ACB - Aurora Cannabis: Bullish On European Opportunity And Improving Financial Profile

Summary

• Aurora's emphasis on the Canadian and international medical-cannabis markets over adult-use (recreational) marijuana offers superior economic returns, given its premium-price structure and recurring-revenue characteristics.
• The market for legal cannabis across Europe could open up in a big way if Germany follows through on a plan to legalize the drug for adult recreational use.
• Though German production could increase to help pharmacies meet increased demand, the country still may need to rely on imports for the next few years, which could spur ACB sales.
• Aurora Cannabis trades at a significant discount compared with its large Canadian peers, based on my analysis of enterprise value-to-forward sales ratio.

Thesis

Aurora Cannabis' ( ACB ) strategy of prioritizing its global medical-cannabis business while pursuing the premium-priced Canadian consumer market makes sense to cull its operating deficit, I believe, given that medical markets offer stable growth and high margins. With the Canadian medical business stable, I think ACB's best hope for growth is international medical. The market for legal cannabis across Europe could open up in a big way if Germany follows through on a plan to legalize the drug for adult recreational use. Though German production could increase to help pharmacies meet increased demand, the country still may need to rely on imports for the next few years, which could be a tailwind for sales growth. Moreover, the management also seeks to monetize its intellectual property in genetics and biosynthesis. This multipronged approach to capitalizing on rising global demand for cannabis products -- and cost benefits from production efficiencies -- are key to near-term financial progress, including a goal to reach a positive adjusted Ebitda. I remain Bullish on the company as I believe ACB has significant topline expansion opportunities ahead of itself. I do not currently have a price target on the company.

Why am I bullish on ACB?

Capturing Cannabis Promise

Aurora Cannabis' strategy to capitalize on legal markets that are opening around the world emphasizes medical marijuana, which offers premium prices and high margins. Secondarily, the company seeks to meet rising demand in Canada for premium-priced adult-use cannabis flower, prerolls, vapes, edibles, and capsules, while shaping a leaner organization with reduced production capacity.

Aurora's emphasis on the Canadian and international medical-cannabis markets over adult-use (recreational) marijuana stems from the belief that medical offers superior economic returns, given its premium-price structure and recurring-revenue characteristics. Aurora CEO Miguel Martin reinforced this strategy on Nov. 10 by noting that the company's medical segment was generating an adjusted gross margin of more than 60% -- about twice that produced by the adult-use market. Aurora also sees opportunity in emerging international recreational markets.

Europe Opportunity

Europe Market Could Be on Verge of Expanding

The market for legal cannabis across Europe could open up in a big way if Germany follows through on a plan to legalize the drug for adult recreational use. Germany, the EU's most-populated country, has been at the forefront of cannabis regulation since legalizing medical use in 2017. I expect that if it permits adult use, other European countries that also allow medical cannabis, like Portugal and Poland, could soon follow. Germany's Health Ministry kicked off hearings in June to study adult-use cannabis policy.

Medical and scientific cannabis imports to Germany, Europe's largest medical-cannabis market, with more than 120,000 patients – have been consistently increasing over the past few years. Although, German pharmacies purchase medical cannabis from only a few cultivators, including domestic producer Demecan and Aurora Cannabis, Canopy Growth ( CGC ), and Tilray Brands ( TLRY ). Tilray Brands, sees a potential $37 billion market in Europe by 2027, has established EU-certified production facilities and is capitalizing on Germany's increasing need for cannabis imports.

Though Germany has said it prefers that domestic companies cultivate cannabis, I expect large Canadian companies, including Tilray, Aurora Cannabis and Canopy Growth to supply the country in the next few years.

Post 2Q Earnings Outlook

Aurora's fiscal 2Q adjusted EBITDA of C$1.4 million, enabled primarily by a 2% rise in net revenue over the prior year and sharply lower operating expenses is a positive development considering Canada's intensely competitive cannabis-market conditions. Still, sales for its core high-margin medical cannabis business fell 14%, hurt by unfavorable timing of shipments in certain international markets. Consumer-segment sales edged 2% above the prior year, supported by company's premium flower brand, San Rafael '71, and its value brand, Daily Special.

Aurora's moves to cut debt since late calendar 2020 have been fruitful, amid greater flexibility to invest more in developing and marketing a broader portfolio of value-added cannabis products. At the end of fiscal 2Q23 (Dec. 31), the company had net cash of C$41.2 million.

The company further reduced debt during 2Q23 through the repurchase of C$135 million in principal amount of convertible senior notes due 2024 for C$128.7 million.

Valuation

Aurora Cannabis' Valuation Lags Behind Large Canadian Peers

Aurora Cannabis has a modest valuation discount compared with its large Canadian peers, based on my analysis of enterprise value-to-forward sales ratio. I ascribe this largely to Aurora's lack of financial backing from a big consumer-products company, which Canopy Growth gets from a roughly 36% stake held by US beverage titan Constellation Brands ( STZ ). Aurora has just posted a positive adjusted EBITDA in Q2, in contrast with Tilray's consistent EBITDA profits.

Risks To The Bull Case

Every jurisdiction with a legal framework in place to allow for legal cannabis sales is effectively its own market. In the U.S., any product crossing a state line is in violation of federal law. While Canada has legalized cannabis nationally, export requires very strict approvals, and its industry will predominantly exist in Canada. As such, the cannabis industry will generally not have the scale efficiency or global opportunity as other consumer industries.

As a nascent industry, most market participants have a limited operating history in the category. Market forecasts for revenue growth have been drastically off. This has occurred even in forecast periods close enough to the actual event where most industries would expect a reasonable degree of accuracy. In some markets, industry forecasts for growth have led to supply addition far in excess of actual demand, and the result has been a poor economic return.

Cannabis has been cultivated by humans for millennia. While the technology around growing and genetics has improved yield and desired plant characteristics, this plant can be grown outdoors at a fraction of the price of indoor or greenhouse cultivation facilities. While strains of cannabis are valued for particular attributes, extracted cannabis for use in products like a CBD capsule or THC vape product become hard for a consumer to differentiate. Without branding or easy identification of some product attribute, consumers may not ascribe value to genetics or growing techniques. As an agricultural crop, there is a risk of commoditization and price compression.

Final Thoughts

If the EU embraces Germany's plan to let adults buy recreational cannabis, it could open up a vast European market for producers like Tilray and Aurora Cannabis. Assuming that the country proceeds with strict guidelines and gains support from the European Commission, sales could start strong in 2024. If the company continues to improve its financial profile I believe that the stock will trade at a higher multiple compared to its current discounted multiple to peers. I remain bullish on ACB and intend to keep the stock in my portfolio for long-term without a near-term price target.

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