Recent Developments Do Not Change Our Stance On Aurora Cannabis

The last time we covered Aurora Cannabis Inc. (NASDAQ:ACB) almost a year ago, we found industry dynamics changing for the better but we did not initiate an investment in the company because of many reasons. Continued dilution of shareholders, increasing competition, the reliance on cost reduction to drive earnings growth, the decision to trim the R&D budget, and the lack of focus on consumer-focused cannabis products were some of the main reasons behind our decision to wait on the sidelines. With Aurora Cannabis stock down 74% since our last article, we thought it best to revisit our investment thesis to determine whether a change in our stance is required today given the company reported fiscal Q3 earnings today.

What to make of the earnings report?

Aurora Cannabis reported revenue of C$50.43 million for the fiscal third quarter of 2022, a year-over-year decline of close to 9%. The company reiterated the target to achieve positive adjusted EBITDA by the end of the first half of fiscal 2023 (I do not prefer to call this metric profits). Although the medical cannabis segment revenue grew 8% YoY, the consumer cannabis segment saw revenue decline 28% as the company had to close down some retail stores due to a lack of demand for its premium cannabis products. I never found the company’s decision to focus on premium cannabis products a good strategic decision given the high demand for lower-priced products in the market. Today, Aurora is being penalized for this strategic decision, and even more importantly, the company still prioritizes the medical cannabis segment which I do not find a prudent strategy as a growth-oriented investor. Confirming the company’s focus on medical cannabis, Aurora wrote:

During Q3, we continued focusing on our global medical cannabis business because it is both defensive and stable, with cash gross margins that exceed 60%. We were pleased to have experienced considerable top-line growth in this segment year over year, and with new international markets poised to open, our track record and ability to navigate complex regulatory environments position us ideally for a significant revenue opportunity globally.

I am not against being defensive, but I believe Aurora had a massive advantage to aggressively penetrate the consumer cannabis segment because of the first-mover advantages. With every earnings report, I feel the company is sacrificing these advantages to ensure short-term predictability of earnings (more on this below).

Aurora also boosted its cost savings target to $150-$170 million by the first half of 2023 from the previous guidance of $60-$80 million. This is certainly not a negative development but as we highlighted in our previous article, we believe some of these cost reductions are capping long-term growth for the company.

The current state of cannabis legalization

Federal legalization of cannabis in the United States will be a boon for the global cannabis industry as a whole. Although Aurora is primarily focused on the Canadian medical cannabis market, it makes sense to look at the legalization efforts in the U.S. as this could not only boost Aurora stock but also open an opportunity for the company to finally tap into the American market meaningfully.

There are two bills every cannabis investor needs to follow.

1. Marijuana Opportunity Reinvestment and Expungement Act or the MORE Act.
2. Secure and Fair Enforcement Banking Act of 2021 or the SAFE Banking Act of 2021

Both these bills have been passed by the House but the Senate is continuing to get in the way of federal legalization. This regulatory dilemma is far from over, and it might take much longer than we initially anticipated to see cannabis legalization on a federal level.

Exhibit 1: The status of the MORE Act and SAFE Banking Act of 2021

The MORE Act decriminalizes marijuana by removing it from the list of scheduled substances under the Controlled Substances Act, and it will also eliminate criminal penalties for manufacturers, distributors, and consumers of cannabis products. The U.S. Drug Enforcement Administration classifies cannabis as a Schedule I drug. Here’s what it means:

Schedule I drugs, substances, or chemicals are defined as drugs with no currently accepted medical use and a high potential for abuse. Some examples of Schedule I drugs are: heroin, lysergic acid diethylamide (LSD), marijuana (cannabis), 3,4-methylenedioxymethamphetamine (ecstasy), methaqualone, and peyote.

Descheduling, as you can imagine, will play an important role in the widespread adoption of cannabis products in the U.S., and this highlights the importance of the passage of the MORE Act.

