Source: seeking alpha

Recreational pot has been a positive and negative for the overall industry, as its legalization in Canada has put cannabis on the global map, while at the same time, because of current restraints on how it can be sold, puts downward pressure on price per gram and shrinks margins.

With recreational pot sales, for now, becoming a larger percentage of Aurora Cannabis’ (ACB) revenue, investors need to understand how to view that in relationship to the impact on the company.

In this article, we’ll look at how Aurora Cannabis has been managing the increase in recreational sales, and why it still remains on track for turning cash flow positive before the end of 2019.

Recreational sales in Canada

As had been expected since the decision by Canada to legalize recreational pot, supply has been struggling to match demand. Consequently, that has resulted in lower sales than some have expected, although as it relates to Aurora, it hasn’t been an issue, as its recreational sales are jumping; now accounting for a little over 50 percent of its revenue as of the last reporting period.

While it has done well in this regard when measured against its peers, it still could and will do better as it continues to boost its extraction capacity, allowing it to sell higher-margin cannabis oil into the market.

There can be no doubt the company doesn’t want to sell any more dried flower than it has to, as it generates lower price per gram and shrinks margins.

In Canada at this time, recreational pot customers exceed medical pot users, and that points to an increasing amount of adult-usage as a percentage of revenue for Aurora in the near term. By near term I’m thinking possibly as long as a year or so. The key there will be how rapidly it grows out international medical sales. That will determine the ratio.

The trend for Aurora is already moving in that direction, as in the prior reporting period, recreational pot accounted for 45 percent of overall sales, and in the last reporting period, it jumped to slightly over 50 percent. That will continue until recreational pot demand is met in Canada.

As for price per gram on the flower side, it dropped 6 percent for the company, primarily because it had more recreational sales to the provinces (wholesalers). That, limited oil inventory, and recreational users tending to prefer lower cost dried flower, all contributed to lower price per gram. That should improve incrementally going forward.

Third-quarter recreational sales finished at C$29.6 million, up 37 percent from the prior quarter, while medical sales climbed to C$29.1 million, a gain of 12 percent from the second quarter.

The good news is the company is driving costs down so quickly it’s more than offsetting the temporary lower prices associated with the changing product mix.

Declining costs

There are three major things driving down costs for the company. They include an increase in international medical cannabis sales, recently completed high-quality facilities, and the boost in extraction capacity.

Sky Class facilities

A major competitive advantage Aurora has is its Sky Class facilities, which are starting to be completed and fully planted, as in the case of Aurora Sky and Bradford.

The other two notable facilities are Aurora Nordic 1 and Aurora Sun. Aurora Nordic 1 is projected to be have its first saleable harvest by the fourth fiscal quarters, with sales expected to begin in December 2019. That assumes regulatory approval has been provided by that time. Aurora Sun should be ready for planting in the middle of calendar year 2020. A notable comment from management in its earnings report was the facility would be 33 percent larger than it was originally planned for, now coming in at 1.62 million square feet.

Scaling of production capacity will help drive costs much lower than the C$1.42 per gram in the third quarter, a decline of 26 percent sequentially. The company says it should be able do drive costs per gram well below C$1.00.

It’s important to note that this isn’t only coming from increased square footage, but improving yields as well.

International medical cannabis sales

International medical cannabis sales in the third quarter finished at C$4 million, a gain of 38 percent. Although this is only roughly 6 percent of the net revenue of Aurora Cannabis, it is growing faster than recreational pot sales are.

Why this is significant is medical cannabis command a higher price overseas than it does in Canada. And while Canadian medical cannabis is higher priced than domestic adult-use pot, it isn’t priced as high as medical cannabis sold in Europe.

The company was constrained in the last quarter because of inventory shortages that reduced revenue potential, that is rapidly being solved by the increase in production capacity.

As this quickly ramps up, it’ll have a positive impact on revenue, earnings and margins. This is where the future performance of Aurora will primarily come from.

Extraction capacity

A short-term factor that did somewhat limit its performance in the third quarter was its extraction capacity. Extract sales in the last quarter were C$8.5 million to medical customers, and C$2.2 million sold to recreational users. Combined, it accounted for about 18 percent of total revenue in the reporting period.

In response to demand, the company has plans to increase extraction capacity from a little under 7,000 kilograms per quarter to approximately 16,000 kilograms in its fiscal first quarter. For now the majority of that will be allocated to cannabis oils, which enjoy higher prices.

Production costs per gram dropped 26 percent in the last quarter, and expectations are it will continue to do so as the impact of the above initiatives are fully realized and in play.

Adjusted EBITDA in the quarter was $36.6 million, down 20 percent, and management continues to guide for positive cash flow or EBITDA by the fourth quarter.

Conclusion

Recreational pot sales in Canada will increase in percentage of sales for a time with Aurora Cannabis, but it’s one of the few companies in the world that can absorb the lower priced segment and continue to improve EBITDA.

Essentially what investors need to consider is all these parts are moving together, yet even in its most challenging product mix environment, Aurora Cannabis is managing to maintain its growth trajectory without sacrificing costs. It’s able to do this at the beginning stages of its increase in capacity, and it’s only going to get better.

Recreational Canadian pot will continue to be an important part of Aurora’s revenue for some time, but it’s going to rapidly change the product mix going forward, and as it does, margins and earnings are going to improve, and it’s going to consistently grow revenue and earnings for a long time into the future.

Because of efficiencies, recreational pot isn’t going to be the potentially negative performer it’ll be for other companies that don’t have the discipline and skills to drive costs down to the level Aurora’s management has been able to, and continues to improve upon.

While I still maintain my thesis that revenue will continue to be the main catalyst for Aurora Cannabis, as time goes on and the cannabis market matures, investors will start looking for companies that can produce positive earnings as well, and it’s hard to see anyone that will surpass Aurora Cannabis as the company stands today.

Disclosure: I am/we are long ACB. 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.