Ready or not, folks, it's earnings season for the marijuana industry, and arguably the most popular and polarizing of all pot stocks kicked things off after the closing bell on Monday, Feb. 11.
Depending on the day and its constant dance with Tilray, Aurora Cannabis (NYSE:ACB) is either the second- or third-largest marijuana stock by market cap behind Canopy Growth, and it's forecast to be the clear leader in peak production, once it's running on all cylinders. Conservatively, Aurora Cannabis has called for in excess of 500,000 kilograms in peak annual output, but yours truly believes that once more than 1.1 million square feet of under-construction greenhouses owned by ICC Labs is complete (Aurora purchased ICC Labs recently), it could push for 700,000 kilos in peak output per year. With the exception of Canopy Growth, no other grower currently looks to top 255,000 kilograms in a given year at their peak.
Aurora allows investors a look under the hood
Given Aurora's seat at the head of the production table -- and its clear popularity with millennial investors -- its earnings report was bound to be one of high interest (pardon the pun).
In many ways, Aurora delivered exactly what was expected of it. Having previously guided to between 50 million Canadian dollars and CA$55 million in quarterly sales, the company reported CA$54.2 million, nearing the upper end of its forecasted range. It wound up recording CA$21.6 million in recreational marijuana sales, with a modest uptick in medical marijuana revenue from CA$24 million in the sequential first quarter to CA$26 million in the reported second quarter. This will likely flip-flop come Q3 2019 and beyond as recreational weed sales take off and supply shortage issues begin to work themselves out in select provinces.
Aurora Cannabis is also well on its way with regard to production. Having only been producing at an annual run rate of 45,000 kilos back in September, the company announced on Monday that it's now operating at an annual run rate of 120,000 kilos, with the expectation that it'll be on track for in excess of 150,000 kilos by the end of its fiscal third quarter (March 31, 2019). No other grower is even remotely close to producing what Aurora is capable of producing, and it shows, with the company's press release citing Health Canada data that it sold a fifth of all cannabis in Canada between Oct. 1, 2018, and Dec. 31, 2018.
Aurora is also doing what it can to improve its future operating margins, which sank in the latest quarter due to the introduction of recreational marijuana excise taxes, and lower wholesale pricing. The company aims to focus more on medical pot patients, who traditionally use high-margin cannabis alternative products, such as softgel capsules and cannabidiol oils, more frequently than recreational weed consumers.
This number should seriously worry Aurora's shareholders
However, there was one number in Aurora Cannabis' earnings report that looks downright dangerous, and which, I'm willing to admit, escaped my own attention on an initial pass of the company's income statement filed with SEDAR in Canada. I know what you're probably thinking, given my dislike for Aurora's share-based dilution and operating losses, but I assure you, it's not the company's comprehensive loss or its rising share count. Rather, it's Aurora's ballooning goodwill.
Goodwill is an accounting term that describes the premium that a purchasing company pays when it acquires another company. Basically, goodwill is what's left over after tangible assets, such as cash, factories, inventory, equipment, and so on, are accounted for.
Some goodwill is to traditionally be expected when making an acquisition. In order for one company to acquire another, the pot needs to be sweetened (yes, another cannabis pun). A purchasing company is often willing to pay a reasonable premium over the actual assets it's acquiring because it expects to offset this goodwill at some point in the future. Be it a company's proprietary products, its branding, cost synergies, tenured management, or something else, goodwill is itself not a bad thing, if it's reasonable.
When it comes to Aurora Cannabis, the company's goodwill has skyrocketed from CA$760.7 million as of June 30, 2018, to CA$3.06 billion as of Dec. 31, 2018. With the company's total assets working out to CA$4.88 billion, this means goodwill represents 63% of Aurora's total assets. Or, in another context, Aurora Cannabis may have grossly overpaid for the companies it has acquired.
How did Aurora's goodwill balloon so quickly? As noted on page 20 of its interim financial statement filed with SEDAR, CA$2.1 billion of its CA$2.64 billion purchase of MedReleaf was allocated as goodwill. Likewise, half of the CA$262.9 million purchase price of ICC Labs was ascribed as goodwill. Aurora's two other acquisitions during the quarter, Anandia and Agropro, also had more goodwill assigned than actual assets relative to the final purchase price.
Understandably, with the cannabis industry still in the early stages of its existence, there's bound to be added premium in every acquisition. For instance, I'm sure Aurora Cannabis is counting on the retrofit of MedReleaf's Exeter facility, use of the adjacent land to the Exeter facility, and the company's premium cannabis brands to close some of this goodwill gap. But at some point as an investor, you also have to recognize that enough is enough and the intangible risk outweighs the potential for reward. With 63% of its assets now recognized as goodwill, and another CA$688.8 million in intangible assets on its balance sheet, the company only has about CA$1.1 billion in actual/tangible assets to lean on out of CA$4.88 billion in total assets. That's really, really scary.
To put things mildly, if Aurora's gamble doesn't pay off, we could see massive writedowns impacting the company's already challenged bottom line within the next couple of years.
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