Aurora Cannabis (ACB -2.79%) emerged as one of analysts' favorite marijuana stocks earlier this year. In March, Cowen analyst Vivien Azer picked Aurora as her top pot stock. Other analysts jumped on the Aurora bandwagon as well, including Bank of America Merrill Lynch's Christopher Carey.
But Carey recently downgraded Aurora to neutral only three months after initiating coverage on the stock with a buy recommendation. Wall Street analysts change their views on stocks all of the time, of course. But this latest downgrade for Aurora illustrates the absurdity of giving too much weight to analysts' recommendations.
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What's behind the downgrade?
Carey still had positive things to say in his note to clients last week. He wrote that "Aurora has emerged as one of the best operators in the cannabis sector, with industry-leading scale and margins even versus other large peers." And he added that Aurora has "global optionality." So far, so good.
However, Carey doesn't think that Aurora Cannabis stock is one that he can recommend buying now. Why? He noted to Bank of America Merrill Lynch (BAML) clients that Aurora is "burning cash." Carey and his team have crunched the numbers for Aurora's cash situation. Their estimates are that the company could run out of cash by the first quarter of 2020.
One problem is that there's around $177 million of convertible debentures coming due in the first quarter of next year. Those debentures could be converted into Aurora stock. However, the conversion price is 13.05 Canadian dollars per share ($9.98 per share). If Aurora's share price is below that level (as it is now), the company will have to pay off this debt.
Aurora could slow down how fast it's burning through cash. But Carey anticipates that the company will still need to raise additional capital soon. And that will probably mean more shareholder dilution is on the way.
Absurdity in action
Don't get me wrong -- Carey is exactly right. Aurora is going to need more cash relatively soon. There's a solid reason why investors should exercise caution with buying Aurora stock right now.
So why does the latest downgrade of Aurora Cannabis highlight the absurdity of Wall Street recommendations? Carey knew this could be a problem when he recommended the stock as a buy on April 17, 2019.
A few weeks after Carey's buy recommendation for Aurora, the company reported its fiscal 2019 third-quarter results. Did Aurora's spending skyrocket unexpectedly? Nope. Sure, there was an increase from the previous quarter. But Aurora's bottom line improved quite a bit despite a 16% bump in spending. In addition, Aurora stated in its Q3 conference call that operating costs should continue to decrease. The company even expects that it will achieve positive EBITDA next quarter.
To be fair, there is one potentially good reason for Carey's change in perspective. His initial recommendation for Aurora in April came with a one-year price target of $11 per share. That reflected a premium of nearly 23% over Aurora's share price at the time. Now, however, his one-year price target is only $8. Had Carey's original price target been achieved, Aurora wouldn't have had to pay off the convertible debentures that are coming due in early 2020. Holders of those debentures would have preferred to receive stock instead.
But Aurora would have needed to raise more cash regardless of what happened with the convertible debenture. Carey knew it back in April. Everyone knew it. Aurora for sure knew it. That's why the company filed a shelf registration earlier this year (before the initial BAML buy recommendation on the stock) to raise $750 million.
My biggest gripe
I don't mean to single out Carey. He's only doing what most other Wall Street analysts do. They often make calls only to reverse themselves a few months later.
My biggest gripe with analysts' recommendations is that they're short-sighted. Analysts tend to focus only on what's happening in the near term, but it's the long-term prospects that really matter when it comes to buying a stock.
If you think the long-term prospects for Aurora are mediocre, a neutral stance makes all the sense in the world. But if you believe the company should be a winner over the long run in a huge global cannabis market, the stock is a buy even if it has to raise additional cash over the short term.
My take is that Wall Street analysts actually do understand this. However, they work in a system that forces them to make short-term calls instead of focusing on the long term. And that system leads to way too much absurdity.
