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Improving Cannabis Market Fundamentals Make Aurora Stock a Buy

Luke Lango

Shares of Canadian cannabis giant Aurora (NYSE:ACB) have been on a roller-coaster ride in 2019. Year to date, ACB stock is up more than 50%. Ostensibly, that’s a huge rally. But that metric itself misses the full picture. Back in late March, ACB stock was up a whopping 90% year-to-date. Thus, since then, Aurora stock has actually dropped 25%.

Improving Cannabis Market Fundamentals Make Aurora Stock a Buy

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What’s driving this roller-coaster ride in ACB stock? Volatility in the Canadian cannabis market, coupled with a lack of visibility as to where Aurora will be in a few years. As such, ACB stock has bounced around over the past few months as investors have struggled to understand: 1) just how big the cannabis market will be, and 2) how important of a player Aurora will be in that market at scale.

These are reasonable concerns. But the present outlook is for the global cannabis market to be huge one day and for Aurora to be an important player in that market. As such, ACB stock should head higher in the long run.

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To be sure, ACB stock will need some catalyst to reverse sentiment and get the stock back on a winning trajectory. That catalyst could come over the next few months, in the form of improving cannabis market fundamentals.

Overall, then, ACB stock looks like a buy here. You have a stock on the heels of a 25% sell-off, with huge long-term growth potential, and a catalyst on the horizon to help the stock realize that long-term growth potential. That sounds like a winning recipe to me.

Aurora Stock Is a Long-Term Winner

The long-term bull thesis on ACB stock is built on three ideas. First, the global cannabis market will be huge at scale. Second, Aurora projects as an important player in that big market. Third, Aurora’s long-term profit growth potential as an important player in a huge market is not priced into ACB stock today.

On the first point, the fundamentals strongly imply that the cannabis market will be huge at scale. Just look at these drug consumption trends among U.S. high school seniors. Cannabis used to be an afterthought two decades ago, while alcohol and tobacco were all the craze. Now, tobacco is essentially irrelevant, and cannabis consumption rates are nearly equal to alcohol consumption rates.

This consumption shift makes sense. Tobacco has awful long-term effects. So does alcohol. The long-term effects of cannabis are less well understood, but to-date, have been found to be less harmful long-term than alcohol and tobacco. The same is true for near-term effects, given that alcohol can often lead to aggression, whereas cannabis does not. Hence, it is reasonable to assume that, following legalization, the global cannabis market will be huge one day — probably somewhere around $200 billion or larger.

Second, given Aurora’s huge and sustained market share, Aurora projects as an important player in that big market. In the fourth quarter of 2018, Aurora sold roughly 4,000 kilograms of cannabis in Canada, good enough for ~19% market share. In the first quarter of 2019, Aurora sold around 5,300 kilograms of cannabis in Canada, good enough for nearly 25% market share. Thus, as time has gone on, Aurora has not only maintained its market share, but actually grown it.

To be sure, Aurora’s market share will drop over time as the market gets bigger and more competitors rush in. But, given Aurora’s early sustained competitive advantage, this company does project as an important player in the cannabis market at scale.

Aurora Stock Is Arguably Undervalued

Third, given its reasonable outlook as an important player in the $200 billion global cannabis market, Aurora has tremendous long-term profit growth potential, only a fraction of which is priced into ACB stock today.

The global cannabis market will one day measure around $200 billion in annual sales. It will take a while to get there. Probably around 10 to 15 years. At that point in time, Aurora won’t control 25% of the market like it does today. Instead, the company’s market share will likely fall to around 5%. A 5% share of a $200 billion market implies $10 billion in revenues in 10 to 15 years.

Gross margins will likely scale towards and potentially even above 50%. The opex rate will likely fall towards 25%, implying operating margins of roughly 25% at scale (roughly equivalent to operating margins in the alcoholic beverage industry). A 25% operating margin on $10 billion in revenues implies $2.5 billion in operating profits. Taking out 20% for taxes, that equates to roughly $2 billion in net profits. Based on a market-average 16 multiple, that further equates to a long-term valuation target of $32 billion.

Discounting that valuation target back by 10% per year over ~12.5 years, that implies a fundamentally supported present market cap for ACB stock of nearly $10 billion. The current market cap on Aurora is under $8 billion. Thus, ACB stock is arguably undervalued relative to its long-term profit growth potential.

Improving Fundamentals Will Get Aurora Stock Back on a Winning Path

Even though ACB stock is undervalued, it has been arguably undervalued for the past several months. That hasn’t stopped the stock from trending lower. Thus, ACB stock is in need of a catalyst to turn this sinking ship around.

Fortunately, it appears that the catalyst is here in the form of improving Canadian cannabis market fundamentals. From December 2018 to February 2019, cannabis sales in Canada dropped 12% amid stagnating demand and supply shortages. But, in March, Canadian cannabis sales rose 14%. They rose another 16% in April. The catalyst? Cannabis store openings throughout Ontario, as well as inventory build to help satisfy bigger demand.

Importantly, a large number of these new proposed Ontario cannabis stores have yet to open, so that catalyst will remain in play for the next several months. At the same time, inventories have been ramping every month this year, so it increasingly looks like the supply shortage headache which has plagued the Canadian cannabis market to-date is being fixed.

Further, cannabis edibles and extracts will be available for purchase in the legal Canadian market by December 2019. The introduction of these new products will broaden and boost demand. It will also push margins higher since edibles and other cannabis alternatives carry high prices and margins.

Broadly, over the next twelve months, the outlook for increased sales volume in the Canadian cannabis market is quite favorable, and this increased sales volume should provide a lift to all pot stocks, ACB stock included.

Bottom Line on ACB Stock

Pot stocks are highly speculative, and not for the faint of heart. But for those willing to take on the risk and stomach near-term volatility, ACB stock is one of the best investments in this space. You have a relatively undervalued stock, with a ton of long-term profit growth potential, and improving macro fundamentals on the horizon. That combination should ultimately lead to ACB stock powering substantially higher over the next twelve months.

As of this writing, Luke Lango was long ACB. 

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