U.S. markets closed
  • S&P 500

    +26.83 (+0.59%)
  • Dow 30

    +294.61 (+0.82%)
  • Nasdaq

    +78.81 (+0.55%)
  • Russell 2000

    +53.62 (+2.96%)
  • Crude Oil

    -1.58 (-2.08%)
  • Gold

    +34.50 (+1.68%)
  • Silver

    +0.24 (+0.92%)

    -0.0008 (-0.08%)
  • 10-Yr Bond

    -0.1260 (-2.90%)

    +0.0086 (+0.68%)

    -1.4040 (-0.95%)
  • Bitcoin USD

    +975.80 (+2.59%)
  • CMC Crypto 200

    +11.20 (+1.41%)
  • FTSE 100

    +75.60 (+1.01%)
  • Nikkei 225

    -55.38 (-0.17%)

The Most Popular Pot Stock Was Downgraded, but for the Wrong Reason

It's no secret that marijuana stocks are creating quite a lot of buzz on Wall Street. Over the past couple of years, some of the biggest pot stocks by market cap have delivered quadruple-digit-percentage gains, fueling hope that there are other marijuana stocks that could deliver life-changing long-term gains. And the big sales figures forecast by Wall Street over the next decade certainly suggest additional upside may eventually be warranted.

However, even the fastest-paced industries encounter growing pains. The Canadian cannabis industry has limped out of the gate rather than exploding, while recreational weed sales in California badly missed the mark in 2018 as extremely high taxes on legal product contributed to a resurgence in black market production and illicit sales.

An up-close view of a flowering cannabis plant.
An up-close view of a flowering cannabis plant.

Image source: Getty Images.

Investors seemingly can't get enough of Aurora Cannabis

These challenges aside, it hasn't stopped investors (especially millennials) from buying into Aurora Cannabis (NYSE: ACB), the so-called most popular pot stock. That's because Aurora Cannabis is the most-held stock on online investing app Robinhood, whose approximately 6 million members average 32 years in age.

Aurora Cannabis is commonly held because it projects as the leading producer at peak capacity in one of the fastest-growing industries on the planet. It's currently leading all growers at an annual run-rate of 150,000 kilos of cannabis, but looks to support at least 625,000 kilos of yearly run-rate output by the end of fiscal 2020 (June 30, 2020). Just a small number of peers will yield even half of what Aurora can produce in a given year.

Its popularity also derives from its vast international presence. It currently operates in 25 countries, including Canada, with Canopy Growth its closest overseas competitor at 16 countries. These overseas markets should be Aurora's saving grace if and when domestic oversupply and commoditization of dried flower becomes a problem in Canada.

In other words, Aurora's leading production (highlighted by 15 grow farms), its geographic diversity, and its focus on medical marijuana patients -- who are known for purchasing higher-margin derivative products relative to adult-use consumers -- should all be catalysts that push this stock higher, in the eyes of investors.

A businessman in a suit giving the thumbs-down sign.
A businessman in a suit giving the thumbs-down sign.

Image source: Getty Images.

The most popular pot stock was just downgraded

However, these catalysts weren't enough to stop Bank of America's Christopher Carey from downgrading Aurora Cannabis on Thursday, July 18. Carey wound up lowering his firm's rating on the company from buy to neutral, and reduced Aurora's price target by 20% to $8 from $10.

The thesis for Carey's downgrade is that Aurora could soon face a cash crunch. In Carey's (and B of A's) estimate, Aurora ended its fiscal third quarter with around $490 million Canadian ($374 million) in cash and accessible capital on its line of credit. But with development costs of CA$270 million for its major remaining projects, maintenance costs of existing cultivation farms of around CA$100 million a year, and other expenses, Aurora could burn though CA$420 million between fiscal Q4 2019 and fiscal Q3 2020, leaving it with a mere CA$70 million in cash and accessible credit by the end of March 2020.

The concern that Carey and his team raised to clients in the rating and price downgrade is that Aurora Cannabis also has CA$230 million in convertible debt that's due in the first quarter of 2020 (calendar year, not Aurora's fiscal year). If Aurora's share price doesn't surpass the CA$13.05 a share needed for these notes to be converted into shares of common stock, the company will be on the hook for the cash value of this debt. That could mean issuing more debt to pay off the upcoming convertible notes, or simply leaning on its $750 million shelf offering (that's in U.S. dollars).

Dilution has certainly been prevalent with Aurora over the past five years, with its share count growing by 1 billion outstanding shares, and Carey seems to think that the company's financial needs warrant caution in the interim.

A person holding cannabis leaves in front of a globe of the Earth.
A person holding cannabis leaves in front of a globe of the Earth.

Image source: Getty Images.

Here's a much better reason to be cautious on Aurora Cannabis

While I don't disagree with Bank of America's downgrade of Aurora, as it's a company that has traded at a substantial premium for some time now (all while diluting shareholders with an aggressive acquisition strategy), I don't believe financing concerns are the most up-front reason to be cautious. Rather, I believe the exceptionally slow ramp-up of recreational cannabis sales in Canada, and the subsequent impact that could have on the international markets, is a better reason to keep away.

Aurora may very well be the kingpin of the international market -- and these overseas sales are very important to its long-term profitability. Remember, with only Uruguay having legalized adult-use weed outside of Canada, the more than 40 countries worldwide that have waved the green flag on cannabis have done so entirely for medical purposes. And medical pot patients tend to generate much higher margins for marijuana companies than do recreational consumers.

The problem, though, is that in order for the international markets to thrive, Health Canada is counting on growers to satiate demand in the domestic Canadian markets first. It sounds easy to do, with "only" an estimated demand of, say, 800,000 kilos to 1 million kilos per year. But the early data shows that growers aren't selling anywhere near enough marijuana to meet consumer demand.

Canada has been contending with a host of supply issues, including a shortage of packaging solutions, and regulatory agency Health Canada being bogged down by licensing requests. Plans are in place to work through these challenges, but the fix isn't going to happen overnight. That means we may not see international markets really start thriving as a result of Canadian exports for years to come. This, not financing concerns, is the real reason to temper your expectations on Aurora.

More From The Motley Fool

Sean Williams owns shares of Bank of America. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.