Pardon the pun, but at this time last year hopes were incredibly high for the legal marijuana industry. Our neighbor to the north was preparing for the launch of high-margin derivative products, such as vapes, edibles, and infused beverages, while in the U.S. numerous states were in the process of pushing forward measures that would legalize medical or recreational pot. With tens of billions in weed sales conducted annually in the black market, the door appeared wide open for the legal market to capture a big piece of this pie.

But this wasn't to be the case. The North American pot industry has struggled under the weight of high tax rates on legal product, production shortages and/or bottlenecks, regulatory delays, and the inability to access traditional forms of financing.

Perhaps no company has been the poster-child of this disappointment more than Alberta's Aurora Cannabis (NYSE:ACB).

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

Image source: Getty Images.

Aurora's acquisition binge hasn't paid off

At one time, Aurora was the cream of the crop. Its 15 production facilities were expected to produce no less than 660,000 kilos per year, in aggregate, at their peak, with Aurora having access to two dozen markets outside of Canada. This international presence was expected to be the key to the company's success. In effect, it would ensure that domestic oversupply never threatened the company's operating margins.

Unfortunately, next to nothing has gone right. The launch of high-margin derivatives was delayed in Canada, and Health Canada hasn't exactly been proficient in approving cultivation and sales licenses in a timely manner. Meanwhile, certain provinces (ahem, Ontario) have sabotaged sales by licensing far too few retail locations. In short, Aurora's perceived-to-be leading production simply hasn't been needed.

That's a problem, because no marijuana stock was more gung-ho on the production expansion front than Aurora Cannabis. Although it does have a handful of organic projects, such as the 800,000-square-foot Aurora Sky facility that's capable of more than 100,000 kilos of output per year, most of the company's growth was the result of an aggressive acquisition strategy. The issue is that, in hindsight, virtually all of these deals turned out to be grossly overpriced. None more so than the all-stock acquisition of licensed producer MedReleaf, which was closed in July 2018.

Two men shaking hands, as if in agreement.

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Why did Aurora buy MedReleaf?

The logic behind the MedReleaf deal was simple: MedReleaf was looking to sell itself for the right price, and Aurora Cannabis was angling to be Canada's top producer.

MedReleaf offered two facilities (formerly known as Markham and Bradford) that spanned 55,000 square feet and 210,000 square feet, respectively, and would produce a combined 35,000 kilos of marijuana per year.

MedReleaf had also recently closed on a 164-acre purchase that contained the 1-million-square-foot Exeter facility. Exeter is a vegetable-growing greenhouse seated on 69 acres that, if retrofit to grow cannabis, could yield in the neighborhood of 105,000 kilos per year. In other words, Aurora was effectively buying 140,000 kilos of peak annual output and a handful of unique cannabis brands for what worked out to CA$2.64 billion in stock (about $1.87 billion U.S., as of May 3, 2020).

Eventually, Aurora Cannabis wound up classifying approximately CA$2 billion of the purchase price as goodwill -- i.e., premium above and beyond tangible assets. The idea being that Aurora would retrofit Exeter for cannabis production, potentially build another facility adjacent to Exeter on the remaining 95 acres of land, build up MedReleaf's existing brands, and reap healthy amounts of cash flow from Markham and Bradford. Through all of these actions, it would recoup its goodwill and look like a genius.

A man chewing on a pencil while closely examining figures from his printing calculator.

Image source: Getty Images.

The MedReleaf deal could sink Aurora Cannabis

But little of this plan has come to fruition, some of it through no fault of Aurora's. As noted, Canada's regulatory issues have plagued the rollout of dried cannabis flower and higher-margin derivatives throughout key provinces in Canada. This meant Aurora had to make some tough choices, one of which was to not move forward with the retrofit of Exeter and to, instead, sell the 164-acre property inherited from the MedReleaf deal. The CA$17 million asking price still hasn't been met, as of this past weekend.

While it was always going to be a costly project to get Exeter retrofit for pot production, the 105,000 kilos of peak annual output from this facility was the main reason Aurora paid so much for MedReleaf. Even if the company somehow gets its meager asking price of CA$17, its net purchase price will still be about CA$2.62 billion.

What has Aurora ultimately wound up with for that CA$2.62 billion? A handful of brand-name products and 35,000 kilos of annual output. According to MedReleaf's annual filing prior to the closing of the deal, it also had about CA$358 million in assets and nearly CA$49 million in liabilities. No matter how you rearrange the puzzle pieces, it's not even remotely close to CA$2.62 billion.

Canadian licensed producers Flowr Corp. and Supreme Cannabis Company both have the capability to produce 50,000 kilos annually at their peak, and their market caps are a respective $50 million and $73 million (both in U.S.). Keep in mind Markham and Bradford are capable of only 35,000 kilos combined. That should offer some idea of what these facilities are really worth at the moment.

Taking into account depressed valuations for property, plant, and equipment, and of course the unused Exeter facility and adjacent land, I don't see any scenario that doesn't involve a future writedown of at least $1 billion (about CA$1.41 billion). To be honest, this $1 billion figure is being generous, as it assumes a real value of CA$1.2 billion for MedReleaf, which I still believe is about 50% too high.

The point is, the MedReleaf deal has been absolutely awful for Aurora shareholders, and there's a very good chance it's not done wreaking havoc on the company's operating results or balance sheet.