The SAFE Banking Act of 2021, on the other hand, addresses another key challenge faced by both businesses and consumers with its focus on prohibiting financial regulators from penalizing banks and financial services companies for providing their services to cannabis companies. Today, only a very few banks and credit unions are providing services to cannabis companies, which is one of the biggest hurdles faced by the industry.

Exhibit 2: Banks working with cannabis companies in the U.S. (as of 2021)

Today, banks that are working with cannabis companies are well-positioned to charge premium prices for the services they offer, and the SAFE Banking Act of 2021 has the potential to change the industry dynamics in favor of cannabis companies.

These two bills will revolutionize the cannabis industry, but going through the Senate is proving to be a difficult task. Considering the Senate is equally split, this does not come as much of a surprise as well, and cannabis investors might have to wait for much longer to see a breakthrough from a legalization front.

The industry continues to move forward

According to BofA Securities, legal sales of cannabis in the U.S. grew 40% in 2021 to $25 billion. According to MJBiz, cannabis sales will reach $33 billion this year, so we are looking at another strong year for legal cannabis sales in the United States and globally. The international market presents a very big opportunity for cannabis companies as legalization moves forward albeit at a slow pace.

Exhibit 3: The state of cannabis legalization globally

The legalization of cannabis for recreational purposes will bring consumers from the black market to legal channels, but this is happening at a slow pace today. Europe is yet to enact progressive policies to support this cause, which is one of the major challenges faced by the industry.

Same old problems for Aurora

Despite regulatory challenges, there’s a lot to like about the cannabis industry considering that legal use of cannabis is still in its infant stages while black market sales exceed $100 billion annually. Despite Aurora being a leading player in the global medical cannabis market, there are a few reasons for us to be skeptical of the company’s growth potential.

Aurora continues to focus on the Canadian cannabis market which is already crowded. Although the company holds the number one market share in this space (23%), we believe it would not be easy for Aurora to build on this leadership position or convert this position into positive earnings any time soon. Even when we account for the recreational cannabis market in Canada, it seems obvious that smaller competitors are taking market share from established rivals.

Exhibit 4: Number of cannabis producers and market share outside the top ten

Although Aurora has a presence in the U.S. through Reliva which serves the market for hemp-derived CBD, the company has always (even in its February presentation) made it crystal clear that it is waiting for FDA regulation to tap into the medical cannabis market in the United States. Aurora CEO Miguel Martin, while answering a question from an analyst last February, said:

We have been saying for a year that the U.S. is a ways off. We also believe and strongly, and I spent my entire career working in the U.S. with regulated agencies that, it’s going to be a medical focus, with the FDA regulating the product with decriminalization, and then we’ll see a pathway towards RAF. That’s what we are seeing in other markets and we’ll see it there.

While many cannabis companies have aggressively moved into the U.S. through acquisitions and deals with multistate distributors, Aurora continues to play the waiting game. We believe the delayed expansion into the U.S. will prove to be a costly mistake in the long run, and this is one of the main reasons for us to remain on the sidelines.

The dilution of shareholders is continuing as well, which is another concern. We are not always against dilution of ownership, especially when it is unavoidable to save the company from a catastrophic collapse. When it comes to Aurora, we believe the company’s lack of partnerships with pharmaceutical and alcohol companies has left the company with no option but to tap into capital markets to raise the funds needed for expansions.

Exhibit 5: Shares outstanding

Overall, we still do not see a clear pathway for growth for Aurora Cannabis despite some promising developments.

Takeaway

Aurora Cannabis reported decent numbers for the third quarter of fiscal 2022 but the company still faces many challenges. Needless to say, Aurora has tried a few different business strategies in the last 3 years but none of these strategies have delivered the expected returns so far. Based on the lack of focus on the U.S. market, failure to tap into the consumer cannabis segment meaningfully, the continued dilution of shareholders, and the over-emphasis on cost savings, we are not changing our stance on Aurora Cannabis today, meaning we will remain on the sidelines.