Aurora Cannabis: Some Faint Positives

The unconstrained cannabis cultivation capacity growth in Canada is finally seeing some cuts.

Aurora Cannabis remains on pace to produce enough cannabis to supply the estimated total demand in Canada for 2021.

The August inventory data shows a market with mushrooming supply, while sales growth is steady as new retail stores rollout.

A recent revenue estimate cut by Seaport Global questions the current $4 billion market valuation of the stock.

My biggest warning on the Canadian cannabis stocks was the massive flood of supply hitting the markets led by Aurora Cannabis (ACB). Some recent production curtailments offer faint hope in the industry, but the large players still need to participate in cutting production goals to make the stock a buy based on August inventory levels.

An investor in Aurora Cannabis needs to look no further than this company to question the supply flood. The company has long promoted the building of greenhouses with the capacity to reach annual production of nearly 700,000 kg.

The latest October presentation appears to exclude the slides on capacity goals along with a list of greenhouse facilities. Going back to a previous presentation, Aurora Cannabis detailed the goal of topping 625,000 kg in capacity by mid-2020.

The company is producing 128,000 kg in Denmark so one can argue that only 500,000+ kg of production is destined for the domestic Canadian market. Either way though, Aurora Cannabis is on the pace to produce nearly an equal amount to the 734,000 kg forecast by the government to cover all of the 2021 cannabis user demand in Canada. The Parliamentary Budget Office predicted total cannabis demand in 2018 at 655 metric tons (655,000 kg) when including illicit markets growing to 734 metric tons by 2021.

A big key here is this equates to total demand, while illicit demand will remain a major force due to lower prices and avoidance of paying excise taxes. Even at a legal cannabis price of C$6 per gram, the legal market would only capture 65% market share or the equivalent of selling 477,000 kg in 2021. In this case, Aurora Cannabis has the projected supplies in Canada alone to top the demand for legal cannabis sales.

The faint hope here is that Aurora Cannabis has already gotten competitors to blink with both Zenabis Global (OTCPK:ZBISF) and HEXO (HEXO) cutting back on production expansion.

This doesn't even count the regulatory issues faced by CannTrust (CTST). The company had goals to produce at least 200,000 kg by 2020 that might never enter the supply stream now.

The biggest problem with any hope of a market equilibrium is the already massive inventory balances held by cultivators, distributors, and retailers. For August, Health Canada estimated the dried cannabis sales grew by 10.5% for an additional 1,225 kg sold in the month while inventories grew by 39,225 kg.

The issue is that total sales are growing at monthly rates far swamped by sales growth. The industry still has over 30 months of supply based on the monthly dried flower sales rate of only 12,917 kg.

Even the planned curtailments by Zenabis Global and HEXO are from plans of doubling and tripling existing facility production capabilities. As an example, Zenabis only produced slightly above 5,000 kg in Q3, and the company still plans to ramp production to nearly 50,000 kg per quarter by mid-2020.

In that last quarter alone, Aurora Cannabis produced 29,034 kg and Canopy Growth (CGC) topped 40,906 kg harvested in the quarter. So far, neither company has hinted at supply restraints going forward, and the market will move on their shifts.

For these issues with tons of supply and slow sales due to limited retail stores, Seaport Global recently slashed the FY21 revenue estimates for Aurora Cannabis to only C$410 million. The analyst has the company generating only $310 million in annual sales, while the stock still trades at a market value of nearly $4.3 billion based on 1.2 billion fully diluted shares outstanding.

The key investor takeaway is that the stock still appears very expensive at over 10x FY21 sales estimates. The potential for stable stock prices comes from some curtailment of cannabis production growth while hopefully leading to the analyst estimates lowered too far with the benefits for Cannabis 2.0 starting in 2020.

At this point, the stock isn't appealing until more production growth is cut, with Aurora Cannabis taking a leadership position. The faint positives are an indication more moves will occur to switch the supply/demand equation in 2020.

I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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