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Wall Street Just Upgraded This Popular Pot Stock, but You Should Avoid It Like the Plague

By Sean Williams - Feb 19, 2020 at 6:36AM

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Make no mistake about it, more bad news awaits this cannabis company.

To say that marijuana stocks have had a bad go of things over the past 10-plus months would be a bit of an understatement. The vast majority of cannabis stocks have lost at least half of their value since hitting their yearly highs during the first quarter of 2019, with some even pushing to multiyear lows.

Why, you ask? Look no further than the growing pains that the cannabis industry is contending with. Canada has dealt with both supply shortages and bottlenecks, which is keeping legal-channel weed out of the hands of consumers, while a number of key U.S. states are struggling with the wide pricing gap between legal weed and black market pot created by high tax rates on legal cannabis.

These struggles have been particularly apparent for shareholders of Aurora Cannabis (ACB -3.62%), the most popular pot stock in the world. Shares of Aurora are down about 85% over the past 11 months, with well over $7 billion in market cap being wiped out over that period.

Silver dice that read buy and sell rolling across a digital screen containing volume and price information.

Image source: Getty Images.

Say what? A Wall Street firm actually upgraded Aurora Cannabis?

Yet, according to one Wall Street firm, the short thesis on Aurora Cannabis isn't a recommended option at this point.

Before the opening bell on Friday, Feb. 14, MKM Partners' covering analyst Bill Kirk channeled a bit of Valentine's Day spirit and upgraded Aurora Cannabis to neutral from sell. However, he also lowered his firm's price target on the company from 2 Canadian dollars ($1.51) to CA$1.75 ($1.32), which actually represents 10% downside from when the research note was released by Kirk, and 16% downside from where Aurora ended the week.

Why upgrade the most popular pot stock? According to the note released by Kirk, it has everything to do with the near-term quarter for Aurora being "largely de-risked." Having recently reported its fiscal second-quarter operating results, Aurora called for flat to modest revenue growth and announced a number of debt covenant adjustments that pushed any immediate concerns about its liquidity a bit further down the road.

Of course, even with this upgrade, Kirk isn't convinced that the worst is behind Aurora Cannabis. In the released research note, Kirk is skeptical that the company will be profitable by the fiscal first quarter of 2021 (ended Sept. 30, 2020), and expects additional writedowns down the line. 

An up-close view of a flowering cannabis plant growing in an indoor commercial farm.

Image source: Getty Images.

Ignore this upgrade and steer clear of Aurora Cannabis

While it is true that Aurora Cannabis' revamped management team looks to (finally) be coming clean about the company's ugly balance sheet and is making a number of tough choices, including laying off 500 workers to reduce expenditures, this isn't a business that's deserving of your investment dollars.

For one, the company has already guided to the very real possibility of zero growth for the fiscal third quarter. That's highly disappointing for a company that's been a marijuana production leader for multiple quarters and is angling to produce a profit within the next three quarters after delivering its largest EBITDA loss in history in the fiscal second quarter. In other words, Aurora Cannabis has a poor track record of delivering on its earnings-based promises, so investors shouldn't exactly take management's word that Q1 2021 will yield positive EBITDA, or that Q3 2020 will even hit CA$65 million in sales, as noted in the company's outlook.

I also firmly believe that Kirk is correct in believing that additional writedowns are warranted. While I wasn't surprised to see Aurora take a CA$762.2 million writedown on its goodwill, what did shock me is that a good chunk of its impairment was tied to its overseas assets and not its MedReleaf acquisition. It's my belief that the MedReleaf deal will go down as the worst deal in marijuana history, with Aurora paying CA$2.64 billion for two facilities (Markham and Bradford) that can produce a combined 35,000 kilos of weed per year. The Exeter greenhouse, which when retrofitted was expected to produce 105,000 kilos per year, is now for sale by Aurora for just CA$17 million. Thus, Aurora paid CA$2.64 billion for 35,000 kilos of output and MedReleaf's brands. There's no doubt in my mind that much of this CA$2.64 billion won't be recouped and will lead to a future writedown.

A clear jar packed with cannabis buds that's lying atop a small pile of cash.

Image source: Getty Images.

Although the bulk of Aurora's debt repayment isn't due until 2024, financing also remains a major concern. In spite of removing its EBITDA ratio covenants, the need to generate positive EBITDA by Q1 2021 to satisfy the newly revised covenants looks to be far from a guarantee.  Aurora is aiming for CA$40 million to CA$45 million in selling, general and administrative (SG&A) expenses by Q4 2020 after just producing CA$99.9 million in SG&A expenses in Q2 2020, which included higher salaries and benefits for certain employees. Transformations don't happen overnight, especially in such a nascent industry.

As one last note, Aurora Cannabis is still going to have to contend with issues that are beyond its control. In Ontario, for example, regulators are now vetting dispensary license applications traditionally, as opposed to using a lottery system. But we're still a few months from seeing a rush of new store openings in Canada's most populous province. It's going to take time before enough retail outlets exist to relieve supply bottlenecks in the region, which means ongoing struggles for Aurora Cannabis and its peers.

As I stated when the year began, Aurora Cannabis remains a marijuana stock to avoid like the plague in 2020.

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