When a company increases its leverage, it’s essentially becoming riskier given that all else remains constant.
Aurora Cannabis (ACB) has been taking on debt financing to grow its operations in the booming cannabis space. It’s not uncommon for companies to utilize some level of debt, primarily because it provides a tax shield that can increase returns for investors.
Comparing cannabis players
Canopy Growth (WEED) (CGC), Cronos Group (CRON), and Aphria (APHA) all have some level of leverage on their balance sheets, as we can see in the chart above. However, Aurora Cannabis’s leverage stands much higher than those of its peers, indicating a larger use of debt financing.
In its press release, Aurora Cannabis mentioned that under its recently closed senior convertible note offering, it has the flexibility to settle the entire principle in either cash, shares, or a combination of the two in the future. In the case of a share settlement, equity investors will see a dilution.
What makes this risky for investors is that in the event the company is not able to optimize the use of this leverage to grow returns that outweigh the downside of its increased leverage, equity investors’ returns will suffer. This may also explain why Aurora Cannabis underperformed its peers (HMMJ) Canopy Growth and Cronos Group in 2018.
Next, let’s discuss how higher leverage could explain Aurora Cannabis’s valuation.