that point.
Politics and Earnings
Given Aurora’s status, the optimism toward ACB stock seems misguided. The stock seems to have been pulled up by the broader small-cap rally and the belief that the election results were good news for Canadian cannabis operators.
On the latter point, I’m skeptical. An evenly divided Senate doesn’t seem likely to push through cannabis legalization. And bear in mind that federal legalization is required for these companies to enter the U.S. market; banking normalization under the proposed MORE Act isn’t enough to produce that result.
Even if legalization is achieved, is Aurora really set to capitalize on it? It has balance sheet problems. It has slashed its costs and is cutting its expenses further. And Aurora does not seem to have the resources needed to absorb the upfront operating losses that the U.S. market will require.
Indeed, I argued a year ago that Aurora’s options in the U.S. were limited, and nothing since has changed my opinion on that. Aurora’s CBD (cannabidiol) business could prosper, as the firm’s CEO certainly seems bullish on it. But that business won’t necessarily get an added tailwind from full legalization.
Meanwhile, Aurora’s quarterly earnings report is due next week, and it could be negative for ACB stock. The stock has been tremendously volatile around the company’s earnings of late, and expectations are high for this report. At this point, anything short of positive EBITDA might well be seen as a disappointment.
But whatever the short-term movement in the shares, they still carry long-term risks. I expect investors to remember that eventually.
On the date of publication, Vince Martin did not have (either directly or indirectly) any positions in the securities mentioned in this article.