In just 10 days, Canada's Senate is set to vote on bill C-45, which is best known as the Cannabis Act. A positive vote could put in motion a long-awaited change in our neighbor to the north that would soon thereafter make recreational marijuana legal. Though Uruguay is the only country in the world to have fully legalized cannabis for adults, Canada would be the first developed country to do so.
Adult-use cannabis means big money for the legal weed industry, as well as to investors. Recreational marijuana is expected to add perhaps $5 billion in annual sales to Canada's legal weed industry, which comes atop what it's already generating from medical pot sales and exports. It's this sales-growth expectation that's been instrumental in driving the share prices of industry giants like Aurora Cannabis (ACB -2.96%) considerably higher. Over the trailing two-year period through May 23, 2018, Aurora's share price was up nearly 1,700%!
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Three reasons to buy Aurora Cannabis' stock
The big question is: Does Aurora still merit consideration as a stock to buy, or should investors be expecting this stock to go up in smoke? Let's have a look at both arguments by examining the three most compelling reasons to buy and the three glaring reasons to sell.
1. Industry-leading production
Arguably, the top reason to buy into the Aurora Cannabis growth story is its industry-leading production. Assuming it closes on its $2.5 billion acquisition of Ontario-based MedReleaf (NASDAQOTH: MEDFF), the company will have peak annual capacity of 570,000 kilograms of dried cannabis. Comparably, Canopy Growth Corp. (CGC -0.66%) comes close at around an estimated 500,000 kilograms per year, but no other grower is within even a stone's throw after that.
Generating such a large amount of cannabis each year means Aurora is likely to secure long-term supply deals with provinces and domestic retailers, as well as with overseas countries looking to supply their medical weed industries. In other words, there are clear advantages to being a market-share leader.
2. Top-tier distribution channels
Secondly, Aurora Cannabis' distribution channels are among the best in the industry. For instance, its Aurora Nordic facility in Denmark, which involves a strategic partnership with Alfred Pedersen & Son, is capable of producing 120,000 kilograms of marijuana annually when at full capacity, and it'll primarily be tasked with supplying Europe with its dried cannabis needs.
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Aurora also announced new distribution channels during its fiscal third quarter with Shoppers Drug Mart and Pharmasave and completed an investment in Liquor Stores N.A., a brick-and-mortar cannabis retail outlet in Canada. Aurora is working on a mobile application, too, which will allow medical weed patients the convenience of ordering marijuana with the click of a button.
3. An improved product mix
The final reason to buy is the company's improved product mix. Whereas most growers have been reliant on dried cannabis, Aurora and a few of its peers are making the push into cannabis oils and extracts. Though cannabis oil is more of a niche product with a narrow consumer base, its higher price point leads to significantly juicier margins than that of dried cannabis.
According to the company's third-quarter operating results, Aurora logged $1.71 million in cannabis oil sales, which compared to zilch ($0) in oil sales in the year-ago period. MedReleaf generated 21% of its total revenue in its most recent quarter from oils and extracts, which means Aurora's proposed buyout of MedReleaf will only further aid in offering a more diverse (and higher margin) product mix.
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Three reasons to sell Aurora Cannabis' stock
However, there are equally compelling reasons for investors to keep their distance from Aurora Cannabis.
1. Profitability may not live up to expectations
Topping the list of reasons to sell Aurora is the expectation that it's not going to be nearly as profitable as optimists expect. Aurora is gung-ho about its expansion efforts, which currently include the nearly completed Aurora Sky project, as well as the Aurora Nordic and Aurora Sun mammoth greenhouse facilities. But investing every ounce of operating cash flow and capital back into these projects is sapping any chance of the company producing a meaningful per-share profit.
According to Wall Street's consensus, Aurora Cannabis only is expected to produce CA$0.10 in full-year earnings per share (EPS) in 2019. That works out to a forward price-to-earnings (P/E) ratio of about 85, which isn't exactly cheap. Though some investors may be willing to overlook Aurora's sky-high P/E because of its rapid growth rate, it'll be no fan of fundamentally focused investors.
2. The potential for domestic oversupply
A second reason to sell would be due to concerns about oversupply. Let's face it -- since no developed country has legalized adult-use weed before, no one is really sure what to expect. Without any true precedent, all the Canadian federal government and Wall Street can do is take their best guess. In many instances, annual domestic demand is expected to fall between 800,000 kilograms and 1 million kilograms.
Here's the issue: Aurora Cannabis and Canopy Growth are capable of more than 1 million kilograms of annual production between them. Add in the other major growers, mid-tier facilities, and dozens of smaller producers, and up to 2.3 million to 2.4 million kilograms of annual production becomes possible by 2020 or 2021. Where does this excess cannabis go? Presumably to overseas markets where medical marijuana is legal.
Unfortunately, we don't know if these foreign markets can absorb this much oversupply. If they can't, dried cannabis prices could plunge, sinking Aurora's margins.
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3. Rampant share dilution
Lastly, massive amounts of shareholder dilution might be a smart reason to sell Aurora Cannabis. As is the case with most marijuana stocks, traditional access to capital is incredibly limited, namely because banks don't want to risk being fined or criminally charged for providing services to a cannabis company. That leaves pot stocks to turn to common stock offerings, convertible debenture sales, and even stock options and warrant sales to raise capital.
The good news for Aurora is that it's had no trouble raising the capital it needs to make acquisitions and complete greenhouse projects. The bad news, assuming its all-share MedReleaf deal goes through, is that its share count may have risen from around 16 million to approximately 1 billion in less than five years. That type of dilution can crush existing investors while making it tough to for Aurora to turn a meaningful future per-share profit.
I find myself favoring the middle ground here. While Aurora's market-leading production and distribution channels can't be ignored, its ongoing dilution, along with supply uncertainties, may hold its share price back. Watching from the safety of the sidelines seems like a prudent move.
