Auxly Cannabis: target down but still a buy, says Research Capital

Research Capital Corporation analyst Venkata Velagapudi has slightly altered his stance on Auxly Cannabis (Auxly Cannabis Stock Quote, Charts, News, Analysts, Financials TSX:XLY), reiterating a “Buy” rating but reducing his target price from $0.50/share to $0.45/share for a projected return of 67 per cent in an update to clients on Monday.

Originally founded in 1987 as Cannabis Wheaton Income Corp. before changing its name in 2018, Auxly Cannabis is a Toronto-based consumer-packaged goods company in the cannabis products market in Canada with a focus on developing, manufacturing and distributing cannabis products for wellness and recreational consumers.

Velagapudi’s latest analysis comes after the company reported its third quarter financial results, with Velagapudi attributing the target drop to lower profitability estimates.

“Auxly will continue to gain market-share in Canada, mainly driven by Auxly’s strong position in manufacturing cannabis 2.0 products, the company’s strategic partnership with Imperial Brands and a strong product pipeline,” Velagapudi said. “In our opinion, a sustainable market-share in the Canadian adult-use cannabis market should mainly determine a Canadian LP’s intrinsic value.”

The company’s report was headlined by $24.5 million in revenue, a 95 per cent year-over-year improvement as well as representing 17 per cent sequential growth. The result beat the Research Capital projection of $23.3 million for the quarter, though it came in slightly below the consensus expectation of $24.7 million.

Auxly reported an adjusted EBITDA loss of $6.5 million in the quarter, significantly missing on the $2.6 million loss projected by the consensus, as well as the Research Capital projection of a $2.7 million loss.

Velagapudi’s analysis noted Auxly’s position as a market leader in several categories of cannabis 2.0 and cannabis 1.0 portfolios, though he also noted that the company’s revenue mix has changed over the course of the year, with Cannabis 1.0 products now accounting for 31 per cent of Auxly’s revenue with the rest derived from Cannabis 2.0 product sales, i.e., cannabis derivatives such as edibles, compared to 20 per cent from Cannabis 1.0 products in the same quarter of 2020.

Consequently, the company’s gross margin has dropped off with a report of 17.6 per cent in the quarter compared to the Research Capital estimate of a 36.7 per cent margin, with the higher costs related to the production of new products (mainly pre-rolls) and one-off cost of $700,000 related to write down of packaging materials.

“We have continued to prudently invest in the people, assets and capabilities that we believe are necessary to win in our chosen consumer segments and product categories and our success in the consumer market is a testament to our focused strategy and our commitment to putting our consumers first and foremost in everything we do,” said Hugo Alves, CEO of Auxly Cannabis in the company’s November 15 press release. 

“As we finish building our asset base, we will focus on cost optimization and increasing operational throughput efficiencies to enhance margins and increase profitability. We will continue to work tirelessly to serve our consumers by offering them innovative, quality products at a great value under brands that they can trust and love. We are just getting started and we could not be more excited for the future,” said Alves.

Despite the target drop, Velagapudi continues to see solid future growth for Auxly, projecting an increase to $81 million in revenue in 2021 from the $51 million reported in 2020 for a potential year-over-year increase of 58.8 per cent, with projections of breaking into nine figures in 2022 ($129 million, 59.3 per cent potential year-over-year increase) and 2023 ($179 million, 38.8 per cent potential year-over-year increase), which is also when the company’s EBITDA is projected to turn positive at $16 million for a margin of nine per cent.

Velagapudi also expects the company’s gross margin to settle in at 24 per cent for both 2021 and 2022 before spiking to a forecasted 33 per cent in 2023.

Despite the slight target drop, Velagapudi believes Auxly is undervalued considering its current market share and valuation, while also noting consistent improvement in the company’s adult use cannabis market share as well as positive changes to the Canadian regulatory framework as potential catalysts for the company’s growth.

“Over the long term, we believe that visibility over positive free cash flow generation will be critical in improving the valuation for Auxly,” Velagapudi said. “Although we expect the margins to dilute due to the growing portion of cannabis 1.0 sales, we believe that the growing revenue base will offset the impact of declining margins leading to an increase in EBITDA gradually.”

So far in 2021, Auxly’s share price is now down about one per cent. The stock topped out at $0.49/share on February 10 before hitting a decline, though it has rebounded slightly since bottoming out at $0.21/share on October 15.