Millennials still believe in Aurora Cannabis (TSX:ACB)(NYSE:ACB) after the stock’s massive 66% peak-to-trough plunge. But could they get hurt by catching the falling knife with no signs of slowed negative momentum and a potential price war on the horizon?
Moving on from a forgettable first year of legalization
The lights went out on the cannabis sector following nationwide legalization, a time when I warned investors to take their profits off the table over concerns that the black market would continue to thrive in a post-legalization era.
“At this point, it looks like the black market may become a major issue, since the cost per gram of [legal] marijuana is expected to become high, especially if regulators slap a more aggressive tax than expected.” I said in a prior piece.
I called the sky-high demand for legal cannabis, a catalyst that many investors going into legalization were betting on, a “hallucination,” also noting that the black market had more than enough capacity to “fulfill the needs of pot users” and that licensed producers (LPs) would need to “take a hit on the chin to keep [legal marijuana] prices attractive” to deal with the pesky black market.
After going through a federal election that didn’t draw nearly enough attention to the state of legal weed in year one and how to better combat the black market, it seems as though LPs are going to have to take things into their own hands to narrow the legal-to-illegal cannabis price spread, which continues to widen.
Aurora could come out a winner in a potential price war
Aurora Cannabis has solid margins relative to its peers in the space, and while it looks to be a top contender on the road to profitability, not even Aurora will be able to dodge the bullets that could come with a price war that would take a big slice out of margins.
Lower margins over the intermediate term mean profitability will be farther away, which is a massive turn-off for investors who are looking for a sustainability move into the green.
Fighting the black market should really be seen as a double-edged sword, though, not just a mere killer of margins and profitability hopes.
With HEXO poised to produce its own line of budget bud, Aurora and other LPs are likely to follow suit and drive down the price of legal weed.
Although margins would initially flop in such a scenario, the massive amount of sales lost to the black market (40% of cannabis consumers get their weed from the black market) will go right into the top-line of the LPs, resulting in massive top-line growth numbers.
Lower margins, higher sales. That’s not necessarily a bad thing in the grander scheme of things when you consider margins are steadily improving for innovative cultivators like Aurora. For poorly-capitalized firms with lousy margins and low bud yields, though, lower margins could be seen as a nail in the coffin.
Furthermore, at 19.3 times sales, Aurora isn’t exactly in “bubble” territory anymore, as many other hyper-growth stocks, including Beyond Meat, are more expensive based on traditional valuation metrics, with less impressive growth potential.
Sure, the incoming “cannabis 2.0” catalyst is encouraging for young investors who can afford to take on more risk, but as we enter what could be a violent cannabis price war to combat the black market, profitability numbers could be a lot farther away than most young investors are thinking. As such, those hoping for quick profits will be left disappointed.
However, those with a long-term horizon should look to Aurora as a top pick on the way down and view sales growth and margin robustness as the metrics to watch for as profits slip away for the time being.
Stay hungry. Stay Foolish.
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Fool contributor Joey Frenette has no position in any of the stocks mentioned.