Is Aurora Cannabis the Best Pot Stock to Own Now?

George Budwell, The Motley Fool - finance.yahoo.com Posted 5 years ago
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Marijuana stocks might represent a once-in-a-lifetime investing opportunity. This emerging market, after all, is projected to grow its annual sales by over 35% per year for the next five years in a row. What's even more impressive is that some key industry insiders believe that red-hot growth pace may last for upwards of a decade or more -- resulting in a market with sales in excess of $500 billion per year.

Which marijuana stocks are best positioned to take advantage of this rapidly rising tide? While a solid argument can be made that some of the smaller entities might represent the best overall values, the largest producers of cannabis are clearly the safest ways to invest in this risky space. Cowen analyst Vivien Azer, for example, recently pegged Aurora Cannabis (NYSE: ACB) as the firm's top cannabis pick because of its industry-leading 575,000 kilogram peak annual cultivation capacity. 

Close up image of a marijuana flower.
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Image Source: Getty Images.

The case for Aurora

Before diving into the details of any specific cannabis-oriented company, it's important to understand the dynamics of this rapidly maturing space. The Cliff's Notes version of the story is that most marijuana companies are likely to fold within the next two years: The Canadian medical and recreational markets are expected to be grossly oversupplied soon, a situation that will lead to brutally low gross profit margins within some of the most popular product categories like dried flowers.   

In that harsh economic environment, peak production capacity will be critical to a cannabis company's ability to survive and develop a viable competitive moat -- for three core reasons:

  • Large operations come with economies of scale that reduce all-in production costs. As gross profit margins shrink across the industry, cost control will thus be a major competitive advantage. 
  • Companies with top-shelf production outputs can expand more quickly and broadly into derivative cannabis markets, as well as international markets.   
  • Growing large amounts of cannabis, across numerous independently operated facilities, lowers the risks associated with singular crop failures or poor quality control at individual grow sites.  

Where does Aurora Cannabis stand in terms of production capacity relative to the broader field? It's on track to overtake Canopy Growth (NYSE: CGC) as Canada's top cultivator, and after its recent acquisition of ICC Labs, it may be able to produce an astounding 700,000 kilograms per year.

Now, Canopy could decide to ratchet up its production in the wake of  its nearly $4 billion tie-up with beverage-giant Constellation Brands (NYSE: STZ) last year. But Aurora will -- at a minimum -- be Canada's second-largest cannabis producer once the dust settles. And that fact alone makes it a fairly safe bet to survive the forthcoming period of oversupply and tighter margins. 

Apart from the company's ability to weather this upcoming storm, Aurora also offers investors several levels of deep value that simply aren't found in most other cannabis stocks. With a footprint in a whopping 24 countries, 11 production facilities in operation, four top-notch recreational brands on the market, multiple subsidiaries that span the entire value chain, and a host of strategic partnerships in place, Aurora is light years ahead most its competitors in terms of business development. 

All told, Aurora has the scale and operational bandwidth to create significant value for its shareholders. 

The case against Aurora

Aurora does have its fair share of drawbacks as a marijuana investing vehicle, however. Here are the three biggest issues in no particular order:

  • Aurora has not sealed a major partnership with a beverage giant or tobacco titan. Such deals come with obvious financial benefits, but they also dramatically increase a company's access to commercial know-how and regulatory expertise, and strengthen internal controls. 
  • Aurora's hyper-aggressive growth-by-acquisition strategy -- which put it at the forefront of the cannabis space -- has also led to tremendous amounts of shareholder dilution. Without a partner to fund further expansion, more dilution could be coming. 
  • Integrating a diverse range of businesses is a daunting task even under the best of circumstances. As such, there's the real risk that Aurora will fail to capitalize on the latent synergies across its motley assemblage of subsidiaries and strategic partnerships, possibly resulting in a bloated, unprofitable company.

The take-home point is that Aurora does have a number of considerable challenges it will need to overcome in order to realize its full potential as an alpha dog in the cannabis sector.  

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Verdict

If your goal is to invest in a relatively safe marijuana stock with reasonable growth prospects, Aurora and Canopy are probably your two best choices. They're poised to dominate the cannabis market in the years to come.

So, the real question boils down to which is the better buy today. On a pure valuation basis, Aurora is the clear winner. At current levels, its shares are trading at about 10 times the company's estimated 2021 sales; Canopy's shares, on the other hand, are presently trading at nearly double that ratio. 

On a risk-assessment basis, though, Aurora simply doesn't compare to Canopy, which has the backing of a major partner in Constellation Brands and a clear path toward sustained profitability as a result. Aurora still needs to figure out how to arrange its various acquisitions into a coherent whole -- a problem that has caused serious headaches for other serial acquirers. 

Bottom line: Canopy may be the more expensive stock by a wide margin, but it also offers a far more transparent investing thesis than Aurora. And there's a lot to be said about knowing what you are investing in -- compared to speculating on what could be in the event that all the stars align. As such, Aurora doesn't appear ready to unseat Canopy as the "best" pot stock to own right now -- and the market seems to agree with this assessment based on their respective valuations. 

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George Budwell has no position in any of the stocks mentioned. The Motley Fool recommends Constellation Brands. The Motley Fool has a disclosure policy.